US Housing Rebound Puts Spotlight on Real Estate by Matthew D. Bass, AllianceBernstein

With a US housing recovery in full swing, this may be a good time for investors to consider securities backed by residential real estate. We think they’re an attractive way to diversify exposure to high-yield bonds and other risk-seeking assets.

But investors looking for newly originated mortgage credit will have to get creative. Since the financial crisis, banks have been reluctant to lend, leaving government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to fund nearly eight out of every 10 new mortgages. But with housing on the mend, we expect that figure to drift down over time toward its precrisis level of 50% to 60%.

We doubt banks will rush back in to fill that gap. New regulations, higher operating costs and postcrisis lawsuits could force many banks to downsize their lending operations for good. Fewer loans mean fewer non-agency residential mortgage-backed securities (RMBS) for investors to buy.

But there’s a bright side. Instead of waiting for banks to act, investors can gain access to residential real estate credit through a new breed of public risk-sharing transactions that act much like non-agency RMBS.

Tight Lending Standards Equal Strong Credit Quality
We see this as part of a global trend in which capital providers are cutting out the middleman and moving closer to borrowers. In our view, the opportunity for capital providers is particularly attractive today in residential real estate.

Why? Mortgage-lending standards are extremely tight. Even former Federal Reserve Chairman Ben Bernanke, who commands about $250,000 per speech, admitted recently that he was unable to refinance his mortgage.

This is frustrating for borrowers, but it also means loans that are made tend to be high-quality ones to worthy borrowers. As the following Display shows, several mortgage credit metrics—including FICO score and borrower debt-to-income ratio—are at or near their best levels since 2005.

Housing

The opposite is true when it comes to syndicated bank loans and high-yield bonds. This makes sense because it’s still early in the housing recovery, even as bank loans and high-yield bonds are moving into the home stretch—a part of the cycle when underwriting standards tend to weaken.

What’s more, tight mortgage-lending standards have opened up a large gap between demand for debt capital and its supply. That creates an opening for alternative credit providers to capture attractive risk-adjusted returns simply by filling the void.

Expanding GSE Risk-Sharing to the Private Sector

Over the last year, GSE risk-sharing transactions have been one of the few ways for investors to access residential real estate credit. These transactions act like bonds, providing investors with regular payments based on the performance of the underlying loans.

But unlike traditional agency mortgage-backed securities issued by Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), these securities carry no government guarantee; private investors, not taxpayers, absorb the losses if a large number of the underlying loans default. So far, the securities have attracted considerable demand—partly because of those strong credit fundamentals—and defaults have been very low.

With the GSE footprint in the US mortgage market likely to shrink, we think this risk-sharing template can be used in the private sector.

One way might be for investors to partner with banks that have strong mortgage-origination capabilities but are unable to hold all the loans on their books. Private investors would set the lending guidelines and fund the loans, while banks would collect a servicing fee.

Because they would directly source the loans, investors would be better able to conduct in-depth research into prospective borrowers than they would when investing in RMBS. This should help keep credit quality high and default rates low.

Building a Healthier Housing Market

We think such an approach would also increase credit availability for borrowers. Under the GSEs’ current strict guidelines, about 15% of the US population that historically would have qualified for a mortgage is unable to obtain one.

In the long run, we think any developments that bring private capital back into mortgage lending will lead to a more stable housing market—and support future growth. That’s good for investors and borrowers alike.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Matthew D. Bass is Chief Operating Officer for Alternatives at AllianceBernstein Holding LP (NYSE:AB).