A3 Financial Accelerates Into Reverse Mortgages
There aren’t many things that the vast majority of financial industry commentators agree on, but diversification being the only free lunch in finance, as the saying goes, is one of them.
Denver, CO-based alternative credit investor A3 Financial investments would, ordinarily, agree. The firm’s A3 Alternative Credit Fund began life in October 2019 with a diversified portfolio of investments in direct lending to SMEs, real estate lending, CLOs and reverse mortgages. These are not ordinary times, however, and consequently the firm has altered the constitution of its portfolio to contain almost 90% exposure to reverse mortgages.
Lars Soderberg, a Co-Founder and Principal at A3 Financial, believes that the current environment necessitates such firm action.
“When we started the firm, we expected reverse mortgages to be a core holding because we’ve been investing in them for more than a decade. But we didn’t start the fund thinking it’s going to be 90% reverse mortgages. Our current portfolio allocations are a direct result of the mayhem we saw in March. As an active manager, we didn’t want to just liquidate everything and hold cash. That’s not what we promise to our investors. Reverse mortgages offer a government-insured investment that can provide yields of 8% - 10%. It made sense to us to put most of our money into them,” he said.
Reverse mortgages – or equity release to those in other parts of the world – are loans where a homeowner (almost always someone in the over-60 age group) takes a cash sum from a bank using the equity in their home as collateral. When the homeowner sells their home for whatever reason – or dies – the bank receives a share of the proceeds from the sale of the home that corresponds with the percentage of the house that they took as collateral for the loan. The bank charges an annual coupon for the loan, which is not payable by the borrower until there is a liquidation event; it’s simply added to the principal in the repayment.
Investment banks bundle reverse mortgage loans – which are AAA-rated - into structured products and sell them to investors like A3 Financial. Investors get paid in one of three ways: the homeowner decides to sell the house, which triggers the repayment of the reverse mortgage, filtering cash to the structured product and then through to the investor; the homeowner dies, which triggers the estate to sell the house and repay the debt; or the loan to value of the reverse mortgage (the principal plus the accrued interest) hits 98%, at which point Ginnie Mae is obligated to buy the debt from the lender, again liquidating the investment. Each structured product contains thousands of underlying loans, meaning that A3 Financial receives a continual stream of income from liquidation events each month.
The A3 Alternative Credit Fund is structured as an interval mutual fund and offers daily pricing. The firm uses Bloomberg as the pricing agent for the reverse mortgage component of the fund; the pricing can be more or less than A3 Financial pays for its investments, meaning that the NAV does, in some months, fall as well as rise. Soderberg says that their internal modelling may differ from public pricing at times, he doesn’t always agree with the pricing data that they receive, but in the medium to long term, the income from reverse mortgages will drive their returns more than short term pricing.
“We tend to not trade our reverse mortgage holdings,” he said. “We want to hold our investments towards maturity. The longer the borrower stays in their home, the better it is for us as the interest compounds. So, the daily pricing is what it is, and we don’t always agree with it, but in the medium to long term, the alpha remains and gets reflected in our NAV.”
Risks inherent to this asset class include government risk and prepayment risk. The former is unlikely but if the U.S. Government were to remove the guarantee to buy the loans when they hit 98% LTV, the risk to the lender and therefore the investor would increase significantly. Furthermore, the effect of removing the guarantee would mean that availability of these loans to Americans would decrease and the interest rate would increase to compensate for the additional risk, further pricing millions of Americans out of this option. Prepayment risk, however, is more likely. Whilst the lender wouldn’t lose any money on the loans – they still get their principal and accrued coupon returned to them – the returns would suffer.
“We try to minimise pre-payment risk wherever possible. There is a lot of due diligence that goes into these structured products – we look at each underlying loan in the product. We don’t want a situation where we’re only getting 50 basis points on a large chunk of our book because it doesn’t make it worthwhile to do it,” said Soderberg.
The person doing the majority of that due diligence at A3 Financial is Co-Founder and Principal Gregg Bell. Bell was instrumental in developing the investable reverse mortgage market in the United States when he worked at Royal Bank of Scotland in the early to mid-2000’s.
“Gregg is one of the leading experts in the country when it comes to reverse mortgages analysis. He sees all of the structured products that the banks sell and has his own screening process that he’s developed over the years to determine if he wants to take a closer look. Modelling the prepayment risk, which includes mortality risk, is critical to ensure that you can make positive returns. You need significant experience to be able to do this properly,” said Soderberg.
Being a mutual fund, the A3 Alternative Credit fund doesn’t require an investor to be accredited. Interval funds offer only quarterly liquidity, however, so many of A3 Financial’s investors are family offices as well as registered investment advisors investing on behalf of their clients. Capacity constraints in the industry – Soderberg guesstimates that the entire reverse mortgage market in the United States is approximately $50bn – means that larger asset managers won’t likely be a significant player in this asset class, but the population demographics of the U.S. means that the market should continue to grow, consequently enabling more of the small to mid-size professional investors to obtain exposure.
“The baby boomer population in the United States is now starting to retire. Reverse mortgages offer them the ability to get cash to do whatever they want to do in retirement whilst staying in their homes. This is a growth market in the United States and, given the government guarantees, is a lower risk profile for investors if you get the pricing right,” said Soderberg.
Ideally, A3 Financial would like a more diversified portfolio but circumstances dictate that, for the next 6-12 months in all likelihood, it plans on sticking to its heavy reverse mortgage allocation.
“We’re very pessimistic about the fixed income and credit markers in the short term,” said Soderberg. “When the stimulus runs out, there are bills to pay. By allocating more of our assets to reverse mortgages, we’re sheltered from what we think will be significant stress in the credit markets. You tell me where else are you going to get triple-A rated, government-guaranteed securities paying an 8% yield at this moment. You’re not. The risk-return profile of whatever is second to reverse mortgages is pretty distant.”
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