One of the presumed takeaways from the 2008 financial crash was the need for lenders, if they are wise, to have a firm grasp of the fixed income assets they originate and service. A US firm that specializes in this area talks to this publication.

One of the lessons that was (hopefully) learned from the sub-prime mortgage crash was that lenders needed more incentive pressure to monitor the loans they lent out. With the supposed benefits of modern technology, there are surely fewer excuses for credit investors not to have deep detail at their fingertips.

The Palisades Group, an alternative asset manager in the US residential credit market, sources construction and property rehabilitation loans through a national network of lending partners. Its investment personnel review each asset before buying it and oversees all post-acquisition credit and risk management activities. It is a labor-intensive job. But the value-add of all that work is considerable, particularly as rising interest rates affect forms of real estate, the firm has told Family Wealth Report. 

“We take a high-touch approach to credit risk management,” Jack Macdowell, Palisades' chief investment officer, said.

The potential opportunities are huge: US residential real estate is a $13 trillion market, he said. That figure compares to a $10.3 trillion corporate bond market and estimated $1.5 trillion private credit market.

This market produces new loans to the order of $2 to $4+ trillion per year.

With interest rates rising to curb inflation, the shift inevitably revives memories of what happened in the run up to the financial crash of 2008, such as the implosion of the sub-prime mortgage market in the US and its knock-on impact around the world. Real estate investment remains a major asset allocation item for wealth managers. Within the family offices space, for example, there's been a trend of more direct investment into property, both commercial and residential, in recent years. This throws up the question of what resources firms can draw on to do the deep due diligence and monitoring necessary to manage risks.

Shining a light
With some parts of the mortgage-backed securities (MBS) market, there’s limited information available to end investors about the underlying assets. Palisades is about shining a light on these assets, he continued. 

“We want to add value by going one layer deeper [than the norm] by buying and owning these loans themselves. This is complete transparency. It allows us to make real-time decisions that influence performance of the underlying investment at the loan, borrower, and property level,” he said.

Founded in 2012, Palisades, which since that year has managed $25 billion of loans and real estate, invests in, and actively manages, residential loans and real estate-related strategies. It runs a mix of residential loans and real estate with a notional balance of about $10.1 billion, with underlying properties located in the US, Europe and Latin America.
 

From distress to complexity
When the firm started – about four years after the financial hurricane hit property and financial markets around the world – a large chunk of its attention focused on distressed assets. 

One point that arose from the sub-prime wreckage was that originators of loans often had no incentive to look too deep into what they were selling, or to whom. “That did not always lead to optimum outcomes for the investor,” Macdowell, with masterful understatement, said. 

“To build an ability to manage thousands of loans was a lot of work. Some firms have outsourced this to Palisades and that’s how we got started. Initially, Palisades was a sub-advisor to large institutions and big family offices,” he said. “These folks with tons of capital want access but don’t have the infrastructure to manage large complex portfolios of residential loans.”

In its early days, Palisades focused on distressed loans, but as the years rolled by opportunities in that sector tapered off around 2016/17 and the business concentrated more on performing loans. Palisades now runs a series of private residential credit funds.

The firm doesn’t try to guess macro-economic policy or broad financial market moves. Instead, its focus on credit risk fundamentals means that it can provide value in different conditions, Macdowell said. 

In supply-demand terms, the US real estate market is “under-supplied,” and the environment has shifted markedly from 2008, he said. The enactment of the Dodd-Frank financial regulations more than a decade ago have also removed some of the practices and abuses that had contributed to the crash, Macdowell continued. Today, there are historically high levels of home equity, loan-to-value ratios are healthy, mortgage-related debt service obligations relative to disposable incomes and vacancy rates for owner-occupied housing are each at historically low levels, and the majority of loans are 30-year fixed with low interest rates, all signs of a healthy housing market from a credit standpoint.

Palisades likes short-duration property loans, such as 12- to 24-month loans, where loan-to-value ratios (LTVs) are around 65 per cent. This can deliver 300 to 400 basis points above non-agency loan products, he said. 

To run these portfolios requires constant monitoring, Macdowell said. 

Regionally, Palisades is no longer as constructive about the Pacific Northwest region, given concerns such as people migrating from certain coastal cities experiencing economic and social disruption, he said. 

“Certain areas have fallen out of favor with our investment committee, however, each neighborhood is unique and we tend to avoid making broad geographic investment decisions,” he said. “While a lot of people have moved to Florida, home price pressures and major increases in property insurance cost are anticipated to curtail recent demographic trends.

Artificial
Inevitably, FWR asked Macdowell whether AI/machine learning will help with the number crunching and analytical chores caused by having to examine thousands of individual loan deals across the US.

“We are really focused on finding ways of bringing AI into our data science environment,” he replied. “We have a huge data set of proprietary information that we are seeking to ring-fence and begin analyzing with AI soon.”

Stori Analytics is one of the firm’s technology applications that currently uses machine learning algorithms to identify key risk factors embedded in large text communication data sets between residential mortgage servicers and borrowers. The firm is working on enhancing Stori with an AI overlay which to his knowledge would be a first of its kind in the real estate credit area, Macdowell added.