The subprime mortgage crisis of 2008 continues to inform the types of risk that investors are willing to invite into their portfolios. Though the mortgage-backed securities (MBSs) market is on the rebound, many investors still prefer alternative mortgage assets, either as their main mortgage investment or to supplement MBS portfolio allocations.
What are direct mortgage loans?
Direct mortgage loans are non-recourse whole loans where funds are lent directly by an investor. With a DML, the lender owns the entire loan, or mortgage, on the collateral asset rather than a portion or fractional unit of a securitized investment.
DMLs are backed by the physical property that the loan supports. For most DMLs, the asset is commercial property (the NAIC categorizes them as office buildings, retail, industrial, apartments, hotel/motel, mixed use, and other. In the event of default the lender can seize the property backing the loan and recoup their investment.
What are the benefits?
DMLs are generally considered safe investments with known cash flows backed by real assets, characteristics that fulfill many insurers’ unique investment needs. They are typically long-term: at least 10 years, and often as long as 30 years.
Another benefit of DMLs is their transparency, especially in contrast to MBSs. Often the lending and borrowing parties engage directly with each other, and in some cases negotiate terms directly, which eliminates some fees and can be beneficial for both the lender and borrower.
What are the risks?
As with any investment, DMLs do carry some risks. There is always the potential that the borrower will default on the loan. DMLs also tend to be more illiquid, making it difficult to exit the investment quickly. However, the combination of illiquidity and borrower default risk often leads to higher yields, since lenders can command a greater premium for tying up investment funds with these possibilities.
How are they structured?
DMLs often start with a borrower who approaches an originator (typically a large bank) and applies for a loan. The originator structures the loan and acts as the initial lender. Depending on the nature of the loan, the originator might already have investors lined up to purchase the loan, or it might shop it out after the origination process is complete. There are other instances where the lender acts as the originator of the loan; this format is typically seen with life insurance companies.
Direct mortgage loan accounting
The NAIC addresses accounting for DMLs in SSAP No.37, which states that all costs associated with the purchase (including origination, acquisition, or commitment to purchase) are to be charged to expense as incurred, and that mortgage loans are to be assessed at fair value.
SSAP No. 37 also requires that amortization of these loans be recognized as an adjustment of yield over the life of the loan in order to produce a constant yield. Insurers that maintain a large portfolio of similarly priced and valued loans, with reasonably predictable repayment schedules, are to include estimates of future prepayments. Any adjustments to yield are to be credited or charted to interest income.
Other important accounting implications include:
- Recognizing prepayments as liabilities, with prepayment penalties assessed to the borrower recorded as investment income
- Understanding when and how to report a loan as impaired (DMLs are considered impaired when the reporting entity can reasonably assume they will not be repaid)
Regulatory reporting implications
Data acquisition and reconciliation can be problematic for DML reporting. Investors should consider the following issues:
- Insufficient third-party data creates challenges if a position is entered at either a premium or discount, because an amortization schedule is necessary for calculating yield and amortization expense or accretion income
- Insurers who report their Schedule B manually must provide additional information beyond standard security master and transactional information, which can further delay filing if that information is not readily available when filings are being prepared
- Companies with many DML investments often have systems that support the origination or servicing of the loans, but not the regulatory reporting
Key considerations
As with any other investment, investors need to assess the balance of their portfolios and determine their own risk tolerance when considering investments in DMLs. Non-standard contracts and counterparty risks have resulted in DMLs developing a reputation for being a riskier asset. However, those same elements increase the potential for higher yield when compared to traditional investments. With the right investment management systems, DMLs can be a worthwhile addition to an otherwise conservative portfolio.
How Clearwater streamlines the DML process
- Accounts for unique transactions and accrual schedules
- Reconciles disparate sources of data
- Provides expertise on DML complexities
- Aggregates and integrates data from leading data providers
- Produces detailed accounting, performance, and risk reports using a robust and flexible accounting engine
For information on other complex asset classes, see our article Are Options Right For Your Organization? To learn how Clearwater can help integrate and simplify your investment accounting, reporting, and analytics, schedule a live demo with a Clearwater expert.