Jan. 10, 2014, will be remembered in years to come as the day that brought sweeping changes to the way mortgage loans are underwritten.
The federal government now sets standards on the types of mortgage loans the vast majority of borrowers will receive as lenders seek a safe harbor from potential future litigation if a borrower falls behind on payments. However, a significant opportunity exists outside the parameters of the qualified mortgage that will allow lenders to make profitable and high quality mortgages posing negligible contingent liability for them.
Such a program will require credit policies that limit risk layering – the housing boom-era practice of allowing multiple risk factors that would each be manageable on its own but proved toxic when combined in the same loans. Lenders will have to surgically identify low-risk borrowers and follow strict controls on documentation and process while rewarding staff and management for outstanding risk management. Banks will have to establish prudent reserving set-asides for potential downstream liability. And as with any kind of consumer lending, they'll need to consistently apply credit policies across customers in a color-blind fashion. We've seen one of the stalwarts of the mortgage industry, Wells Fargo (WFC) recently announce its move into this area, and other lenders could likewise adopt a similar strategy by following a few simple but critical steps.
The impact of QM on the mortgage market is not inconsequential, according to analysis by CoreLogic. An astounding 60% of mortgages would not meet QM standards, the data firm found. About one-quarter of these loans would not pass QM due to having debt-to-income ratios above 43%. This bright line test of ability-to-repay can actually become an underwriting opportunity. The Consumer Financial Protection Bureau, in promulgating QM, clearly did not understand the concept of compensating factors when it came up with the DTI standard. In other words, not all DTIs over 43% are apt to be defective later on. A borrower with a 750 FICO score putting 20% to 30% down on a home who can fully document income and assets and has been employed in a professional occupation for five years or more would turn out to be an incredibly safe loan But CFPB provides no such guidance for compensating factors other than deferring to the Federal Housing Administration, Fannie Mae and Freddie Mac underwriting standards for loans that fall outside QM but otherwise pass their credit screens.
At the heart of a well-designed non-QM loan program are prudent credit standards that leverage the compensating factors concept. If I were still responsible for establishing credit policy at a lending institution, I would insist the criteria dramatically lower the likelihood of a default, a trigger for a potential legal challenge by the borrower (and an undesirable event in its own right). Consequently I would think about requiring ample skin in the game from the borrower of at least 20% down if not more.
Demonstrated willingness to pay, in the form of high credit scores, is a must, as is experience with paying a mortgage. This would not be a program for first-time homebuyers or property investors, certainly not at first. Conceivably, it could be expanded to include such borrowers when conditions warrant. (Right now, many readers are probably thinking, "here we go again." There is indeed a danger of opening Pandora's Box. On the other hand, prudent risk-taking is what banks do, or else they should fold the tents.)
Further, the program would require full documentation of income, assets and employment, although I could see allowing some streamlined documentation for borrowers with previous strong mortgage histories with the bank. Developing a program around certain occupations could also be a way of limiting risk. Programs, for instance, focusing on teachers, government employees or other stable occupations could be part of the eligibility criteria. Credit unions, for example, might find a useful play in a non-QM offering that taps into their exclusive customer base.
Some programs could be designed for high-income earners with special needs such as flexible payment terms. Yes, that implies such features as interest-only periods and even negative amortization. However, these products can be quite sound if marketed to financially sophisticated borrowers. That may be like playing with fire in this regulatory and legal environment. The trick is not falling into the trap of mass-marketing the product and that's where strong governance from the top is required.
The other leg of a non-QM offering is exceptional process and controls. Without these, the offering is begging for problems in the future. Simple as it sounds, banks historically have had a tough time putting in place the solid origination and servicing practices needed to ward off trouble if a bank has to head to court one day. These controls also include consistency in the application of underwriting standards and adherence to fair-lending requirements throughout the process of underwriting and pricing the loan. The motto for a bank pursuing such a strategy should be, "when in doubt, err of the side of conservatism and prudence rather than blindly chasing the revenue stream."
Living in a QM world does not consign the mortgage industry to an environment of negative growth and minimal risk-adjusted profitability. On the contrary, the CFPB just served up the industry an opportunity to establish a robust lending business in a significant part of the market – if executed intelligently.
Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland and a Principal in Chesapeake Risk Advisors LLC.