The Case for Non-Qualified Mortgages – A Two Part series

Part Two- The Case of Non-qualified Mortgages

Introduction

In the first part of the article we noted that the ability to repay rules make a demarcation between “qualified” and non-qualified mortgages.   Qualified mortgages must have the following characteristics: 

• The borrowers debt to income ration cannot exceed 43 percent
• The points and fees on the loan cannot exceed the cap established in the regulation^[1]
• May not have balloon payments
• May not contain interest only payments
• May not exceed 30 years

 

We noted that if the loan terms do not meet these parameters, then the loan is considered nonqualified and a lender must meet the ability to repay standards.  The ability to repay standards include specific components which are designed to document that a lender has established the borrower’s ability to repay a loan under the worst case circumstances of the terms of the loans. 

 

We noted further that many lending institutions have taken the stance that in the face of these rules, they will only make qualifying mortgages.  However, several prudential regulators have made it clear that avoiding nonqualified mortgages was not the intention of the regulation.   On the contrary, there are several legitimate reasons why “thinking outside the box” and making nonqualified mortgages should be considered.  

 Why make Non-Qualified Mortgages 

For purposes of this discussion, it is important to point out that the borrowers who require nonqualified loans fit into two rather extreme categories.  There are the very wealthy borrowers whose financial characteristics don’t fit into the traditional borrowers.  These are borrowers who may have highly liquid assets, but irregular income.  Or perhaps these borrowers want a “bridge” loan to buy a house while they await completion of a large business transaction that will result in an influx of cash.   For these borrowers the need for nonqualified mortgages is largely an accommodation. 

The second set of borrowers are the potential homeowners in low to moderate income areas.   These borrowers tend to be outside of the qualified loan parameters through economic circumstances that without some level of assistance will result in continued struggle.   It is this second set of borrowers that we have in mind in the remaining discussion. 

Increased interest margins- Non qualified loans generally present a higher level of risk than qualified loans.  As a result, higher loan fees and rates are appropriate.   This is in no way meant to say that lenders can return to the bad old days of predatory lending.  Remember that the regulatory requirement is that the lender must prove that they have documented the borrowers’ ability to repay the loan.  The calculation must be made while considering the worst case scenario for the borrower. [2]

When considering these loans, it is also important to remember that with the proper underwriting, even though there is higher risk, the performance of loans in lower to moderate income neighborhoods has been actually equal to or better than the performance of other neighborhoods.  For example, a study performed by the Federal Reserve Bank found that during the financial meltdown of 2008;

Federal Reserve researchers also report that subprime mortgages made in CRA-eligible neighborhoods perform at least as well as those made in similar non-CRA-eligible neighborhoods, that a Large national affordable mortgage program has substantially lower defaults than the subprime segment, and that the majority of recent foreclosure filings have occurred in non-CRA eligible middle- and upper-income neighborhoods. [3]

 

Reduced Competition – Just because so many financial institutions have eschewed the non-qualified mortgage doesn’t mean that the need for these loans has disappeared.  In fact, the fear of what might happen with non QM’s has left a void.   As a result there is actually a strong market for non QM’s and the lender who decides to enter the market can have the virtual “pick of the litter”.  

In 2013, three former regulators with the CFPB saw this opportunity and launched an investment firm that provides financing for investors in the Non QM resale market.    The first venture of the firm was to launch a wholesale mortgage company. The venture table funds non-QM loans and assume all the risks from the lenders.

Minimal Infrastructure Changes – The whole point of the ATR rule is that lenders must develop sound systems for determining that a borrower can repay a loan.  The essence of the regulation is acting in a safe and sound manner.  For those institutions that wish to thrive and survive, safe and sound policies and procedures should be a daily practice.  The steps that are required to meet the ATR rule should be second nature

Meeting the Credit Needs of the Community – Many lenders talk about meeting the credit needs of the community in their Community Reinvestment Act statements.  Of course, more often than not, this statement is theoretical and can’t really be documented.   A program that allows first time homebuyers with a legitimate chance at asset acquisition is one of the largest credit needs of most communities across the country.  There are a number of institutions that have recognized this need and have developed successful lending programs that are couple with credit counseling.  The results have been excellent.    Both Time Federal Savings of Medford Wisconsin and Geddes Federal Savings in Syracuse NY have implemented non QM programs for first time homebuyers with unquestioned success.   

The CRA rewards innovation- for lending institutions that are subject to the Community Reinvestment act, there is a strong reward for innovative lending practices.    

“[The] ending Test also favors the use of innovative or flexible lending practices “in a safe and sound manner to address the credit needs of low- or moderate-income individuals or geographies.”[4]

  

The development of a lending program that allows nontraditional borrowers to obtain mortgages can lead to an outstanding CRA rating. 

 

In the end, there is absolutely no reason to run away from Non-qualified mortgages.   The potential for good results far outweighs the risk. 

---

[1] These caps are specified in the regulation and vary depending on the size of the loan.

[2] In this case, worst case means, when all of the highest rate increases and fees have kicked in. 

[3] Glenn Canner and Neil Bhutta, Memo to Sandra Braunstein “Staff Analysis of the Relationship between the CRA and the Subprime Crisis”

(November 21, 2008), available at http://www.federalreserve.gov/newsevents/speech/20081203_analysis.pdf.

[4] Federal Financial Institutions Examination Council (FFIEC), “A Guide to CRA Data Collection and Reporting,” (January 2001), available at

http://www.ffiec.gov/cra/guide.htm.

The Case for Non-Qualified Mortgages – A Two Part Series

Part One- Qualified Loans and the Ability to Repay Rule

Starting in January of 2014, the Ability to Repay /Qualified Mortgage Rule took Effect.  This rule established a standard for closed end consumer credit secured by residential real estate.  The rule establishes “qualifying” loans and non-qualifying loans.   Since the time that the rule was implemented, many if not most lenders have decided to stay away from non-qualified loans.  However, there is a case to be made that “non-qualifying” loans should be considered.   

Some Quick History

The ability to repay rule was enacted in direct response to the financial crises of 2009.  In particular, one of the lending practices that was popular at the time was the practice for “low documentation” or “no documentation”, or “stated income” loans.   These are loans that are approved with little to no documentation of the borrower’s ability to repay the loan.  In fact, the lender would simply take the borrower at his or her word that they had sufficient income to pay the loan without checking further.  As we are all painfully aware, these practices lead to record numbers of defaults on loans, foreclosures and in generally, economic upheaval.  

The Dodd Frank Act has provisions that are designed to stop many of these practices.  It should be noted that the legislation was also designed to benefit both sides of a transaction.  In exchange for sticking to the qualified mortgage parameters, the lender was given some legal protections against a lawsuit by the borrower in case of foreclosure.   For a loan that is considered a qualified loan, the bank can enjoy the legal presumption that it performed all of the documentation necessary to have determined the borrower’s ability to repay the loan.  This is very important in a lawsuit for foreclosure on the loan because one of the strongest defenses that a borrower might have is that the bank did not act in good faith in granting the loan and is therefore not entitled to foreclosure. 

The rule establishes standards that lending institutions must meet for mortgage loans to be considered qualifying. 

Qualifying Loans  

The ability to repay rule has one big safe harbor; if a loan is considered a qualifying loan, then the lender does not have to meet the other requirements of the ability to repay rule.   For a loan to be qualifying:

• The borrowers debt to income ration cannot exceed 43 percent
• The points and fees on the loan cannot exceed the cap established in the regulation^[1]
• May not have balloon payments
• May not contain interest only payments
• May not exceed 30 years

 

 

Again, If the loan is a qualifying loan, the assumption is made that the lender has established the ability to repay, and the borrower could not use a bad faith defense in an action of foreclosure.  

There is an exception to this rule that allows for small lenders with assets of less than $1 billion and who serve mostly rural and underserved communities.  For these institutions the 43% debt to income ratio can be exceeded.     There are some other exclusion also that time will be discussed at another time and place. 

Impact on the Mortgage Market 

Many banks have also used the QM/ATR rule as a shield to protect against the claims that mortgage loans to low income (often minority) borrowers have been hurt by the rule.    Like many things that involve federal rules, the truth is far more complicated than that.  The rules were definitely designed to stop predatory lending practices.  Predatory loans take advantage of borrowers by starting out with rates and terms that are unrealistic to get the borrower approved.  Once the loan is approved, the lender collects fees and the loan itself often becomes irrelevant.  As we discovered in the financial meltdown, the loans made by predatory lenders (often called sub-prime) had little to no chance of being repaid and as soon as the full terms of the loan were realized, borrowers were no longer able to make payments and the mortgages collapsed into foreclosure.  Predatory lenders were more than happy to make these transactions because there was a robust market for selling the toxic loans to others and by the time they went into foreclosure, the loan was somebody else’s headache.    ^[2]

In the event that the loan an institution wants to make doesn’t meet the qualified mortgage parameters, then the “ability to Repay” rule applies.   This rule, more commonly known as the ATR rule, requires that a lender must consider several factors to determine a borrower’s ability to repay.  These factors include:

1.       Current or reasonably expected income or assets (other than the value of the property that secures the loan) that the consumer will rely on to repay the loan;

2.       Current employment status (if you rely on employment income when assessing the consumer’s ability to repay);

3.       Monthly mortgage payment for this loan. Monthly payment on any simultaneous loans secured by the same property;

4.       Monthly payments for property taxes and insurance that you require the consumer to buy, and certain other costs related to the property such as homeowners association fees or ground rent;

5.       Debts, alimony, and child- support obligations;

6.       Monthly debt-to-income ratio or residual income, that you calculated using the total of all of the mortgage and non-mortgage obligations listed above, as a ratio of gross monthly income;

7.       Credit history

 

The ATR rule does not ban any particular loan features or transaction types, but a particular loan to a particular consumer is not permissible if the creditor does not make a reasonable, good-faith determination that the consumer has the ability to repay. Thus, the rule helps ensure underwriting practices are reasonable.   

When the ability to repay rule first took effect, many lenders immediately took the position that they would issue only qualified loans.  The rationale has been that these loans not only possess the necessary protections, but they also appear to be the preferred loans of the regulators.    Put another way, many traditional lenders such as banks and credit unions, seem to take the position that regulators did not want them to make unqualified loans.  

More recently however, regulatory agencies have been showing a desire to get lenders to consider the possibility that nonqualified loans can still be considered both safe and sound.  For example,  

“Scott Strockoz, a deputy regional director for the FDIC also said that the regulators would take a flexible view of non-qualified mortgages that banks do decide to issue, particularly if the bank can demonstrate that the mortgage is still well-written and even if they fall outside of the parameters that would make it a qualified mortgage.  He acknowledged, however, that some institutions were already pledging to steer clear out of the space because of potential litigation risks or other concerns” [3]

The Comptroller of the Currency also noted regulators "don't want to see our institutions not make non-QM loans – we were pretty clear that we did not see that as being a safety and soundness issue for those institutions."[4]

The point here is that with right set of internal controls, Non QM loans are not only safe and sound, regulators have an expectation that financial institutions will continue making these loans.  

Non-Qualified Mortgages- a Tale of Two Borrowers  

There are currently two markets that are developing in the non QM mortgage area.  The first is for the nontraditional wealthy borrower.  In many cases, this borrower may not fit the traditional QM parameters.  They may have a great deal of cash set aside, but minimal ongoing income for example. 

Matthew Ostrander, CEO of Parkside Lending emphasized that some non-QM loans can be safer than QM loans. He described two scenarios.  The first is a non-QM borrower with a $1 million income, 70% LTV and a 760 FICO score, but with a 55 DTI that falls outside of QM requirements.   These borrowers are finding that there is a very strong market for QM loans.   These loans tend to be “bridge” financing that allows the borrower an opportunity to purchase housing that will eventually be refinanced with a more traditional (qualified loan) at some time in the future when the borrower is ready.  

The second sets of non QM borrowers are first time home buyers for whom the QM represents something or a bar.  This is a borrower with a $50,000 income, 43 debt-to-income ratio, 97% loan-to-value and a 620 credit score.  These are also the borrowers who were set upon during the financial crisis of 2008.  The truth is that these borrowers represent both an opportunity and a risk.  However, these characteristics should not be a bar to offering mortgages.   The caution here is that the underwriting requirements should be realistic and should reflect the risk appetite of the bank.  

Congressman Barney Frank commented on this dichotomy: 

Chairman Frank was emphatic: "Yes, it is a problem when people get mortgages they shouldn't get. It has been a historically greater problem that some people couldn't get mortgages they should get. I will guarantee … that doesn't happen."[5]

There are actually many good reasons why a financial institution should consider non-qualified mortgages.  In part Two, we will discuss those reasons

---

[1] These caps are specified in the regulation and vary depending on the size of the loan.

[2] The Movie, “The Big Short” provides and excellent description o predatory lending practices.    

[3] Regulators nudge banks on non-QM lending,  Rob  Soupkup  April 2014  Finpro  

[4] Ibid

[5] American Banker “Dodd-Frank's 'Qualified Mortgage' Was Intended to Be Broad”  Raymond Natter April 25, 2012

What to do when the regulators have a finding

Introduction

If you are or have been in the compliance arena you are familiar with this scenario; The examiners have just come to your office with a most somber countenance.   They are here to report a significant finding that has resulted from their review.  You have several options, you can:

A)      Hide under your desk and hope they go away

B)      Engage in histrionics and accuse them of picking on your bank

C)      Threaten to sue

D)      Listen closely to what they are saying and ask a series of questions that will allow you to deal with the finding in an effective manner

The fact is that findings happen!  The fact also is that there are findings and there are FINDINGS!   The way you deal with each of these will greatly impact your compliance life.    There are a number of critical steps that your institution can take that will allow your response to have the greatest impact.   

Step One- What, Exactly is the Finding? 

It is critical to find out all you can from the examiner when they are presenting the finding.  In many cases, findings are the result of a miscommunication or misunderstanding of questions being asked.   For example, at one bank, an examiner asked where flood insurance policies are stored and was told they are kept in the loan file.   However, the person who gave this answer was unaware that the procedure had been changed and flood loan policies were now kept in a different place.  In this case, the examiners originally were ready to cite the bank for several violations of the flood rules because the information in the loan files was stale.  It is very important to determine form the outset the exact nature of the violation being cited.  

Along these lines, it is important determine the specific regulation, guidance or rule that has been violated.  By going to the source of the regulatory requirement, you can get the clearest picture.   As part of this process, it is also useful to get an understanding of whether or not the rule in question is new or has been around for some time.  While it is generally true that the older the rule, the bigger the concern that is being cited as a finding, there are circumstances where this may not be the case[BW1] .   For example, a reinterpretation of a rule has the same impact as a new rule.   There are sometimes areas that receive new or increased focus.  For example, the requirement that a flood insurance customer receive notice of being a flood area every time a loan is modified, is a requirement that has recently received greater attention, even though the requirement has been in place for many years. 

The source of the finding can be a critical consideration when determining the level of enforcement action.     

Even though it is understandable, we recommend that your never use the “I was never cited for this before” answer.    You drive faster than the speed limit on the freeway on a regular basis.  This doesn’t mean that it is okay and you would try that answer with a highway patrolman! 

At the end of the day, make sure that you can explain the violation to someone else as a test to ensure that you understand the issue.   

Step Two- Why did this Happen? 

A frequent mistake that institutions make is to simply fix the problem that is cited in the regulation – i.e., missing disclosures; we will simply start making the disclosures going forward.  The problem with this approach is that it is simply a bandage.  It doesn’t necessarily address the real concern that may have caused the finding in the first place.   The next step in managing a finding is getting to the root of the problem that caused it. 

There are several questions to ask when determining the root cause of a finding.  Was it a training issue or were policies and procedures outdated and inefficient?  One the most important questions to ask is whether or not the problem is systemic or limited to an individual staff member or business line.  Is the root of the problem that we don’t understand what the regulation is asking or is it more the case that training needs to be reinforced?    Determining the root cause of a finding allows the institution to frame the magnitude of the issue and to build a response that is appropriate.  

 

Step Three- Is this indicative of a bigger problem?

Once the root cause of a finding has been determined, it is necessary to determine if the findings are an indication of a much bigger problem.   There are as many reasons that findings occur as there are findings.  However, some reasons are indicative of a much larger problem.  For example, if the root cause of the problem is that the institutions was simply unaware of changes to the regulation, there is a fundamental flaw in the overall compliance management program.  This does not mean that your compliance staff is incompetent.  There are many regulations that are coming at financial institutions on a regular basis.  There have to be sufficient resources to ensure that the changes in regulations are communicated and necessary procedures implemented.  

In the alternative, perhaps the issue is one of training.  Many institutions use online training programs.  These programs are a cost effective means to training staff and are widely accepted by regulators.   There are however, times when the on-line training may not be sufficient.  In many cases, the opportunity to receive in person training that details the history and goals of a regulation is the best most effective way to reduce findings and violations.  

The compliance examination of your institution is ultimately a test of the effectiveness of the compliance management program.   The role of the program at its core should be to identify and to mitigate risks.  If the system that you have developed is not capable of performing this function effectively, findings are indicative of a much bigger problem.  

 

 

Step Four – Communicating

It is important to communicate the finding(s) to senior management and the Board so that they are fully informed.   As a best practice, the root cause and the proposed solution should be communicated simultaneously.  Communicating the understanding of the finding as well as the plan for fixing the problem is an excellent way to demonstrate to the regulators that you understand the breadth and depth of the concern.  The relationship built on trust and communication will go a long way where there are severe findings. especially if the findings are servere.

Step Five - Find out as soon as you can what the regulatory implications will be

As we noted earlier, there are findings and there are FINDINGS!  In some cases, the finding can simply be a matter of a small correction.  In other cases, the examiner many find that a pattern and practice of violations exists.  In these cases, the examiner can recommend enforcement actions up to and including civil money penalties.    For example, it is critical to find out from the examiners whether or not they will consider a finding a repeat finding.  Repeat findings are an indication of general weakness in the compliance program and are always considered grave, no matter the area of the finding.  In this way, a minor or technical finding can become a matter requiring attention or even the basis for a supervisory letter.   The regulatory implications of the finding must also be communicated to senior management.   

Suppose you Don’t Agree

We are aware that many financial institutions either don’t agree or that have misgivings about a finding, but go along to get along.  While this practice may seem to make life easier, it is not actually the most prudent path to take.   ASK for clarification- this is not to be argumentative, but without doing so, you can lock yourself into an untenable position.  In the event that the examiner may be asking something of the institution that is infeasible (e.g. acquiring a new software program).  This is also why it is important to understand the source of the finding- if it is an interpretation or the regulation, there is likely to be a change in the next examination; different examination teams have different interpretations of the regulation.  Ultimately, a forceful yet respectful disagreement is a good thing and is respected by the regulators. 

All of the regulators have a system in place to allow for appeals of decisions in those instances where both parties may agree to disagree.   

Pick Your Battles

Remember that the compliance review is ultimately an analysis of the compliance management program.  Individual findings do not necessarily indicate a fundamental weakness of the CMP.  Make sure that you keep the difference between findings and FINDINGS in mind.

 

**PLEASE JOIN US THURSDAY MARCH 17, 2016 AT 10AM PST FOR OUR FREE 15 MINUTE REGULATORY BRIEFING “WHAT TO DO WHEN THE EXAMINERS HAVE A FINDING”  FOR MORE INFOMRATION AND DETAILS GO TO WWW.VCM4YOU.COM

---

 [BW1]