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

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[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