Restarting Mortgage Finance: Step 1

Recently the Consumer Financial Protection Bureau (CFPB) released a much anticipated rule that finally gets the ball rolling on reform of the mortgage finance industry. Investors fled the market following the housing bust, reducing the flow of financing to borrowers. Likewise, many homebuyers were sold mortgage products that were untenable, resulting in damaged credit and lost savings. Transparency, verification and documentation are keys to restoring confidence from investors and homebuyers. The majority of the market will benefit from the new QM rule, but a subset of the market will likely face higher prices or lose access to financing all together.

The Qualified Mortgage rule, or QM, lays out basic requirements for lender underwriting. In short, the originator of the loan must verify all sources of income and assets and verify that the borrower has the ability to repay the mortgage (ATR). A number of loan types are prohibited from receiving the QM statu,s including those with negative amortization (balloon payments), interest-only features, as well as those with durations greater than 30-years. Finally, there is a cap on fees that lenders can charge of 3% (with an exception for loans under $100,000) and the back-end debt to income ratio (DTI) must be less than or equal to 43%.

Mortgages that qualify as a QM will be further bisected by those that have a rate 1.5% above the prime borrowing rate and those that do not. Loans below the 1.5% will receive special legal status known as a safe harbor, where the borrower in default must first prove that their loan was not affordable when originated in order to sue the lender. If the loan is QM and above the 1.5% rate threshold, then there is a rebuttable presumption where the lender must prove that the borrower had the ability to repay. Under the rebuttable presumption, even if the lender can prove the loan met the ATR, the lender incurs legal costs making the case of $70,000 to $110,000 [1] according to some industry analysts, while others analysts argue that the incidence of claims would be extremely low [2]. However, if the lender cannot demonstrate that the borrower had the ability to repay, then the lender faces new enhanced legal fees. Furthermore, the borrower’s ability to fight the foreclosure applies for the life of the loan, which would extend foreclosure timelines, increasing costs to banks. Lending outside of either definition of a QM may be sparse as the lender would have to raise rates further to compensate for litigation risk since these would fall outside either definition of a QM loan; these higher rates might then reach HOEPA limits.

So, who will fall outside the QM?

• Jumbo loan users with DTIs greater than 43%, which is estimated to be roughly 0.5% to 1.0% [3] of the entire market.
• Mortgages where fees are greater than the 3% cap – this is difficult to quantify, but it could be a large portion of the market. Still, lenders can “pay for” some costs by including them in a higher rate, so long as it is under the 1.5% cap, thereby ameliorating the impact to the market.
• Borrowers who use interest-only or negative amortization loans. Some estimates have this portion of the market in the range of 15%. However, this type of financing is commonly used by wealthier individuals with large reserves who can shift to different financing options.
• Borrowers with interest rates 1.5% or more above the average prime borrowing rate are roughly 4.9% [4] of the purchase market and just 0.04% [5] of the jumbo segment. Some borrowers in the conforming space may be able to shift to FHA, which is seeking an exemption to this point, but more borrowers may be pushed into this space if banks finance origination costs to comply with the 3% cap.
• The subprime market will be more restricted. The FHA will likely be the only option for borrowers with a FICO less than 620 and DTI over 43% as the FHA recently rescinded the ability to process these loans through automated underwriting.

The Impact on Today’s Market

Lenders can use the automated underwriting models of the GSEs and FHA to vet mortgages that are not financed by the government since there is currently no automated underwriting for a QM loan. However, jumbo loans will have to be manually underwritten as there is no automated underwriting for jumbos. As a result, these may take more time or cost slightly more to compensate originators for the underwriting costs and risk of writing to the QM definition.

In time, though, the FHA, USDA, and VA will derive their own QM definitions and the GSEs could come out of conservatorship. When this happens, loans not meeting the new QM definitions established by the government agencies will need to meet the narrower QM definition. By that time, it is hoped that lenders will have more confidence in making non-QM loans. In the near term, this final rule should help to stimulate some bank and investor demand for non-government backed QM mortgages as it clarifies and boosts protections for lenders and who make loans and hold them in portfolio or shelve them for securitization.

An interesting outcome of the new QM rule is that it will raise the importance of the high-cost loan limits that delineate the maximum limits at which the GSEs and FHA can lend. In high cost areas like California, New York City or Washington, DC, many borrowers may not be able to use the government programs or their automated underwriting programs. As a result down payment may rise as buyers with DTIs greater than 43% seek to reduce mortgages below conforming limits in order to avoid the more strict 43% limit on QM loans in the jumbo space. First-time buyers in these areas may be the biggest casualty, as this group may not have the resources to increase down payment. As a result, the loan limits will play an increasingly important role as home prices rise over the next decade. Worse yet, if loan limits were to decline, a larger portion of the market would fall outside the QM.

In addition, for safety and expediency, lenders are likely to defer to the agency’s automated underwriting (AU) systems in the near term. This shift places more importance on how the AUs are defined by the agencies going forward.

After nearly two years of waiting, the final QM rule has been released. While some aspects of the rule will limit market activity, the long awaited clarity will likely help to stimulate demand. However, before investors come back in strength, the market will need additional clarity as to what mortgages will meet the qualified residential mortgage (QRM) rule, which dictates the type of mortgages that can be securitized and sold as MBS without risk retention, and how the Basel III rule will affect the treatment of loans and mortgage servicing rights on bank balance sheets. Still, the finish line is in sight for regulatory reform.

[1] MBAA comment letter on the QM rule
[2] Memorandum on ``Rebuttable Presumption: A Perspective on Litigation Risk by the Numbers'' from Center for Responsible Lending and National Consumer Law Center, to Consumer Financial Protection Bureau, dated October 11, 2011.
[3] Author’s estimates with 2011 HMDA and Corelogic data
[4] 2011 HMDA
[5] 2011 HMDA