Loan originators, their advisors and service providers are moving rapidly to achieve compliance by January 10, 2014 with the Consumer Financial Protection Bureau’s (“Bureau’s”) new rule, which generally imposes an affirmative obligation on mortgage lenders to document a customer’s ability-to-repay whenever a residential mortgage loan is made (“ATR Rule”). The ATR Rule provides certain legal protection from suitability challenges with respect to loans that are treated as qualified mortgages (“QMs”). 

The ATR Rule fundamentally changes the U.S. residential mortgage finance market from one that is largely based on a disclosure liability standard, to one that is focused on the suitability of the loan for the borrower. This significantly rebalances the legal relationship between the lender and its borrower, a fact which may impact the value of a residential mortgage and residential mortgage-backed securities (“RMBS”) from several different perspectives. Moreover, mortgage loan purchasers, securitizers, RMBS investors, and equity and debt investors in mortgage-related companies must also consider how the new rule may impact their businesses.  

Dechert will soon release “The Investors’ Guide to the Ability-to-Repay Regulation,” which will discuss the legal risks which impact the measurement and pricing of the exposures created by the new rule from the buy side. The insights provided in the Investors' Guide have been significantly informed by our representation of the American Bankers Association (“ABA”) in regard to the ABA-Dechert publication, “A Strategic Guide to the ATR/QM Rules,” as well as discussions with ABA bank members with regard to the implementation of the ATR Rule. 

There is a broader context, which is beyond the scope of this OnPoint. It includes changes that will follow from new mortgage servicing and foreclosure standards, the creation of risk retention requirements for securitizations, and the reconstruction of the secondary markets.¹ Those changes are yet to be fully defined.

What follows is a short summary of the Investors’ Guide. 

The Ability-to-Repay Rule: A Game Changer

The Dodd-Frank Act (“DFA”) prohibits a lender from making a covered residential mortgage loan unless the lender makes a reasonable and good faith determination, based on verified and documented information, that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan according to its terms, and to pay all applicable taxes, insurance and assessments (“ATR Requirement”). 

Once the ATR Rule comes into effect, mortgage lenders will have three options:

• Satisfy the requirements for a “QM Safe Harbor” loan to take advantage of the defense it provides to borrower claims for damages or recoupment or offset. 
• Satisfy the requirements for a “QM Rebuttable Presumption” loan to take advantage of the lesser degree of defense provided.  
• Offer non-QM ATR loans that will not have the benefit of any special legal protections and would be subject to a case-by-case judicial determination as to whether they satisfy the ATR Requirement.

A discussion of the attributes and protections provided by QM loans is set forth in Appendix A. The defenses that borrowers may assert against the lender in a foreclosure or other non-payment situations and the affirmative actions that they may take seeking damages for alleged violations of the ATR Rule are set forth in Appendix B.

The greater the number of loans that may qualify as QMs, the more loans are likely to be available to prospective borrowers. It is expected that many lenders will be reluctant to make non-QM loans because of the uncertainties about the risks inherent in such loans. 

It is notable that the Federal Housing Finance Agency has directed Fannie Mae and Freddie Mac to limit their residential mortgage loan purchases to loans that meet certain QM requirements upon the effective date of the ATR Rule. Specifically, Fannie Mae and Freddie Mac will be prohibited from purchasing any loan that is subject to the ATR Rule and is a loan that (i) is not fully amortizing, (ii) has a term in excess of 30 years, or (iii) has “excessive” points and fees.

Many lenders are likely to build their policies, underwriting standards and portfolios around QM loans  in the short run until a knowledge and experience base of ATR lending and court decisions is established. 

Interests of Loan Purchasers, RMBS Investors and Mortgage Finance Entity Investors: Key Risk Evaluation Considerations 

Loan purchasers will need to develop a new approach to their purchasing strategies. As an initial matter, they will have to decide which of the three types of loans they will be prepared to purchase. They will have to consider the extent to which the legal status of a particular type of loan, as well as the associated risks, costs and potential impediments to foreclosure, may impact their purchase and pricing decisions. 

RMBS investors will not have the same type of direct contact and negotiating position that loan purchasers will have with lenders. However, RMBS investors must understand the approach that the securitizer has taken with respect to the types of loans that the securitizer has acquired for an RMBS, and how the securitizer, servicer and trustee plan to monitor, mitigate and handle the risks associated with the various types of loans that the RMBS may hold. 

Similarly, investors in entities that originate residential mortgage loans and/or that hold significant amounts of such loans must now understand and evaluate the policies that the entity maintains in regard to the ATR Rule. Such investors must also understand how the originator will seek to address and mitigate the risks presented by the particular types of loans that it originates and/or holds in portfolio. To the extent that the lender will originate non-QM ATR mortgage loans, the value of the portfolio will turn on the embedded risks where safe harbor and rebuttable presumption defenses are not available. Similarly, if the lender decides to make only QM loans, then there may be risks of lending discrimination claims that may arise under disparate impact discrimination theory.²

Key considerations that loan purchasers, securitizers, RMBS investors and investors in mortgage-related entities will need to evaluate are set forth in Appendix C.

Conclusion

Mortgage loan purchasers, RMBS investors and investors in mortgage finance entities should no doubt try to take advantage of the new opportunities in the marketplace created by the ATR Rule. Indeed, to the extent that financial institutions retreat to the relative safety of QM lending, private capital may fill the void left in the non-QM ATR lending space. Those companies and their investors are facing a rapidly evolving marketplace for residential mortgages, which creates both a challenge and a business opportunity.  

In any event, participants in these new markets must evaluate and price the risks inherent in these transactions. This will result in new templates, standards and terms and conditions to make the markets work as efficiently as possible, but only if we understand the elements of the last mortgage finance crisis will we be able to comprehensively underwrite future markets and avoid the next great mortgage crisis.