The Federal Reserve made the right call recently when it delayed new risk-based capital standards for mortgages, likely until the impact of the Consumer Financial Protection Bureau's ability-to-repay rules is understood. A change in the weighted capital requirements for mortgages could itself have been a sea change for financial institutions. As it stands, the CFPB's ATR rules will create significant changes in the U.S. mortgage finance delivery system by shifting from a disclosure to a suitability-based regime.
As of Jan. 10, 2014, a lender will have a legal obligation to document the basis on which it determines that its borrower has the financial capacity to repay a mortgage loan. The ATR rules provide borrowers with significant defenses and damage claims, which may impact the corresponding value of mortgage assets.
Other important rules also become effective next year. The "2013 CFPB Dodd-Frank Mortgage Readiness Guide" issued this month warns lenders that in January they must be ready to roll out lending products that are consistent with Regulation X & Z's new high-cost mortgage counseling and mortgage servicing rules; Regulation B & Z's rules regarding appraisals for higher-priced mortgages; and Regulation Z's additional lender compensation rules.
The corresponding challenges facing lenders are daunting no matter the direction that lenders turn. Let's consider a few potential scenarios.
Scenario One. To minimize risk and increase collectability, lenders may choose to offer only safe-harbor qualified mortgages. That may produce a higher-value mortgage portfolio that Fannie Mae, Freddie Mac and other securitizers will accept. But that strategy may also shrink the universe of acceptable borrowers, increase competition for quality mortgages and decrease profit potential. Home builders will begin to face the prospect that as housing continues to improve, a range of prospective buyers may not be able to find financing.
Perhaps the most significant indirect new risk for lenders in this scenario will be the potential for fair-lending and discrimination charges by a variety of agencies as moderate- and low-income borrowers are left on the sidelines. Regulators are poised to address this issue armed with their recent emphasis on disparate impact liability, often referred to as no-fault discrimination.
Scenario Two. Alternatively, lenders may decide to expand their market and test the protections of rebuttable presumption QM loans, or even make non-QM loans. The value of that portfolio may be impacted by the collectability of non-QM loans (i.e., the new defenses to repayment), reps, warranties and haircuts required to make them acceptable to the secondary market, the extent to which they may collateralize institution borrowings and other ancillary risks, such as fair-lending discrimination charges related to risk-based pricing.
From a corporate governance perspective, this spectrum of new risks suggests a corresponding need for lenders to analyze their options and legal risks before deciding what mortgage products they will offer, or how they will offer them. Indeed, the CFPB's Readiness Guide underscores the need for good corporate governance, including a review by each lender's board of directors, with effective audit, compliance and internal controls.
Lenders will need to evaluate the wide range of regulatory, corporate and litigation standards and risks they will confront before they can underwrite and price satisfactory mortgage products. Such an analysis or legal stress test suggests an evaluation of a number of factors:
- ATR Compliance:Will the loan be collectable, and who can challenge compliance with new rules?
- Fair Lending: How will the risk of a challenge by the government or third parties under evolving fair-lending discrimination laws increase or decrease, and what defenses will or can be available?
- Mortgage Asset Value: How will the increased risk of non-payment and suitability claims impact the value and liquidity of the mortgage portfolio?
- Capital and Leverage:How will the value of the mortgages originated or held in portfolio impact the company's future capital requirements and borrowing power?
By definition, changes in the risks assumed require express managerial decisions that are reviewed by the board of directors. The quality of the record that the lender creates to document a prudent analysis of risks and the reasonability of business judgments is the secret sauce that encourages regulators and third-party litigants to move on and challenge the lender down the street, which might not have such a solid record.
The most significant risks to lenders in this environment are the ones that arise if they fail to evaluate these risks. Such failures may impact their regulatory status, capital requirements and ability to raise capital, expand, make acquisitions or be acquired. The inability to entertain a transaction when it presents itself because of an inadequate appreciation of the risk on the balance sheet will likely be an event no executive will want to confront.
Thomas P. Vartanian chairs the financial institutions practice at Dechert LLP and is a co-author of the American Bankers Association's "Strategic Guide to the ATR/QM Rules."