Underwriting And The Qualified Mortgage Rule

In the hands of skilled credit union underwriters, creative loan structures can help deserving buyers acquire affordable homes and achieve the American Dream.

 
 

There are two different-but-accurate ways of looking at the new Qualified Mortgage (QM) rule. It is a new standard for conforming loans that defines a common form of home mortgage to create an efficient secondary market. It is also a tool of moral suasion to discourage the use of loan types that are safe, sound, and fair to the buyer when used properly and sensibly.

Forty-year terms, higher than average debt-to-income or loan-to-value ratios, low credit scores, interest-only loans, balloon payments, and higher than average points and fees … these are practices that were abused during the 2000s to put people in houses they couldn’t afford and should not have been buying. But in the hands of skilled, experienced credit union underwriters, they are also responsible ways to help buyers acquire homes they can afford and keep.

The QM rule locks loans with these terms out of the core secondary market, hurting the hardworking, middle-class Americans the original conforming standard was conceived to help. That’s a problem for credit unions because these folks comprise a large cohort of member-owners who depend on their credit unions to tailor mortgages to meet their individual needs. That was simple when a credit union could sell any properly underwritten conventional loan to a GSE, but with the tight new constraints of the QM rule, things are different.

So what’s a credit union to do? The popular press would have us believe the QM is like a seal of approval and anything non-QM is somehow substandard, subprime, or even sub-ethical. That’s nonsense. In credit terms, there is no difference between a conforming loan that a credit union would have made on January 9, 2014, and a conforming loan that does not qualify for GSE purchase because it was made after January 10. Credit union leaders, management, and boards need to understand this; there is nothing wrong with a non-QM loan. 

The difficulty with these loans is their lack of liquidity. For the time being, credit unions must hold them in portfolio. This entails interest rate risk and the potential for concentration risk. Unfortunately, there is also a modicum of additional liability risk because of the new Ability-to-Repay (ATR) Rule. As with QM, it’s important for credit unions to understand the difference between the hype and the facts regarding ATR. It’s also important to understand the illogical relationship between QM and ATR.

The Relationship Between QM And ATR

ATR is the codification of good underwriting and record-keeping practices — things credit unions should already be doing. To comply with ATR, the lender must make “a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms.” The lender must also document this effort. However, ATR was written as an amendment to the Truth-in-Lending Act (TILA). TILA is a disclosure rule, but ATR is not about disclosure. This creates a disconnect between the application of the rule and the consequences of failing to comply with it. 

Because ATR is part of TILA, it does not create new liability for creditors as much as more of the same type of liability they already face. As in the rest of TILA, there is the limited possibility of affirmative legal action, including the possibility of a class action lawsuit against the lender by borrowers or regulators. In addition, all creditors — originators and investors alike — also face broader exposure to the set-off defense in the case of foreclosure.

In other words, ATR is a reasonable and manageable, if poorly located, standard. Or at least it would be if not for a third legislative non sequitur. As established, QM is a set of restrictive loan terms masquerading as a conformance standard and ATR is an underwriting standard pretending to be a disclosure rule. The third leg of this bizarre stool is the QM exemption to ATR. 

The Third Shoe Drops

QM and ATR are unrelated in function, but they are both provisions of Dodd-Frank. This shared parenthood is the only justification for a so-called safe harbor from compliance enforcement. If a mortgage complies in form with all the restrictions of the QM rule, the lender is presumed to have complied in practice with all of the totally different obligations of ATR. Although this makes no sense, it means lenders making QM loans are effectively exempt from ATR rules on those loans. This has the triply unjust result of stripping many borrowers of a meaningful form of consumer protection, focusing all compliance efforts on a small subset of loans to which ATR applies, and exacerbating the conflation between "non-QM" and "somehow toxic."

Despite this web of illogic and inconsistency, credit unions can and should continue to make mortgage loans that best meet the particular needs of their member-owners. Remember, a well-underwritten, carefully configured loan can be safe, sound, and sensible even if it isn’t QM-compliant. The risks are largely known and can be managed, and the following considerations can help credit unions do just that.

The only true unknowns regarding the liability of non-QMs relate to court behavior.

  • How liberal will the courts be in allowing class actions and class action discovery, which can be burdensome?
  • How high a bar will the courts set regarding what satisfies as proof of ATR compliance?

Class action exposure is limited.

  • Affirmative legal actions can only be brought within three years of origination and class actions can apply only to loans less than three years old.
  • Liability exposure is capped at the lesser of $1 million or 1% of the lender’s net worth. This is a lot of money for a credit union, but not for a class action, which will limit the motivation for bringing such a suit.

The longer a loan is in repayment, the stronger the evidence of ATR compliance, particularly for fixed-rate loans and ARMs that have not reset.

The nature of the set-off defense means the party in default cannot collect any cash.

Total financial exposure from the set-off defense is limited to not more than three years of interest payments plus reasonable attorney’s fees and up to an additional $4,000 set-off.

  • In total, this is not enough to drive additional strategic defaults in which the borrower triggers foreclosure to game the system.
  • Because this amount is known, and default rates are also known for various types of loans, credit unions can factor a provision for this exposure into the cost of the loan.

A 25-basis-point premium in the mortgage rate more than covers the worst-case scenario of ATR exposure with non-QM loans over the average seven-year life of a loan.

For more about the potential liability if an institution fails to verify a borrower’s ability to repay, read The Liability In The Ability-To-Repay Rule.

— Michael Emancipator contributed to this article.

 
 

April 7, 2014


Comments

 
 
 
  • Very interesting article and Mr. Howard makes some valid points. However, he trivializes the "Unkown" portion that must be settled by courts. I don't recall many favorable court rulings regarding Financial Institutions (credit unions or not)and the poor disadvantage consumer who is losing their home. Nor does he mention the 43% debt ratio that is part of the rules and for all the debtor attorneys to see. I do believe there is some prudent lending available in the "non-QM" niche, but until congress acts rationally like removing the debt ratio limit on affordability, this is an open field loaded with landmines no matter the member's needs; not the open road as alluded to in the article.
    DMH
     
     
     
  • Wow, one of the best articles I have seen in the past 2 years regarding this topic. Particularly am impressed with the author's (and contributor's) understanding of the secondary market and its role in the mortgage business, and conversely their understanding of portfolio lending and its role in the mortgage business. This is a must read for all CEO's and Boards. {Disclaimer: I do not know the author and have never heard of him. I am the Chief Credit Oficer of a $1.8 billion institution and have been the managing partner of a private equity firm specializing in residential real estate constructing financing nationwide.}
    Tom B