By Colgate SeldenThe non-QM market has been “coming soon” since the Qualified Mortgage safe harbor of the Ability-to-Repay rule took effect in 2014. But now, thanks to changes in banking regulations and growing participation by both originators and investors, non-QM lending and securitization are finally gaining traction. As community and midsize banks consider non-QM opportunities, it is worth keeping in mind these products, while attractive, do come with some inherent challenges—particularly potential buy-back liability in the event of compliance issues or underwriting defects.
A $200 billion opportunity?
While the overall mortgage origination market has been stagnant or declining over the past few years, the non-QM category has been growing. Last year, Nomura estimated that non-QM lending volume could grow to more than $100 billion within 10 years. Since then, other observers have suggested the potential market could be twice as large. Non-QM securitizations are a growing part of the private-label RMBS market. In fact, S&P expects non-QM securitizations to double in 2019 to $20 billion.
Market demographics are one of the tailwinds driving non-QM growth. These products have the potential to address the financial needs of:
- 16 million self-employed consumers in the U.S. who faced challenges in qualifying under the QM rules
- Millions of “underwater” borrowers who have since repaired their credit in the post-crisis period
- Millennial borrowers who, due to student loan burdens, are carrying higher debt levels
- High-net-worth borrowers with non-traditional assets
- The aging cohort of baby boomers who are retiring with an estimated $30 trillion in assets
Higher yields, minimal ATR rule litigation and enforcement to date and the strong performance of the first generation of non-QM loans have also increased the industry’s comfort level with this asset category. In the first quarter, for example, major money center banks, insurance companies and asset managers have all announced programs to acquire non-QM assets and issue securities backed by them.
Non-QM vs. QM
There are several factors determining whether a loan can be considered QM or not. These include debt-to-income ratio, which must be below 43%; its structure (interest-only and balloon terms, for example, usually make it non-QM); the points and fees charged; and the documentation used in underwriting. Generally, loans falling outside these criteria are considered non-QM. In addition, loans with expanded credit, business purpose loans for fix-and-flip projects and asset-depletion loans are usually non-QM.
Selling high-DTI loans to Fannie Mae or Freddie Mac through what’s become known as the “GSE patch” has allowed lenders to avoid non-QM classification. The patch, however, is an option only while the GSEs remain in conservatorship and is set to expire in 2021, regardless of GSE conservatorship status.
S. 2155, the regulatory reform law passed last year, gives banks with assets below $10 billion the ability to change non-QM loans to QM simply by holding them in portfolio. As a result, these banks are no longer constrained by normal non-QM parameters, including Appendix Q of the ATR rule, 43% DTI or credit characteristics, as long as they are willing to own the asset.
While the new rules give banks a competitive advantage over nonbanks in non-QM lending, most observers expect banks to use them cautiously—for example, gradually expanding their IO and balloon offerings or being more accommodating to the needs of longtime self-employed customers. The return of no-doc, subprime lending is considered much less likely.
To keep their options open, astute bankers wanting to take advantage of the new portfolio lending option, will most likely originate products that could eventually be sold to non-QM investors/issuers if needed. Fortunately, the universe of investors that can provide this exit strategy is growing. Today it includes new mainstream entrants, as well as the original set of investors—specialty aggregators, REITS and private equity players—that pioneered the market.
Non-QM origination compliance considerations
In terms of compliance, non-QM loans are generally subject to the same regulations as a QM loan, including TRID, HOEPA, fair lending and state and local regulations.
Lenders who typically hold loans in portfolio or sell mainly to the GSEs or FHA may be surprised at the higher levels of scrutiny their loans will receive when selling to non-QM investors in the private secondary market. This is particularly true when it comes to the concern for TRID errors. Recently, an executive from one of the leading ratings agencies made this point by sharing a due diligence “exceptions” report on a 2,500-plus loan pool. The pool had 89 open exceptions for credit, three for property/valuation and more than 6,800 for compliance.
Because loans with TRID errors can be kicked out of securitization pools, originators have strong incentives to review and address these issues quickly. Some investors will accept loans with potential TRID issues if the lender will guarantee or create a set-aside to offset any future devaluation from a loss due to inadequate compliance. Usually, ratings agencies and issuers only allow large lenders with significant resources to use these options.
While non-QM loans by definition don’t meet QM criteria, they must, however, comply with the eight borrower repayment factors of the ATR rule. Demonstrating ATR rule compliance will most likely be easier to prove as a de facto matter for older non-QM loan programs that have large data sets and low historical default rates.
Some non-QM products, such as asset depletion or bank statement loans, may fall into gray areas of the ATR rule. For example, repayment factor 7(vii) looks at the “consumer’s monthly debt-to-income ratio or residual income.” How should a lender consider this on an asset depletion loan where there is no income? The Consumer Financial Protection Bureau clearly had contemplated the possibility of asset-based loans meeting ATR rule requirements when writing factor 1(i). However, a lender cannot quantitatively consider income for factor 7(vii). Factor 1(i) provides that the creditor must consider “the consumer’s current or reasonably expected income or assets, other than the value of the dwelling, including any real property attached to the dwelling, that secures the loan.”
If the loan is underwritten solely based on assets, there is less certainty for how to comply with factor 7(vii). Asset depletion loans will be an attractive option for retirees with significant asset holdings but minimal income derived from those assets or other sources (for example, large quantities of treasury bond holdings without enough total yield to support DTI ratios). Depending on the loan type and its features, it’s not uncommon for asset-depletion loan programs to require that borrowers have enough assets to support at least five years or more of monthly mortgage payments.
Because the borrower’s proceeds from the asset sales typically aren’t considered income, it is possible in some cases that borrowers have an insufficient amount of monthly fixed government program income to support the loan payment. But as a de facto matter given the amount and liquidity of the assets, the borrower could clearly be able to repay.
Additionally, there are other QM (and non-QM) related ATR issues that have not yet been clarified by the CFPB and could affect loan program underwriting guidelines. By and large, these issues have more to do with the QM space than the non-QM market, given some of the vague income qualification requirements in Appendix Q and the liberal use of GSE underwriting guidelines by some lenders to meet perceived “gaps” in Appendix Q. As a practical matter, loans or loan programs intended to be QM, but with structural defects causing them to not be designated QM, may still comply with the ATR rule—but without the safe harbor status.
A non-QM option for midsize and smaller banks
To help expand the non-QM market, some investors are taking new approaches to due diligence that may help banks and originators get more comfortable with non-QM. Investors (including the GSEs) are also moving loan reviews and due diligence closer to the point of sale. Today, several active investors are using third-party underwriting fulfillment service providers to conduct pre-loan sale underwriting reviews on the non-QM loans they buy. The process is used to identify and clear conditions. These efforts also help to reduce the number of scratch-and-dent non-QM loans in the market.
The steady stream of new product options and the ever-changing underwriting guidelines have prompted some originators – including banks and credit unions – to outsource non-QM underwriting to recognized and experienced third-party fulfillment providers. This approach can provide comfort both for the originator and the investor since both parties are subject to TILA liability and buyback demands. By using these fulfillment providers, some less-experienced or smaller originators may find it easier to obtain approval from investors and warehouse lenders for participation in non-QM programs.
All signs indicate 2019 will be when banks will have to consider, or reconsider, whether non-QM should be part of their overall mortgage strategy. Given the market opportunity to meet underserved borrower needs, a more supportive regulatory environment and investor acceptance, non-QM may now represent a viable method for banks to remain competitive and gain volume. A more strategic understanding of potential risks in origination and secondary market execution can help lenders participate in this expected growth through a comprehensive and well thought out compliance management program. Banks should also take a moment now to consider how life might look without the GSE patch.
Colgate Selden is managing director and head of regulation and compliance for Promontory MortgagePath, whose Promontory Fulfillment Services unit is endorsed by the American Bankers Association for residential mortgage loan fulfillment.