New standards for mortgage lending

New standards for qualified residential mortgage (QRM) lending went into effect Monday, January 10th, 2014. Based on the inquiries we have been receiving, there are many misconceptions as to what the new regulations entail, and how they may effect mortgage lending and the real estate market as a whole. I thought now was a good time to revisit these standards and explain their implications.

The Consumer Financial Protection Bureau (CFPB) issued their QM rules which went into effect January 10, 2014. The rules determine the limits on the loan types which can be offered by banks, the fee structures which can be charged by banks, and other such issues. (For more details, you can download the 7 page summary or the 804 page full document issued by the CFPB). The CFPB’s QM standard already clearly stipulates what is considered to be a safe and sound loan, and adding additional layers of regulation could limit credit availability for first-time home buyers and borrowers without large down payments, and prevent private capital from entering the market.

For most home loan borrowers, the change will have little or no impact on whether they can actually get a mortgage, experts say, but they may have to show even more proof that they can afford one. Here’s a look at the rules, what they do and why they matter.

What are the new rules, and where did they come from?

There are several terms to know. The first is the “ability-to-repay” rule. It was required by the 2010 Dodd-Frank financial overhaul legislation as a response to the financial crisis. The rule was crafted by the Consumer Financial Protection Bureau, which will oversee its enforcement.

What do the new rules do?

As you can see above, the new rules require mortgage lenders to make sure borrowers can actually afford their loans, over the long term, by weighing their income, assets, savings, and debt against their monthly house payments. “It really is pretty basic,” says Richard Cordray, head of the CFPB. He calls the changes a “back to basics” approach for mortgage lending.

What else is new?

A “Qualified Mortgage” meets new guidelines, and borrowers who get them are presumed to meet the ability-to-repay requirements. If lenders make QM loans, they have more protections against future lawsuits should the loans later go sour. Much of the industry’s attention is focused on the new Ability-to-Repay/Qualified Mortgage (ATR/QM) Standards, which require lenders to demonstrate they have made a reasonable and good faith determination, based on verified and documented information, that the consumer has a reasonable ability to repay the loan. The lack of such documentation was common during the housing boom in the late 1990s and early 2000s and was one of the contributing factors of the housing collapse that began in 2007. With the CFPB’s heightened scrutiny over lender practices, a relapse is much less likely to occur. The ATR/QM rule is just one of the new rules aimed at helping lenders close less risky loans.

The goal behind the ATR/QM rule is for lenders to demonstrate they have made a reasonable and good faith determination, based on verified and documented information, that the consumer has a reasonable ability to repay the mortgage loan according to its terms. To meet this standard, lenders must consider, verify and document that the consumer has sufficient income and assets to repay the loan, generally using the eight underwriting factors described in the ATR/QM rule.

Qualified residential mortgages

Qualified residential mortgages should make home buying more costly in 2014. On January 10, 2014, a new provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act goes into effect. The “qualified residential mortgage,” or QRM, may have far-reaching effects that will lessen the number of people who can obtain home loans. In my eyes it particularly affects ‘entry level‘ buyers. Most of us started as ‘entry level‘ buyers, which forced us to save a bit more and allowed us to build equity for our next house. Not having more lenient financing for these type of buyers will have a definitive long term effect on housing. ‘Entry level’ buyers will be forced to pay more and more of their income to continually escalating rents. The inability to have tax advantages and the ability to share in one of the best leveraged ‘hard assets’ in the nation will have long range affects on the Millennials and others that also are not seeing the positive effects of inflation on other assets that the Baby Boomers saw.

QRMs were designed to set the bar for residential mortgages and to minimize the risk that borrowers may default. It requires that debt ratios be limited to 43 percent and loan fees limited to 3 percent, and interest-only loans and negative amortization are not allowed in most cases. The Dodd-Frank bill also requires the lender to retain 5% of any mortgages they make. Most lenders do not have the ability to retain 5% since they are making less than 2% on most loans. This opens the door for mortgage lending to the large banks, who have deposits and other capital they can pledge as that 5%. In other words, if they make a $100,000 loan, they must retain $5,000 to secure the loan. QRM loans are exempt from the risk retention rules. This means that the lender can sell the loan on the secondary market without having to retain the 5 percent. The effect of these provisions is already being felt in the lending industry. Citibank has restricted its lending to those areas where it has a banking presence. Compliance departments have tripled in size at many large lenders. Community banks and credit unions are being choked by the regulations and often lack the resources to meet the new compliance requirements.

Community banks and credit unions have historically had a much lower default rate compared to other lenders. The reason is that they know their customers. Community bank loans have often been based on a handshake, a borrowers character, and knowing the customer over a longer term. In terms of credit union loans, people feel they are hurting themselves and other members if they default. That is what makes the new provisions so difficult for lenders. In the past, loans have been turned down primarily due to credit issues. For the first time in history, lending decisions may be made based upon compliance issues rather than just credit issues. Imagine that you made a mistake on a purchase agreement contract. The buyer and seller want to change the agreement to correct the mistake, except the law prohibits you from doing so. If a lender makes a mistake with any part of the compliance, the lender now has to pay all of the borrower’s closing costs. Even if the mortgage agent made the mistake, the mortgage agent must still be paid. The lender cannot deduct any costs or losses resulting from the mistake. The lender still has to close the loan. These provisions will be particularly difficult for online mortgage sites.

In addition to the issues above, jumbo loans currently fall outside the QRM provisions. A jumbo mortgage is a mortgage loan that may have high credit quality, but is an amount above conventional conforming loan limits – $625,000 in Texas. This creates tremendous uncertainty as to what will be required of lenders who want to sell jumbo loans on the secondary market. The result will most likely be that be even fewer jumbo loans will be available.

What are the QM guidelines?

QM loans cannot:
• Contain risky features, such as terms that exceed 30 years, interest-only payments or payments that are less than the full amount of interest so that the home loan debt grows each month.
• Carry more than 3% in upfront points and fees for loans above $100,000.
• Push a borrower’s total debt load above 43% of his or her monthly income, unless the loan is eligible to be backed by Fannie Mae or Freddie Mac, or a federal housing agency such as the FHA, or is made by a small lender that keeps the loan on its books.

Ability to repay standards QRM / ATR guidelines are as follows:
• Current or reasonably expected income or assets
• Current employment status
• Monthly payment on the covered transaction
• Monthly payment on any simultaneous loan
• Monthly payment for mortgage-related obligations
• Current debt obligations, alimony, and child support
• Monthly debt-to-income ratio or residual income
• Credit history

The Dodd-Frank Act and ATR/QM rule provide that a lender making a special type of loan, known as a Qualified Mortgage, is entitled to presume that the loan complies with ATR requirements (safe harbor). The rule establishes different types of Qualified Mortgages that are generally identified as loans with restrictions on loan features, limits on fees being charged, and underwriting requirements.

Can lenders still make loans outside those guidelines?

Yes, but they’ll still have to make sure borrowers can afford the loans, and they’ll have less protection against future legal challenges if the borrower fails — even if they resell the loan after they first make it. Some banks will continue to do interest-only loans. Many borrowers in high housing-cost areas also frequently have debt-to-income ratios that exceed 43% and lenders will likely keep making home loans in those areas, too. Many lenders say they’ll keep making non-QM loans that are “perfectly sound”, whether they look to sell them on the secondary market or maintain them within their own mortgage portfolios. The point is QM/QRM guidelines will not rule all new mortgages.

How many mortgages are likely to fall under the QM definition?

Currently he CFPB estimates that 92% of mortgages in the current marketplace would meet the QM requirements.

Why is this needed?

One of the big causes of the ‘great recession’ was the financial meltdown caused by the lenders risky lending habits. Most analysts estimate that 50%+ of recent home loan defaults could have been prevented had the QM rule been in place when the loans were made, largely before the housing bust. Over time, should the housing market get superheated again, the new rules will “serve as a barrier,” against another financial melt down caused by aggressive risky loan practices,

Will the rules make it harder for some people to get home loans?

Some professions will find it may be tougher to qualify if they have difficult-to-validate incomes, including those for whom tips, bonuses, commissions, rents or investments constitute a big part of their total income. One in nine Americans are also self-employed, and that income is harder to substantiate than wage income. It is important to work with a competent, experienced mortgage professional.

Those borrowers above the 43% debt-to-income level will also face more hurdles, but mostly in terms of documentation. That’s because lenders have to be able to prove that they exercised extreme due diligence in making such loans. Borrowers should expect to have to produce even more tax records, pay stubs and bank and investment account information.

What’s going to be the required minimum down payment?

The rules don’t set any down-payment requirements. There appears to be a common misconception that the new rules will bring mandatory down payments for borrowers. But that is not the case presently. It was a suggestion in 2011, and met with a lot of resistance.

The lending changes should not have a direct effect on down-payment requirements in 2014. Nor will they impose a mandatory down payment of 20%, as many people believe. In 2014, as in past years, loan-to-value ratios (and their inverse, the down payment) will primarily be influenced by the mortgage insurance industry and the business practices of individual lenders. It is highly unlikely the federal government will impose any minimum down-payment requirements on borrowers in 2014.

Will the rules mean it’ll take longer to get home loans approved?

This is a great question to ask in a seller’s market. A seller will probably look at cash deals before qualified mortgages in the essence of speed. Any new guidelines slow the process historically. It’ll still take lenders more time to get systems up and running that track and handle new documentation requirements. While lenders have had months to prepare, he still expects that loan officers, underwriters, and compliance offers will need more training. Guidelines have been written, but until underwriters and the industry get some experience in what guidelines the CFRB is expecting, it will be slower and should include more conservative guidelines.

What concerns are there about these changes?

Anytime you change underwriting guidelines that come with federal penalties, you cause an industry to remain conservative. That is a big concern for entry level and affordable housing. Also many critics say minimum-down-payment requirements would be a good thing. Analysis shows that eliminating loans with risky features (zero documentation, zero down, etc.) would have eliminated over 60% of defaults that occurred in loans issued in 2007; it also would have prevented 30% of the loans that didn’t default, too.

As discussed earlier, it may be tougher for some borrowers to qualify if they have difficult-to-validate incomes, including those for whom tips, bonuses, commissions, rents or investments constitute a big part of their total income. One in nine Americans are also self-employed, and that income is harder to substantiate than is wage income.

Most underwriters are sticking to remaining conservative in their outlook and interpretation of these rules. My take is that mortgage lending will continue to be harder to qualify for, rather than easier.
There will be fewer loan choices as community banks and credit unions are squeezed out of the market, making it even harder for many borrowers to qualify. The loan process will also probably take longer due to the increased compliance measures. Lenders generally want to issue loans that meet QRM criteria. It gives them an exception to a rule they find troubling. It allows them to sell a higher percentage of their mortgages into the secondary market, thereby reducing their long-term risks. As a result, the majority of lenders will impose these guidelines upon their customers. These rules will essentially set the bar for mortgage lending standards in the U.S. Those borrowers who fail to meet these criteria will have a harder time finding a loan compared to borrowers who do meet the criteria.

Remember in 2005, the median home value in Austin was around $171,000, and today it is around $220,000. But with wages staying flat during this time in Austin as well as the rest of the country, it makes affordability and qualifying further out of reach. With a healthier economy, they might end up paying a higher interest rate as well. Lenders claim that risk retention increases their operating costs, so they will likely charge more for loans that are subject to risk retention.

So here’s the bottom line: why wait to buy? Values, rates, lending all are increasingly making it harder to buy. Encourage anyone who is on the fence about selling or buying to do so soon. Otherwise, they may be caught up in maelstrom of new regulations that can sink their sale and that might also hamper the real estate recovery.