Introduction. In January of this year, the Consumer Financial Protection Bureau (“CFPB”), issued what turns out to be a not-so-final rule[1] regarding the ability to repay (“ATR”) requirement for certain residential mortgage loans. As if the Big Banks hadn’t already learned their lesson during the easy money years of 2004-2008 and their near-death experience of 2008, the CFPB decided to implement a series of rules apparently to remind them that their Bad Boy days are over.
But, as is usually the case when regulations follow a crisis, the pendulum swings wildly in the opposite direction. The CFPB’s new ATR rule will saddle residential lenders with – in my opinion anyway – incredible liability for non-compliance. The concern, of course, is that first-time borrowers, and those with less than stellar credit (read: “subprime”), will face more difficulty in obtaining home loans. Here is a small sampling of the smorgasbord of rules being served up by the CFPB:
Ability-to-Repay (“ATR”) A creditor is prohibited from making a residential loan unless it first makes “…a reasonable, good faith determination of a consumer’s ability to repay any consumer credit transaction secured by a dwelling (excluding an open-end credit plan, timeshare plan, reverse mortgage, or temporary loan) and establishes certain protections from liability under this requirement for “qualified mortgages.” [See CFPB Summary, here.]
In complying with the ATR rules, a lender must consider and verify the following borrower information:
- Current or reasonably expected income or assets [other than the value of the home that secures the loan];
- Current employment status;
- Monthly payment on the mortgage loan;Monthly payment on any simultaneous mortgage loan that the creditor knows or has reason to know will be made;
- Monthly payment for mortgage-related obligations [e.g., insurance, taxes, assessments];
- Current debt obligations;
- Monthly debt-to-income ratio, or residual income; and
- Credit history.
The creditor making the loan is required to calculate the mortgage loan payment based on:
- The fully indexed rate or any introductory interest rate (whichever is greater)[2]; and
- Substantially equal monthly installment that will fully amortize the loan amount over the loan term.[3]
At first blush, perhaps these requirements don’t seem so burdensome, since one would think any smart lender would follow these protocols anyway. But remember, back in the easy money days, lenders were not keeping most of their loans on their own books; instead, the loans were “securitized”, i.e. bundled and sold as securities to investors all over the world. This meant that circa 2004 – 2008, the originating banks that funded these residential loans were quickly repaid by investors and were never going to have to deal with them if and when they failed. Hence, bank underwriting was virtually non-existent back then – except, of course, for those loans the banks were going to keep on their own books (sometimes referred to as “portfolio loans”).
Qualified Mortgages. The Dodd-Frank Act has established a term, “Qualified Mortgage,” or “QM,” that provides a safe harbor for lenders. That is, if the loan is a QM, there is a legal presumption that the lender complied with the ATR underwriting rules, and therefore the penalties for non-compliance are either eliminated or substantially reduced, as discussed below. If a presumption is “conclusive,” no amount of evidence to the contrary will defeat it. But if a presumption is “rebuttable,” the party opposing the presumption has an opportunity to rebut it by introducing evidence to the contrary.
For a mortgage to be a “Qualified Mortgage,” it must meet the following requirements:
- Elimination of “Non-Traditional” Loan Features – This refers to features that we saw in the past, e.g. negative amortization, interest-only payments, and certain balloon payments;[5]
- The loan may not exceed 30 years;
- If the loan is for $100,000 or more, it cannot have points or fees greater than 3% of the total loan amount. There are different and stricter limits for smaller loans. Certain “bona fide discount points” for prime loans are not included in these limits;
- Income Verification and Monthly Debt-to-Income Ratio Cap;
- Monthly payments must be based on the highest payment that will apply during the first five years of the loan; and
- The borrower’s total monthly debt-to-income ratio (i.e. all housing and non-housing expenses, such as food, automobile, child care, etc.)[6] can be no greater than 43%.
The presumptions afforded to lenders making QM loans gives lender protection in the following two categories:
Safe Harbor QM loans – Conclusive Presumption. These are prime loans that (a) Meet the ATR compliance rules including the eight underwriting requirements above; (b) Are secured by a first lien on the residence; and (c) Carry an interest rate that is less than 1.5% higher than the average prime rate available.[7] The presumption of ATR compliance is conclusive. It is a complete safe harbor.
Higher-Priced QM Loans – Rebuttable Presumption. Here, the presumption of ATR compliance is rebuttable. These loans include first-position liens with an interest rate of equal to or greater than 1.5% over the available prime rate. Essentially, these loans are “higher priced” because the borrowers’ credit is less than prime, i.e. the loan is, in the vernacular, “sub-prime.”
Although it is beyond the scope of this article, lender compliance with the QM rule will remove commercial mortgage backed securities (“CMBS”) from the 5% risk retention rules imposed on sponsors of the securities. More about that here.
Noncompliance with the ATR Rules. Violations of the ATR rules are harsh, and likely to stifle any types of loans that hint of non-compliance. If a material violation is established, the borrower would have the ability to recover back all of the finance charges and fees paid, plus actual damages, statutory damages, attorney fees and court costs. The plaintiff’s bar and the class action bar must be sharpening their knives.[8] There is a three year statute of limitations from the date the violation occurred. Although some claims might occur pro-actively by plaintiffs trying to rescind their loans, it is likely that ATR non-compliance will be raised, if at all, in foreclosure cases, once the law goes into effect next year.
Conclusion. It’s kinda hard to feel too sorry for the Big Banks that brought this on themselves. There is some cosmic irony in lenders now being required to become consumer watchdogs, making sure that they don’t make loans their borrowers can’t afford. [“Now this isn’t toooooo much money is it? You’re gonna be able to pay us back, right?”] And there’s even more irony – perhaps rising to the level of cosmic justice – in permitting borrowers to claim that their lenders lent them more money than they should have. [“Don’t you remember the look of surprise on my face, when you actually agreed to make the loan I asked for?” “You should have known I wasn’t joking when I said, ‘imagine how many lottery tickets I can buy with this loan!'”] Can you imagine if this catches on and gets extended to McDonalds, Burger King, and Wendy’s? [“That’ll be a Double Big Mac with extra cheese, large fries with extra grease, a Big Gulp and a McFlurry – You sure wanna eat all this? I’m mean, it’s over 7,000 calories.”]
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[1] Technical corrections and adjustments have come out several times since the original “final rule” and it appears the CFPB has now begun to refer to each of their prior iterations as “”proposed” rules. Here is the complete list of updates from the CFPB website: “September 13, 2013: We issued a final rule amending certain provisions of the rule. It is based on a proposed rule issued in June 2013; July 10, 2013: We issued a final rule amending certain provisions of the rule. It is based on a proposed rule issued in April 2013; January 10, 2013: We issued the document containing this final rule; On January 30, 2013, the Office of the Federal Register published the final rule;
May 29, 2013: We issued a final rule amending certain provisions of the rule. It is based on a proposed rule issued in January.”
[2] E.g. when the loan has an adjustable rate.
[3] In the case of certain hybrid loans, e.g. interest-only loans, negative amortization loans, and loans with balloon payments, special payment calculations will be required.
[5] There are limited exceptions for certain “small” creditors, based upon the number of loans originated during the preceding calendar year, and those operating in predominantly rural or undeserved areas. [Although even the term “rural or underserved” has been a topic of some debate lately.]
[6] This is sometimes referred to as the “back-end ratio.” The “front-end ratio” is the monthly housing debt [principal, interest, taxes, insurance, and HOAs, if applicable] compared to the borrowers’ gross monthly income.
[7] For subordinate, i.e. “junior” liens, the rate is less than 3.5% higher than the average prime rate available.
[8] Although, in a class action, plaintiffs may recover no more than three years of finance charges and fees.
