A small group of insurance companies have started investing in whole residential mortgages and the entire industry is going to follow their lead, according to a report by a recently assembled team at Ellington Management Group, the $10 billion hedge fund.
“You’re looking at a dramatically different mortgage world out there today which, in the last five years, has really gotten the attention of insurance companies,” said Douglas Dupont, a managing director and the head of insurance strategies at Ellington.
After the financial crisis in 2008, insurance companies effectively abandoned investing in residential mortgages. Poor underwriting by loan originators — the root of the housing collapse — spooked investors away from the asset class. Then, during the decade that followed, interest rates were so low that investments in mortgages often didn’t make sense from a relative-value standpoint.
Today, most insurance companies invest little in whole residential mortgages, generally allocating just 1 percent of their portfolio to the loans. But some outliers have emerged and Ellington expects they are precursors for the insurance industry.
Since 2018, five big life insurance companies, including MetLife and AIG, with long histories of investing in and managing whole residential mortgages have been aggressively buying loans from originators. They now account for approximately 75 percent of residential mortgage loans held on insurance company balance sheets over the past five years, or roughly $21 billion, according to Ellington. Meanwhile, a group of private-equity backed insurers developed the ability to manage mortgages and grown their residential loan portfolios from $5 billion in 2018 to over $30 billion in 2022.
Many of those loans were also given to non-qualified borrowers based on characteristics other than income. Private-equity backed insurers have become prominent capital backers of non-qualified residential mortgages — increasing their exposure from less than $1 billion in 2018 to almost $10 billion in 2022 — as traditional banks have become less interested in those borrowers and having those loans on their balance sheets. (The same happened to corporate credit; only about 20 percent is on bank balance sheets today and non-bank lenders have stepped in to serve the market, according to Ellington.) Default rates for non-qualified mortgages have fallen dramatically thanks to better underwriting, Dupont said, and research shows that non-bank loans appear to have lower credit risk relative to comparable loans. “The insurance company bid has become increasingly significant in providing a diversification of capital sources for non-QM, and residential whole loans more broadly,” Ellington explained in a note to clients expected to be published this week.
And there are plenty of mortgages to go around. The residential loan market is massive — the public market is $9.3 trillion and the private market is $3.8 trillion — and more insurance companies are going to turn to the asset class, according to Ellington.
Insurers, with their long-term liabilities, want to take advantage of higher interest rates and are seeking longer-term debt. They also want the diversification benefits that whole residential loans provide. In some asset classes, insurance companies have long had various investment options to get exposure in their portfolios. For example, life insurers are big investors in whole commercial real estate loans, which have informed their investments in the related mortgage-backed securities and collateralized loan obligation markets. Insurers want that flexibility and better informed decision making whenever they can get it. “The same thing is happening in the residential [loan] space,” John Simone, managing Director and head of insurance solutions at Ellington said.
Overall, it’s getting easier for insurance companies to make investments in residential loans, Dupont said. If they can’t originate the loans themselves, insurance companies are turning to asset managers like Ellington and some others, which have bulit platforms to manage the loans and deep analysis of the loan portfolios.
Ellington says it is already benefitting from the trend it’s prediciting.The hedge fund’s group focused on insurers, which Dupont and Simone helped start less than two years ago, has $1.8 billion of funding and commitments.
In the same report, Ellington also said in its report that it expects insurers will invest more in structured products.
“Compared to the overall industry, private equity-backed life insurers have achieved higher returns by increasing their allocations to structured products. Shifting structured products to insurers with stable, long-term capital should dampen price volatility in tail scenarios, as well as fuel demand,” the report said.
