Sep022015

The ability-to-repay rules prevent irresponsible lending

Qualified mortgage standards and the ability to repay rules provide a rigid framework designed to prevent lenders from irresponsibly inflating another painful housing bubble. The rules as drafted should achieve the desired effect.

honorable_borrowersThe housing bubble inflated because lenders underwrote huge loans to borrowers who didn’t have the capacity to repay unless the value of the underlying collateral kept rising to bail them out. It became a massive Ponzi scheme that imploded and wiped out the housing market, the economy, and nearly our entire financial system. Regulators were wise enough to understand that much, and they were brave enough to pass the Dodd-Frank law to attempt to rein in the worst offenses. Part of the implementation of Dodd-Frank is the establishment of rules regarding the ability to repay a loan.

It’s shocking that bankers must be regulated in order to properly evaluate a borrowers ability to repay; prior to the age of securitization, lenders loaned their own money, and they lost money if they loaned it irresponsibly. In a system of originating to hold loans, lenders concerned themselves with the borrower’s ability to repay as a matter of survival; with securitization, lenders found they could pass the risk of default on to others, so they lost their concern for a borrower’s ability to repay the loan. Regulators had to restore it.

The Dodd-Frank Act Turns Five, The Lingering and Lasting Effects

Stuart Quinn, August 14, 2015

There was significant concern in the housing finance industry about the QM/ATR rules and their subsequent impact on future originations, litigation and mortgage pricing. Within the rule, the CFPB established an exemption for Fannie Mae and Freddie Mac (GSEs) that allowed loans to be QM eligible so long as they were approved under their automated underwriting systems. This exemption and further exceptions for smaller institutions and rural lenders largely muted the near term origination concerns going forward. The rules solidified existing trends in the origination space. For example, low-documentation and no-documentation loans peaked at the end of 2005 at 42 percent, and by the time the Dodd-Frank Act was signed in July of 2010, the number had tumbled to 4 percent of purchase originations.

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Furthermore, adjustable-rate mortgages, which are not banned but are treated differently than fixed-rate mortgages under the QM rules, had also largely disappeared from the marketplace comprising only 7 percent of purchase originations.

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One origination trend that did pivot in March 2011 was the weighted average debt-to-income (DTI) ratio for purchase mortgages, which peaked that month at 37 percent.

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In April 2011, the Federal Reserve released their initial proposed ATR/QM rule indicating that debt-to-income ratio would be one determining factor, though no specific threshold was cited. Since then, the weighted average back-end DTI of purchase originations has dropped to 33 percent, approximately 10 percent below the final 43 percent DTI threshold established by the CFPB under the final ATR/QM rules that went in to effect in January 2014.

I am pleased to have such talented and thoughtful people who read this blog each day. One of our frequent astute observers, Perspective, agreed to write up a brief but detailed description of the ability to repay rules. Perspective has been an attorney in the consumer financial services field for over ten years, making him an expert.

The following is not intended as legal advice, and if anyone claims it is, they are some fool looking for a scapegoat for their mistakes, which I refuse to be. 

Ability To Repay Rules

No Recourse if Lenders Make Mortgage Loans Borrowers Cannot Repay

Prior to January 10th, 2014, if a lender made a mortgage loan that a borrower couldn’t afford to pay back, there was no legal recourse.  A borrower couldn’t file a lawsuit complaining that the mortgage couldn’t reasonably be repaid.  There was no federal law against making mortgages to borrowers regardless of the borrower’s ability to repay the mortgage.

Duty on Lenders to Make Only Mortgage Loans Borrowers Can Reasonably Repay

After January 10th, 2014, federal law (12 CFR § 1026.43) requires all lenders ensure borrowers have the ability to repay every mortgage loan a lender makes.  If a lender fails to do so, a borrower may within three years of the loan’s origination, file a lawsuit claiming the lender failed to consider and verify the borrower’s reasonable ability to repay the mortgage loan.  A successful lawsuit could result in statutory damages totaling up to three years’ finance charges and fees.  Other statutory damages are available, in addition to actual damages, court costs, and attorney’s fees.  A borrower may also assert a violation of the ability to repay rules (“ATR”) in a defense to a foreclosure action at any point in the mortgage’s term.  The damages in this claim are limited to statutory damages totaling up to three years’ finance charges and fees.

There is no free house for a borrower if they win an ability-to-repay lawsuit, thankfully; however, the punishment is stiff enough that lenders will not want to face a rash of costly lawsuits from aggrieved borrowers either.

Ability to Repay

How does a lender establish proof the borrower had the ability to repay the mortgage loan?  The lender must make a reasonable and good faith determination that the borrower will have a reasonable ability to repay the mortgage loan by considering and verifying all of the following eight underwriting factors:

1)     Payment Underwriting

2)     Mortgage-Related Obligations

3)     Income or Assets

4)     Employment Status

5)     Simultaneous Loans

6)     Debt, Alimony, Child Support

7)     DTI or Residual Income

8)     Credit History

These underwriting factors are fairly self-explanatory and there’s a long history of standard underwriting guidelines establishing what is reasonable.  The borrower must provide all of this information and paperwork, and the lender must consider it, verify it, and document it.  There is no ATR limit on the debt to income ratio (“DTI”), but the lender must use the real payment to qualify the borrower.  The payment in a fixed-rate mortgage loan doesn’t change, but the payment can change in non-fixed mortgage loans.

Ability to Repay: Payment Underwriting in ARMs

The monthly payment on an adjustable rate mortgage (“ARM”) used to qualify the borrower’s ability to repay must be calculated using the higher of the fully-indexed rate or introductory rate on a fully-amortizing substantially equal payment stream.  Borrowers use ARMs to stretch the amount they can finance, but ATR limits this practice.

In my opinion, this is the most important part of the legislation, this is what will stop lenders from using teaser rates to inflate future housing bubbles. Borrowers can still use foolish, toxic financing options if they wish to lower their payments, but they won’t be able to finance a larger mortgages because the lower payment. The main reason borrowers use ARMs is to finance a larger loan; the ability-to-repay rule stops that practice cold.

e.g.  5/1 30-year ARM; first 60 payments fixed at 2.5%; current rate on index applicable to start months 61-360 is 3%; margin at initial adjustment is 2%.

The initial monthly payment on an $800,000 mortgage loan with this ARM would be $3,161, but the lender must use the payment ($4,295) on the fully-indexed rate (5%) to qualify the borrower.   ATR does not establish a front-end nor back-end DTI limit, but if a lender’s typical front-end PI (principal + interest, not considering taxes, insurance, HOAs, etc.) DTI limit is 28%, then:

  • A verifiable income of $135,471 is necessary to minimally qualify for the $3,161 payment; but
  • A verifiable income of $184,071 is necessary to minimally qualify for the $4,295 payment.

Ability to Repay: Payment Underwriting in IOs

The monthly payment on an interest-only mortgage (“IO”) used to qualify the borrower’s ability to repay must be calculated using the higher of the fully-indexed rate or introductory rate on a fully-amortizing substantially equal payment stream over the remaining term of the loan after recast (when the IO period ends).

e.g.  30-year IO; interest-only payments fixed at 4% for ten years; current rate on index applicable to start months 121-360 is 3%; margin at initial adjustment is 2%.

The initial monthly payment on an $800,000 mortgage loan with this IO would be $2,667, but the lender must use the payment ($5,280) on the fully-indexed rate (5%) based on the fully-amortizing payment of the final 20 years to qualify the borrower.   If a lender’s typical front-end PI (principal + interest, not considering taxes, insurance, HOAs, etc.) DTI limit is 28%, then:

  • A verifiable income of $114,300 is necessary to minimally qualify for the $2,667 payment; but
  • A verifiable income of $226,286 is necessary to minimally qualify for the $4,295 payment.

cant_pay_ocSince lenders must qualify the borrower based on the fully-amortized payment after recast, interest-only loans lose their ability to finance larger loan balances; in fact, since the fully amortized payment after recast is so large, interest-only loan balances end up being much smaller than fully amortizing loans, making interest-only loans useless as an affordability product.

Ability to Repay: Qualified Mortgages

A lender can mitigate its ATR risk/exposure by originating a Qualified Mortgage (“QM”).  If a mortgage qualifies as a QM, the lender is provided a Safe Harbor.  If a borrower claims a violation of ATR within three years of origination or at foreclosure, a lender can plead the mortgage loan’s QM status and the court will conclusively presume ATR compliance and quickly eliminate the ATR claim.

If the APR is above a defined threshold, but otherwise qualifies as a QM, the lender is provided a Presumption of Compliance.  If a borrower claims a violation of ATR, the lender can plead the mortgage loan’s QM status and shift the burden to the borrower to prove the lender did not make a reasonable and good faith determination of the borrower’s ability to repay.

Shifting the burden of proof is a huge advantage to lenders. If lenders originate non-qualified mortgages and the borrower sues, the lender must prove they did everything properly, increasing the lender’s costs and risks. If lenders originate qualified mortgages, the burden of proof falls on the borrower, greatly reducing the lenders risk and cost involved. This shifting burden of proof is the primary reason most lenders will not originate anything other than qualified mortgages.

In addition to considering and verifying the eight ATR underwriting factors, a QM may not include an interest-only, negative amortization, nor balloon payment feature.  The term may not exceed 30 years.  The points and fees are limited to 3% (in loans of $100,000 or more).  The back-end DTI is limited to 43%.

The standards of qualified mortgages still provides lenders plenty of leeway to make bad loans, which seems to be what they all want to do, but the parameters are tight enough to greatly limit the chances of inflating another massive housing bubble.

Ability to Repay: Qualified Mortgages – Payment Underwriting in ARMs

The QM payment calculation on ARMs is slightly more conservative than general ATR.  The lender must determine the borrower’s ability to repay the ARM loan using the maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment will be due.  Lenders must assume the interest rate increases as rapidly as possible.

e.g.  3/1 30-year ARM; first 36 payments fixed at 2.5%; current rate on index applicable to start months 37-360 is 3%; margin is 2%; annual adjustment cap is 2%; max lifetime rate is 12%.

The initial monthly payment on an $800,000 mortgage loan with this ARM would be $3,161, but the lender must use the payment ($7,619) on the fully-indexed rate (11%) to qualify the borrower:   Index (3%) + margin (2%) + max adjustment at 36th payment (2%) + max adjustment at 48th payment (2%) + max adjustment at 60th payment (2%) = 11%!  If a lender’s typical front-end PI (principal + interest, not considering taxes, insurance, HOAs, etc.) DTI limit is 28%, then:

  • A verifiable income of $135,471 is necessary to minimally qualify for the $3,161 payment; but
  • A verifiable income of $326,529 is necessary to minimally qualify for the $7,619 payment.

The last QM factor is the APR must not exceed the Average Prime Offer Rate (“APOR”) by the following margins:

  • Safe Harbor QM:  The APR may not exceed:
    • 1.5% plus the APOR in a first lien loan; or
    • 3.5% plus the APOR in a subordinate lien loan.
    • Presumption of Compliance QM:  The APR exceeds the Safe Harbor QM thresholds.

Loose Ends

HELOCs are exempted from ATR, but ATR includes an evasion provision that prohibits lenders from structuring mortgage loans as HELOCs in order to evade ATR requirements.  The FHA and GSEs’ (Fannie/Freddie) guidelines for QMs may deviate from the standard QM requirements for the next seven years, but their guidelines must comply with ATR.  The Safe Harbor provided by a QM, is only safe to the extent the loan is actually a QM.  A plaintiff’s attorney can argue a mortgage loan never qualified as a QM.  If the points and fees were calculated incorrectly, a correct calculation could eliminate the QM status.

Is reckless lending a thing of the past?

The big question is whether or not these rules provide a rigid enough box to prevent lenders from lending irresponsibly and creating another unstable housing bubble. Only time will tell how these provisions are enforced, but since lenders will face the wrath of millions of disgruntled borrowers rather than the impotent prods of captured regulators, I believe the qualified mortgage rules and the ability to repay rules go a long way toward keeping residential mortgage lending on the up and up.

[Thank you, Perspective, for that great summary of the ability to repay rules.]

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