Since 2014, home loans in the US have fallen into two categories: qualifying (QM) and non-qualifying (non-QM).
The Consumer Financial Protection Bureau (CFPB) introduced the concept of the former as part of the Home Mortgage Disclosure Act, which was designed to reduce risky practices in the market. The QM designation involved a variety of metrics, most notably a debt-to-income ratio of less than 43%.
The Act inevitably spawned the non-QM mortgage sector, targeted at those that fall outside those strict QM specifications.
The non-QM definition is very broad but tends to incorporate four types of borrower: the self-employed, those borrowing for investment properties, those with a debt-to-income (DTI) of more than 43% and loans to foreign nationals.
But there is one enormous exception to this: under current rules, any mortgage that is backed by either of the government sponsored enterprises (GSEs) ‒ Fannie Mae or Freddie Mac ‒ automatically qualifies as a QM loan regardless of whether it falls into any of these non-QM categories, under an arrangement known as a 'patch'.
The GSEs currently guarantee a total of $4.5 trillion in residential mortgage loans and, according to KBRA, are now purchasing more than $150 billion mortgage originations per year that comprise loans with a DTI greater than 43%.
This patch arrangement is now due to expire in January 2021. If this happens, borrowers of billions of dollars of mortgages will suddenly find themselves classed as non-QM rather than QM.
This would be bad news for the borrowers, but very good news for the non-QM RMBS market, which has been supressed by the GSE QM patch. Standard & Poor’s reckons that non-QM mortgages will make up 25% of the $100 billion of non-agency RMBS market in the US this year – but will still only account for roughly 2% of total US RMBS issuance.
But the sector is growing fast – from $12 billion of issuance in 2018 to a projected $25 billion this year and $40 billion expected in 2020. If the QM patch expires in 2021 then those numbers will skyrocket.
Lenders are understandably at pains to emphasize the clear line of separation between non-prime, non-QM mortgage origination today and the tarnished pre-crisis sub-prime RMBS sector of the mid-2000s. A multitude of regulations has been implemented to clean up the industry since 2008, but among the most significant is one that was also ushered in as part of the Home Mortgage Disclosure Act in 2014: the ability to repay requirement (ATR).
The sector is growing fast – from $12 billion of issuance in 2018 to a projected $25 billion this year and $40 billion expected in 2020. If the QM patch expires in 2021 then those numbers will skyrocket
Under this regulation it is the responsibility of the lender to make sure that the borrower has the ability to repay the loan and that the documentation complies with a set of requirements known as Appendix Q. This covers income verification, stability of income, probability of continued employment and the treatment of other income such as alimony or child support and applies to both QM and non-QM mortgages. It is the lender’s responsibility to make sure the documentation is in order and – even if they themselves default – the borrower can sue and be awarded penalties if it is not.
This was tested in a landmark lawsuit in Ohio earlier this year (Elliott v First Federal Community Bank of Bucyrus), where the plaintiff had received alimony payments far below those agreed at the time the loan was signed and had defaulted as a consequence. The case attempted to prove that the lender had failed to comply with ATR but was thrown out – to the huge relief of the mortgage lending industry.
As investors and issuers gear up for a potential bonanza in non-QM RMBS, this is an example of the kind of risk that they need to be thinking about. Whether or not such a case could be brought against investors in a securitization of such loans has yet to be tested but cannot be ruled out.
As KBRA analysts recently noted: “Given the market’s almost singular focus on GSE lending post-crisis, educating investors on non-QM standards in an ATR mandated regulatory environment will be critical going forward.”
It is not only the borrower that can sue if ATR rules are not complied with: statutory penalties can be imposed on the lender (and potentially the RMBS investor) by the CFPB itself and the relevant state legislatures.
The likelihood that the CFPB will simply remove the QM patch without changing the existing QM definition is pretty remote. It could also be politically ruinous to raise borrowing costs for low income households. Lenders are therefore lobbying hard to have the 43% DTI limit for QM mortgages removed and Appendix Q scrapped. This would keep many borrowers compliant with the QM requirements but would dilute their fundamental purpose.
Even if the QM umbrella is broadened, it seems certain that the size of the non-QM mortgage market will still balloon, boosting the prospects for the entire private label RMBS sector along with it. This is a welcome step away from the GSE’s dominance of the US mortgage lending space, but is not without risk for potential investors.
The removal of the QM patch needs to be approached with great care – not least because its removal date of January 2021 coincides with another somewhat significant event in the capital markets calendar: the end of Libor.