The Qualified Mortgage and Ability to Repay Rules Although green shoots are appearing, the post financial crisis mortgage market has faced numerous challenges and uncertainties. Chief among them has been the looming set of guidelines and requirements created by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) that were initially undefined as specific rule making has lagged the Act s passage. As is seen with many markets, a lack of information will cause a very conservative viewpoint to be utilized to compensate for that uncertainly, and the Non-Agency mortgage market is no exception. The Qualified Mortgage ( QM ) and Ability to Repay ( ATR ) rules stood at the top of the undefined list and likely caused many bank and mortgage company executives to experience more than a few sleepless nights. Although the final rule defining the criteria for QM and ATR was released on January 10, 2013 by the Consumer Financial Protection Bureau ( CFPB ), there were still many questions as to how the specifics of these rules should be applied, how these new regulations would impact individual market participants, and how could these rules be implemented to maximize risk management but minimize initial and ongoing cost. The final rules are critical as prior to their release, there was no clarity on how a borrower s ability to repay an obligation had to be determined and how the features of a loan would directly relate to the protection afforded the borrower and the originator. This article summarizes the initial rule, addresses the amendment that occurred on May 29, 2013, provides insight into the impact of these rules for individual market players, outlines some of the outstanding questions and associated risks related to these rules, and describes Navigant s experience in helping implement solutions for QM and ATR. CONTACTS» Paul Noring Managing Director Valuation & Financial Risk Management 202.973.6550 pnoring@navigant.com John DelPonti Managing Director Valuation & Financial Risk Management 704.347.7644 john.delponti@ncacf.com Beji Varghese Managing Director Valuation & Financial Risk Management 704.347.7639 beji.varhese@ncaf.com Patrick DellaValle Associate Director Valuation & Financial Risk Management 202.481.8348 patrick.dellavalle@ncacf.com navigant.com 1 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules
SUMMARY The QM and ATR rules are covered under the CFPB s amendment of Regulation Z, which implements the Truth in Lending Act (TILA). Regulation Z prohibits a creditor from making a higher-priced mortgage loan without regard to the consumer s ability to repay the loan. The final rule implemented sections 1411 and 1412 of the Dodd-Frank Act, which generally require creditors to make a reasonable, good faith determination of a consumer s ability to repay any consumer credit transaction secured by a dwelling (excluding an open-end credit plan, timeshare plan, reverse mortgage, or temporary loan) and establishes certain protections from liability under this requirement for qualified mortgages. This ATR regulation applies to all 1-4 unit dwellings, regardless of occupancy of where the loan is held, (i.e. sold to a Government Sponsored Entity (GSE), held in a bank portfolio, or included in a private label securitization.) The final rule also requires creditors to retain evidence of compliance with the rule for three years after a loan covered by the rule is consummated, a key consideration from a document tracking and retention perspective. This all leads to the fundamental questions: what exactly is required under QM, who does QM pertain to, and why should senior bank executives be concerned with QM? Simply stated, non-compliance or uncertainty of compliance carries a potentially steep financial penalty, significant potential legal costs, ongoing risk to all origination activities, and increased scrutiny from regulatory agencies. On January 14, 2014, the rules and penalties become effective, so the window for implementation of robust solutions and related policies is quickly closing. BACKGROUND Under the Dodd-Frank Act, responsibility for drafting the ATR rule initially fell to the Board of Governors of the Federal Reserve System, but was delegated to the CFPB in July 2011. The Act also provides the CFPB the authority to define criteria for certain loans called Qualified Mortgages that are presumed to meet the ATR rule requirements, and ensure that mortgage lenders made a reasonable and good faith determination that the consumer had a reasonable ability to repay the loans. In May 2012, the CFPB sought public comment on new data and information and conducted meetings with stakeholders from the industry. On January 10, 2013, The CFPB amended Regulation Z of the Dodd-Frank Act, which governed the mortgage lending policies, and came out with the final set of standards for the ATR and QM rules, under TILA. The rules attempt to address a delicate issue that needs to be appropriately balanced - the creation of standards to provide protection for a borrower who may not be as well versed in the nuances of mortgage documentation, yet also provides safe harbor protections for the lender to ensure sufficient comfort around contingent liability, (i.e. reducing the risk of repurchase or delayed foreclosure) so that credit standards are not set at an unreasonably tight level. If lenders must incorporate the possibility of higher repurchase obligations or increased litigation and foreclosure costs, we may see an environment that constrains the mortgage origination markets and availability of credit to borrowers. The above rules were born out of aggressive and misaligned lending practices prevalent in originations prior to the financial crisis. Principally, four questions arise from an industry perspective: 2 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules
How is ATR Defined? How is a QM Defined? Types of QM - When is a lender protected by safe harbor versus more limited protection provided under rebuttable presumption on a loan that complies with the QM standards? Are all institutions governed by the same standards? (The impact of the May 29, 2013 Amendment) ABILITY TO REPAY - DEFINED First and foremost, a lender is required to evaluate a consumer s ability to repay both the principal and the interest over the long term not just during an introductory period when the rate may be lower, a requirement that applies to all loans, whether or not they fall under the QM definition. To sufficiently determine a borrower s ATR, a loan must be underwritten with financial information supplied and verified, and at a minimum taking into consideration the following eight standards: 1. Current or reasonably expected income or assets 2. Current employment status 3. Credit history 4. The monthly payment on the mortgage 5. The monthly payment on any loans associated with the property (simultaneous second liens, etc.) 6. The monthly payment for mortgage-related obligations, such as property taxes 7. Other debt obligations such as other loans, alimony and child support 8. The monthly debt-to-income ratio or residual income the borrower would be taking on with the mortgage. (Debt-to-income ratio is a consumer s total monthly debt divided by their total monthly gross income) Important additional notes: Lenders must use reasonably reliable third-party records to verify the information they use to evaluate these factors. For an Adjustable Rate Mortgage (ARM) loan, the monthly payment calculation depends on whether it meets the definition of a QM. If it is non-qm, the payment is calculated using the fully indexed rate or the introductory rate, whichever is higher. If it is a non-agency QM, the calculation uses the maximum rate in the first five years. If is it an agency QM, the agency determines the calculation. For consumers trying to refinance a risky loan, exemptions apply: Creditors refinancing a borrower from a risky mortgage such as an ARM, an interest-only loan, or a negative-amortization loan to a more stable, standard loan can do so without undertaking the full underwriting process required by the new rules. A QUALIFIED MORTGAGE - DEFINED To meet the criteria of a QM, a loan must have the following features: Regular periodic payments that are substantially equal over time With an exception for the payment changes on an ARM or step-up loan. Loans must have a back-end DTI which is less than 43% Conversely, a loan cannot be considered QM, if it includes the following features: Alt-A, Low Doc, and No-Doc Loans (those that verify neither income nor assets) are prohibited Points and fees paid by the consumer cannot exceed 3% of the total loan amount; higher fees are permitted for loans under $100,000 (Up to 2 bona fide discount points are exempt) 3 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules
Negative amortization is prohibited Interest-only payments are prohibited Balloon payments are prohibited (except for small creditors serving rural areas, something we address in greater detail in the fourth section) Terms exceeding 30-years are prohibited Important notes: For a temporary, transitional period, loans that do not have a 43 percent debt-to-income ratio but meet government affordability or other standards such as that they are eligible for purchase by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac) will be considered Qualified Mortgages. The agency exemption will phase out at the earliest date of: The Federal Agencies listed above issue their respective QM rules, GSE Conservatorship ends Seven years from effective date TYPES OF QUALIFIED MORTGAGES Once a loan has been determined to meet the criteria previously described, a second filter must be applied to determine what type of protection the lender will receive in the event that a creditor or borrower may attempt to claim financial injury as a result of an improperly originated mortgage. There are two types of protection that can be received: Qualified Mortgages with Safe Harbor: A loan will receive Safe Harbor if it is considered to be a lower-priced loan, one that would typically be provided to a borrower that poses a lower risk of default. This is the stronger of the two levels of protection for the lender, and if the loan does default, the lender will be considered or presumed to have legally satisfied the ability-to-repay requirements and made a good faith and reasonable determination of the consumer s ability to repay. Consumers are still legally allowed to challenge their lender, but in order to be successful in their claim, they would have to prove the loan did not meet the definition of a QM when it was originated. The definition of lower priced is such that for a first lien loan, the Annual Percentage Rate (APR) on the mortgage is less than 1.5% above the Average Prime Offer Rate (APOR), which is a measure of the market level of mortgage interest rates For second or other subordinate liens, the rate must be less than 3.5% above the APOR The APOR will be calculated by the CFPB and in a manner and intent similar to the Primary Mortgage Market Survey Rate calculated by Freddie Mac Qualified Mortgages with Rebuttable Presumption: A loan will be considered to have a rebuttable presumption if it is a higher-priced loan, one that is typically provided to consumers with insufficient or weak credit history. This is the weaker of the two levels of protection for the lender, and if the loan does default, even though it did qualify for QM, a consumer can rebut the presumption that the creditor properly took into account their ability to repay the loan and argue that loan did not meet the ability to repay test. The argument can be invoked at any time during the life of the loan. For a successful claim, the consumer would need to show that they did not have sufficient residual income, i.e. would have to prove the creditor did not consider their living expenses after their mortgage and other obligations the creditor was aware of, or should have been aware of, such as alimony, child support, and could also include recurring medical bills. The amount of residual income required to allow a borrower, a critical definition in the rule, is never officially defined and as such poses risk to the originator. 4 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules
Non-QM: QUALIFIED MORTGAGE SEGMENTS 1 QM: Negative Amortization Loans Interest Only Loans Loans with Balloon Payments (except for small creditors serving rural areas) Loans with terms exceeding 30 years Loans with no verification of income and no verification of assets Loans with upfront fees>3%, higher fees are permitted for smaller loans (up to 2 bona fide discount points are exempt): Loans must have standardized features including regular periodic payments that are susbstantially equal, except for the payment changes on an Adjustable Rate Mortgage. Upfront points cannot be more than 3%. Loan must have back-end Debt To Income Ratio <43% or be eligible for agency execution. Safe Harbor: Rebuttable Presumption: Loan Amount $100,000 or more 3% Loans >43% back end Debt to Income Ratio and ineligible for agency execution Cap $60,000 to $99,999 $3,000 $20,000 to $59,999 $12,500 to $19,999 Less than $12,500 5% $1,000 8% Mortgage Rate <1.5% above the prime mortgage rate Mortgage Rate >1.5% above the prime mortgage rate How do you rebut a rebuttable presumption? By showing a borrower has insufficient residual income. Insufficient vs. sufficient residual income is never defined The table above illustrates the breakout of QM Segments. MAY 29TH AMMENDMENT ARE ALL MARKET PARTICIPANTS EQUAL? A key criticism of the initial rules as they were original articulated in January 2013, was the potential impact of the new rules on small lenders and the potential for restricting credit to the broader marketplace. The recent amendment made several significant changes, providing exemption from QM regulations for banks and credit unions with $2 billion or less in assets that issue 500 or fewer mortgages each year as well as certain non-profit organizations that originate 200 or fewer loans per year, and mortgage loans made in connection with certain Federal emergency economic stabilization programs. Additionally the amended rule modifies the requirements regarding the inclusion of loan originator compensation in the points and fees calculation, a critical element as only loans with points and fees under 3% are eligible for QM status. Under the amendments issued on May 29: 1 CFPB and Amherst Securities 5 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules
Small Bank Related Changes Small banks and credit unions can issue loans with Debtto-Income (DTI) ratios greater than 43 percent if they keep those loans in their portfolio. Small institutions can continue to originate mortgages with balloon payments for a two-year transition period while the CFPB conducts a study on small-bank lending. Small banks and credit unions can originate mortgages at 3.5 percent above the average prime offer rate (as opposed to 1.5%) and still have them eligible for qualified mortgage status and exempt from rules governing high-priced mortgages, specifically the type of lender protection that those mortgage would afford. The CFPB estimated that approximately 9,200 small institutions, such as community banks and credit unions, are likely to be affected by the proposed definition of a small bank or credit union. Loan Originator Compensation Related Changes The amended rule excludes from points and fees ( P and F ) loan originator compensation paid by a consumer to a mortgage broker when that payment has already been counted toward the P and F thresholds as part of the finance charge. The amended rule also excludes from P and F compensation paid by a mortgage broker to an employee of the mortgage broker because that compensation is already included in P and F as loan originator compensation paid by the consumer or the creditor to the mortgage broker. The amended rule also excludes from P and F compensation paid by a creditor to its loan officers. CHALLENGES TO IMPLEMENTATION Given the complex rules outlined by the CFPB in their 800 page document, as well as the opaqueness of several key components of the rules (i.e. definition of required residual income), mortgage lenders and banks have a significant undertaking to not only comply with the new regulations, but to document that compliance, and perhaps most importantly, implement flexible solutions that permit changes in a cost effective and time efficient manner, as changes are inevitable, and the penalties for non-compliance severe. Several of the key challenges have been identified below: 1. Scalable and flexible methodology for evaluating and storing income documentation and verification a. Ensuring that all debt obligations have been identified ii. 2nd liens iii. Other debt obligations b. Ensuring income is accurate and complete 2. Proper calculation of P and F 3. Comprehensive documentation management and illustration of compliance 4. Detailed policy and procedure documentation showing support activities that align with the overall QM and ATR adherence 5. Training on compliance with the new regulations 6. Reporting, both internal and external 6 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules
Financial Repercussions The potential financial impact for a mortgage lender for noncompliance can be significant. In an analysis by Amherst Securities 2, it is estimated that if a lender is sued for violating the ATR statute, the cost to defend each case would be $70 100K. This potential cost is simply to address the time and cost to defend the case. In addition, if an institution was found to have violated the ATR, they would be subject to enhanced damages. Enhanced damages include actual damages, 2x the finance charge (including interest and points and fees) paid in the first 3 years, all fees the consumer paid in the first 3 years, statutory damages of up to $4,000, court costs, and reasonable attorney s fees associated with the enforcement action. It bears repeating that a borrower can assert potential violations of ATR at any point during the life of the loan, and this can be utilized as a potential reason to delay foreclosure. Thus, the time and litigation cost could potentially increase the foreclosure timeline and assumptions for cost management in the default process. CONCLUSION The QM and ATR rules have provided some level of clarity and certainty to the mortgage markets, in that they have defined the general framework and process for determining a reasonable ability to repay the mortgage obligation. However, inherent in this framework is the tremendous burden on the originators, not just the burden of proof, but more so the burden of creating a process, infrastructure, technology, and reporting framework to ensure the rules are implemented. This is not a simple change and will require significant pro gram management including: exten sive training, incorporation of human capital, compliance, and fundamental changes to the approach of mortgage origination and the comprehensive way that an audit trail is created and maintained. Navigant has helped a number of firms prepare for and successfully implement strong compliance and reporting frameworks to create a QM and ATR compliance system, as well as strong policies to ensure ongoing compliance and easy access for any regulatory requests. At its core, technology is the best weapon, as it provides optimal flexibility, scalability, and speed. Combined with robust policies and procedures, and a strong compliance and risk management approach, a pro-active plan to QM and ATR, can allow your firm to quickly take market share from competitors in a safe and prudent manner while also remaining flexible for the changes ahead. 2 Amherst Securities - QM: Mortgage Market Implications, January 16, 2013 7 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules
HOW NAVIGANT CAN HELP Navigant has implemented mortgage solutions for a wide range of institutions related to compliance and regulatory requirements such as the Qualified Mortgage and Ability to Repay Rules. An overview of the service offerings we have implemented is below, but each engagement is approached with a customized execution strategy built around your company s needs and budget, always supported by a leadership team that brings the right mix of functional and technical expertise. Compliance Reviews CFPB Preparation Loan File Testing QC Outsourcing/Staff Augmentation Strategy reviews Servicing operations reviews Securitization structuring and accounting Risk analytics Mortgage loan accounting Troubled debt restructurings Controls deficiency remediation Competitor analysis / benchmarking Forensic compliance System selections and implementation Targeted operating model development Valuation of loans and RMBS / CMBS Allowance for loan loss Risk and capital modeling Process and workflow automation Organization design and process re-engineering HASP / HAMP compliance Bankruptcy compliance and monitorship 2013 Navigant Consulting, Inc. All rights reserved. 00001902 Navigant Consulting is not a certified public accounting firm and does not provide audit, attest, or public accounting services. See navigant.com/licensing for a complete listing of private investigator licenses. 8 PERSPECTIVES The Qualified Mortgage and Ability to Repay Rules