To QM or Not to QM? That Is the Question for Banks
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Mortgage bankers' quest for product edge that will allow for better margins has taken on added importance as mortgage origination profits declined substantially in the first half of 2014. Banks are also struggling to determine what methods they can use to meet the credit needs of all their customers from wealth and private banking clients to lower-income borrowers looking to purchase a home. Enter the role of mortgages outside of the qualified mortgage box.
As most in the industry know, a qualified mortgage is one that meets the Consumer Financial Protection Bureau's specific underwriting, fee and documentation requirements or (for now) meets the underwriting requirements of Fannie Mae and Freddie Mac and does not contain what are deemed to be risky product features. The rules for this type of loan, which went into effect at the beginning of 2014, aim to create a structure that would prevent the issues that led to the last mortgage bust. A non-QM is one that fails to meet these criteria.
Many have predicted that most banks would be unwilling to accept the additional risks associated with non-QM lending. But the real story may be more complicated.
Many of Fannie Mae's mortgage banking customers are reluctant to embrace lending outside of QM, according the results of the agency's early June survey of 186 lenders. Only 19% of mortgage companies indicated that they planned to actively pursue non-QM lending, with another 46% taking a wait-and-see approach and the remainder indicating they would rule out non-QM loans.
However, interest in non-QM lending appears to be building, and rating agencies are beginning to determine criteria about how to assess the risks of certain types of non-QM loans. And more players are entering the space. Fenway Summer, the firm founded by CFPB official Raj Date, is moving to build a prime, non-QM lending capability. Deutsche Bank is returning to the mortgage market and has said that it sees "enormous potential" in non-QM loans.
Smaller community and regional banks may also be more open to non-QM lending than the Fannie Mae report indicates, according to a recent survey by my own firm, Stratmor. In fact, 9 of the 10 banks that participated indicated that they would be involved in making mortgages outside the QM requirements.
Most banks predicted that their non-QM lending would be a low percentage of overall volume less than 5%. However, some lenders, particularly those with a history of lending for portfolio, are originating a much higher percentage of non-QM loans as a way to provide more service to their customers and generate additional interest-earning assets.
The survey shows an evolving understanding of the risks and returns of this segment. The mortgage world is separating into two camps. In the first are banks that can fund non-QM loans and see the risk of not offering such loans to creditworthy customers as greater than the risk that the loans will go bad and expose the bank to losses. In the second group are mortgage bankers who are less likely to be involved in this type of loans because they are bound by the lack of availability of non-QM outlets in the secondary market.
The required maximum 43% debt-to-income ratio appears to be the most likely area where banks are willing to veer from QM requirements, followed by loan file documentation levels and use of assets beyond the GSE guidelines as part of the ability-to-repay analysis.
However, the survey revealed some information that may strike a cautionary note about how banks are evaluating their approach to non-QM lending. For example, less than a quarter of the banks indicated that they had undertaken a formal analysis of the assumed total cost of offering non-QM loans, including credit costs.
Despite the fact that non-QM loans may be riskier, banks are not applying pricing premiums on these loans. Nor are they considering additional loan-loss reserves for non-QM loans placed in their portfolios. While banks intend the loans to be of high credit quality, with minimum credit score requirements between 660 and 700, it will be a number of years before there is available data on loan performance. We will also have to wait to see the number of cases that challenge foreclosures based on whether banks made a good-faith effort to determine borrowers' ability to repay before extending non-QM loans. Rating agencies such as Fitch are assuming a low frequency of such challenges, but there will be some. The potential costs of court litigation and eventual settlements are also part of the ratings agencies' analyses.
Non-QM loans are currently much less liquid than qualifying mortgages, which would indicate the need for a pricing premium. And if non-QM loans are being offered to lower-income borrowers as part of a fair lending strategy, banks take on the risk of greater operational and credit costs.
In order for regulators to understand how banks are evaluating participation in the non-QM market, it is critical that banks document their decision-making process and financial assumptions. This documentation will also provide executive management and bank boards with peace of mind knowing that all areas of operational and financial risk have been appropriately considered, whether non-QM lending is being done as part of a portfolio lending strategy today or for an originate-to-sell strategy in the future.
Garth Graham is a partner with Stratmor Group and has over 25 years of mortgage experience.