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Primary Credit Analyst: Jack E Kahan, New York (1) 212-438-8012; jack.kahan@standardandpoors.com Lead Analytical Manager, U.S. RMBS: Sharif Mahdavian, New York (1) 212-438-2412; sharif.mahdavian@standardandpoors.com
Table Of Contents
How The ATR Rule Works How Would Loans Issued Before The Rule Stack Up? ATR Standards May Increase Losses, Liquidation Timelines, And Loan Mods In Securitization Trusts Other RMBS Considerations Looking Forward
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New Ability-To-Repay Rules?
A set of new mortgage regulations could mean that more conservative lending is on the horizon. The new ability-to-repay (ATR) and qualified mortgage (QM) regulations under the Truth in Lending Act (TILA)--collectively, "the rule"--take effect early next year. Beginning with loan applications accepted on Jan. 10, 2014, the rule will require loan originators to make a reasonable, good faith determination of a borrower's ability to repay a loan. It also creates liabilities for originators and assignees of any loans covered by the rule if the originator fails to originate loans meeting the ATR standards. An additional set of standards will allow a loan to conclusively meet, or be presumed to meet, the ATR standards as a "QM" and will qualify the loan for certain protections from noncompliance liabilities. The rule focuses on the documentation of the borrower's ability to repay and will require creditors to keep evidence of compliance with the rule for three years after the covered loan is originated. Standard & Poor's Ratings Services examined the potential effects of the new rule on the residential loan market and originator best practices, particularly its impact on residential mortgage-backed securities (RMBS), and has developed a framework to assess those effects. In general, we believe that the scope of the rule, which will cover most closed-end residential loan products, will make it more difficult for borrowers to obtain loans and tighten already strict underwriting standards. The rule generally codifies many of the standards that have existed in recent years before its introduction. We anticipate that the rule will prevent many of the types of loosely underwritten mortgages that caused systemic risk during the 2006 and 2007 origination period, but may do so at the expense of limiting credit access--sometimes to qualified borrowers. The standards may also increase losses, extend foreclosure timelines, and lead to servicers pursuing foreclosures less frequently in favor of loan modifications, deed-in-lieu, or short sales. Overview The ATR and QM standards under TILA will require loan originators to make a reasonable, good faith determination of a borrower's ability to repay a loan using reliable, third-party written records. If violated, originators and assignees can face liabilities and litigation brought on by borrowers during foreclosure proceedings and even outside of foreclosure proceedings. However, they can be protected from some of these liabilities if a loan meets the QM standards. Depending on the loan's status, increased loss expectations resulting from additional assignee liability, longer liquidation timelines resulting from borrower defenses in foreclosure proceedings, and additional loan modification experience can affect securitization trust performance. Sensitivity testing using the damages outlined in the rule suggests that additional loss experience will generally be mild for prime jumbo backed securitizations even under conservative assumptions for litigation risks. Trusts backed by loans with higher credit risk, lower balances, and originated by unfamiliar or below-average originators will be at risk of higher losses than prior to the rule. We expect that while the rule will prevent underwriting standards from loosening towards the more risky mortgages originated during the 2006 and 2007 financial crisis, it may also limit credit access to borrowers and make it more difficult to obtain a mortgage loan.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Purchase, refinance, and home equity loans Mortgages secured by timeshare interests Temporary/bridge loans with terms less than or equal to 12 months Construction-to-permanent loans where construction is less than or equal to 12 months Any business-purpose loans secured by residential property
We believe that because the rule does not explicitly say how an originator should consider these factors, it allows originators to choose how they comply and borrowers how they could raise a suit against an originator. The ability to raise a defense to foreclosure under the rule, especially against assignees, presents an additional risk to securitization trusts since the trust would liable as an assignee for damages. Notably, the lender must verify these items when determining ATR and fully document each using reasonably reliable, written, third-party records. We believe this requirement alone--limiting originations of loans only to those that have been fully documented--will create a more stable loan performance environment going forward. To provide originators with greater certainty surrounding litigation risk for generally less-risky loans, the CFPB created
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
rules that would designate certain mortgages as "qualified." A QM loan will have certain protections from liability, or a level of conclusive or presumed compliance with the ATR rules. Those that don't meet these standards will need to prove compliance in the event the borrower's ability to repay is challenged. Though there are other options for obtaining QM status, most loans must pass the following tests: Product type test: The loan's term must be less than or equal to 360 months and be fully amortizing (no negative amortization, interest-only, or balloon features). Points and fees test: The points and fees for a loan should be no greater than 3% for loan balances greater than or equal to $100,000. Those less than $100,000 will use a sliding scale, and the points and fees can be up to 8% of the loan balance. Underwriting test (43% DTI or government-sponsored entity standard): The loan must be underwritten to a similar set of standards (without considering credit history) as those for ATR, with some differences in calculating P&I payments, specific rules for acceptable income and debts, and a hardline DTI cutoff of 43% or less. Instead of underwriting to those factors, a loan can meet the underwriting test simply by verifying eligibility for purchase by Fannie Mae or Freddie Mac, insurance by the U.S. Department of Housing and Urban Development (HUD) (Federal Housing Administration) or Rural Housing Services, or a guarantee from the Department of Veterans Affairs (VA) or the Department of Agriculture. A loan that uses this option must still meet the product type and points and fees tests.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
The rule describes the damages to which a borrower is entitled by way of recoupment or setoff against the liquidation value of the home. Specifically, the borrower may recover: Special statutory damages equal to all finance charges and fees the borrower paid (capped at three years); Actual damages equal to compensatory damages, other than the special damages to which the borrower may be entitled; Statutory damages of up to $4,000 per violation; and Court costs and attorney fees.
QM protections
A loan will have one of two protections from liability if it meets the QM definition--a "safe harbor" or a "rebuttable presumption"--depending solely on the loan's annual percentage rate (APR) compared to the relevant average prime offer rate (APOR) at the time when the mortgage's interest rate was set. Higher-priced mortgage loans (HPMLs), or loans that have APRs exceeding the APOR by more than 1.5% for first liens and 3.5% for second liens, can benefit from a "rebuttable presumption" if they meet QM standards. Non-HPMLs, or loans that have APRs that do not exceed 1.5% above APOR, can benefit from safe harbor protection if they meet QM standards. The concept of an HPML already existed under TILA before the CFPB's final ATR rule. Since the APOR reflects the average interest rate available to low-risk borrowers, HPMLs are therefore expected to have greater credit risk than non-HPMLs. In this way, one could think of non-HPMLs as prime and HPMLs as nonprime. QMs give creditors an option to originate loans with more certainty of compliance with the rule. A QM loan under the safe harbor is conclusively in compliance with the rule. If creditors can show that they have met the QM definition for a non-HPML, they do not have to show separately that the borrower can repay the loan. This protection gives originators greater compliance certainty because the QM standards are narrower than those for the ATR rule compliance. This safe harbor creates a layer of protection and may allow quick dismissal of an ATR suit through summary judgment, or a ruling by the court without a full trial. The safe harbor protection's efficacy therefore depends on the clarity of the QM definition. Some of the criteria, notably the DTI calculation, may dent the safe-harbor armor. The DTI calculations can become more subjective for some borrowers, particularly those who are self-employed, retired, or do not have an annual wage-driven income. Standard & Poor's has observed many data discrepancies related to DTI calculations in third-party due diligence results for issuances throughout 2013. While these discrepancies are typically small, the 43% threshold does not allow for any level of variation above the threshold, meaning a 43.01% DTI will exclude a loan from being a QM. HPML QMs will have a rebuttable presumption of compliance, a lesser protection than a safe harbor. A borrower may be able to overcome this presumption by showing that the originator did not make a reasonable and good faith determination of their ability to repay. The borrower would need to show that the originator was aware that the borrower's income, debts, other nondebt recurring expenses, and the loan payments would leave the borrower with insufficient residual income or assets to meet his or her living expenses. The rebuttable presumption therefore creates limited protection against liability for the originator, as it shifts the burden of proof to the borrower. Non-QM loans will not be presumed to comply with the rule, and originators will be responsible for proving, if a claim is made to the contrary, that they complied with the ATR rule.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Within the framework above, there are a few other notable outcomes from the rule, including some exemptions, QM protections for certain balloon loans, and restrictions on other loan features.
Refinance loans
Certain refinance loans are exempt from ATR underwriting rules. Originators for these certain loans will not have to underwrite the borrower's ability to repay; instead, the loan needs to be a refinance of a "non-standard mortgage" to a "standard mortgage," and the originator needs to meet the following requirements: The originator of the refinanced loan must be the current holder of the existing loan; The refinanced loan's monthly payments must be materially lower than the existing loan's; The originator received the application for the refinance no later than two months after the existing loan's recast; and The borrower has not been 30 days delinquent more than once (on a rolling basis) in the past 12 months and never 30 days delinquent in the past six months. Table 2 outlines the differences between standard and non-standard mortgages.
Table 2
Balloon loans
Certain balloon loans will be considered QMs if they satisfy certain criteria and are originated by originators with less than $2 billion in assets and that originate no more than 500 first-lien covered loans per year (see table 3).
Table 3
Most limiting, however, is that the rule requires that originators generally retain these loans in their own portfolios to
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
maintain the QM status, though certain instances allow their sale or assignment while remaining QM. As such, we expect they will remain outside of securitization transactions.
Prepayment penalties
Lastly, the rule generally prohibits prepayment penalties of any kind on QM loans but allows them for non-QM loans, with restrictions. Where penalties are allowed, they generally follow the rules in table 4.
Table 4
Chart 1 below describes a potential loan's initial status under the rule.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Given these new rules, we see five possible TILA status options for a loan: QM with safe harbor; QM with rebuttable presumption; Non-QM that meets the ATR rule; Non-QM that does not meet the ATR rule; or Not covered or exempt from the rule.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Chart 3
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Chart 4
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Chart 5
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Chart 6
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Chart 7
Based on our observations, most prime jumbo loans made before and during the financial crisis would not have met QM standards. In contrast, the non-QM loan types that have been originated post-crisis represent mainly interest-only loans or loans with high DTIs. Non-QM subprime loans proliferated from 2005 through 2008 as a percentage of the total subprime market. The Alt-A segment is biased toward non-QM status given their characteristic limited documentation and negative amortization features, which preclude QM status. Based on these performance data, we can assume that the rule will limit those loan types that were responsible for significant defaults throughout the credit crisis. Prime loans originated in 2006 and 2007 that had non-QM characteristics were more than twice as likely to default as those that met the QM standards. Alt-A loans and subprime loans showed a similar divergence, with Alt-A non-QM loans defaulting 50% more than Alt-A QM, and subprime non-QM defaulting 30% more than subprime QM. The single condition for meeting the ATR rule that would have eliminated many of the worst-performing loans during the credit crisis, in our view, is the requirement for full documentation when considering the borrower's ability to repay. This change alone significantly reduces default risk.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
ATR Standards May Increase Losses, Liquidation Timelines, And Loan Mods In Securitization Trusts
Securitization trust risk framework
As we noted above, the rule imposes new obligations on lenders as well as liabilities to assignees that did not previously exist. We believe the rule could have three main effects on securitization trusts, depending on the loan's status: increased loss expectations resulting from additional assignee liability, longer liquidation timelines resulting from borrower defenses in foreclosure proceedings, and more loan modifications than may have occurred without the rule. Our expectation for increased losses stems from the greater underwriting obligations for originators in terms of the scope of loans covered as well as increased liability if they do not comply. Since 2009, TILA rules have covered HPMLs and have a similar (though not identical) standard for lenders to consider the borrowers' repayment abilities. The rule, however, will now also cover most non-HPMLs, in addition to extending the penalties for noncompliance to assignees. To evaluate expected losses under the rule, we identified a framework for what additional loss, if any, we believe a securitization trust may bear for a loan in each of the three initially compliant and covered general designations (QM-safe harbor, QM-rebuttable presumption, and non-QM/compliant) (see chart 8).
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
In this framework, we first identified the relative probability that a loan covered by the rule would default. The loan's expected default probability is important because, as discussed above, assignee liability is likely to apply only in a defensive claim. Once the default frequency is determined, the relative probability that the borrower will claim a defense to foreclosure under the rule will determine whether that loan's liquidation timeline will extend. The probability of extended timelines and the extension's length may be affected by whether the loan is in a state with judicial or nonjudicial foreclosure processes. Next, the relative probability that the defense to foreclosure claim is successful under the rule will determine whether the trust will be subject to damages. Taking each of these expectations and additional losses into account through the various paths identified above indicates the loan's expected loss under the rule. Besides additional losses expected through increased liquidation timelines or assignee liability, we noted that borrowers under financial stress may threaten litigation to negotiate a loan modification. Although these modifications may affect a transaction's credit enhancement or the collateral's weighted average coupon, such modifications are covered under our current loan modification criteria.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
The additional loss severity will likely be a function of increased liquidation timelines and the assignee liability for a loan that does not meet the ATR standards. The assignee liability includes actual damages (assumed to be $0 for this example), special damages (assumed to be three years' finance charges and fees), statutory damages (assumed to be
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
the $4,000 TILA cap), and additional court/attorney fees (assumed to be a flat $10,000). Based on these costs, we expect the increase in loss severity for a successful claim to be a function of the additional time in the liquidation timeline, during which we assume the servicer will make interest advances, and the loan's interest rate, which will increase the interest advance loss as well as the loan's special damages. For this particular example, we found that a loan's loss severity can increase significantly depending on these variables. In this example, a loan with a 5% interest rate and a liquidation timeline that lengthened by one year could expect the loss severity to be more than 65% greater than it would have been before the rule. As the sensitivity matrix shows, the increase in losses derives mainly from assignee liability. In the same 5% interest rate example, with no additional liquidation time, the severity still increased by approximately 55%. Since the additional loss severity will be a function of the interest rate, we believe that HPMLs will be more sensitive to the rule than non-HPMLs, all else being equal, because they will bear a higher interest rate, to say nothing of their potential increased credit risk. We also compared the potential damages under the rule and under anti-predatory lending laws with assignee liability. We noted that while the potential damages under the rule are generally lower than most potential damages under anti-predatory lending laws, the rule's scope actually extends beyond that of any anti-predatory lending law that we have reviewed.
The sample of loans has the same characteristics ($725,000 balance, 35% original severity, 5% interest rate, 12-month additional liquidation timeline, and a 15% default frequency). The 15% default rate loan with its 35% original loss severity had an expected loss rate of 5.25% (15% x 35%). If 25% of the borrowers who default make a defensive claim and 50% are successful, the pool's expected losses would increase by just over 8% to 5.70% (5.25% + 0.45%). This sensitivity analysis shows that, while increased loss expectations may be material, even under conservative assumptions they are not extreme. This sensitivity analysis aims to provide a general idea of the impact of the rule on potential losses to securitization trusts. Each designation would likely have its own defense and success rates that reflect their level of protection, and such rates may differ within those designations because of other loan characteristics. QMs, particularly those with safe
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
harbor protections, may find defense rates to be exceedingly low. The CFPB's federal register provides its own analysis of the costs associated with originating QM and non-QM loans. In particular, it discusses a borrower's tendency to bring a defensive claim under the rule. While there is no empirical evidence because the rule has not yet taken effect, the CFPB notes that commenters showed that 900 TILA-related claims have been filed each year for the past few years (while acknowledging that the data is limited). To put this in context, there have been 1 million-2 million foreclosure starts during each of the related years. Even if the number of actual related claims were 10 times as large, these claims would occur under 1% annually. Another possible benchmark may come from a Federal Reserve report earlier in 2013 with data related to 4.4 million foreclosed loans, which it identified as part of its independent foreclosure review. The Fed sent mailings to 4.4 million eligible borrowers who had been or were in the process of foreclosure in 2009 or 2010. The mailings allowed the borrowers to receive a free review of their foreclosure to determine whether the borrower suffered financial harm from the foreclosure processes. While the report focused on foreclosure processes and not a borrower's ability to repay, it may show the propensity of borrowers who had financial hardship to engage in legal proceedings when cost barriers are removed. The report found that approximately 11%, or 493,000 of the 4.4 million eligible borrowers, requested a review. Still, many things could affect the actual rate of defensive claims and their success under the rule. Empirical results of these probabilities would require actual defaults and liquidation timeline lapses in a sufficient nationwide sample, a process that would take years. Attorney fees and court costs, loan performance, judicial sentiment, industry standardization, home prices, and many other factors will influence these rates. Until those observations are available, originators and investors must be practical and use good faith determinations to minimize their exposure to liabilities.
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
Looking Forward
As the rule comes into effect in 2014, originators and aggregators are likely to continue originating non-agency loans based on similar credit standards before the rule. Super-prime borrowers will continue to be in demand, as loans with lower potential defaults will minimize risks to securitization trusts arising from the rule. Some originators may originate only to QM safe harbor standards to try to avoid the specter of assignee liability, while others may find opportunities originating to the potentially underserved non-QM prime borrowers. Particularly, borrowers seeking the prevalent interest-only products, as well as high-net-worth borrowers with non-wage incomes, may find that getting a loan is more work in 2014 than it was under the already-stringent processes of 2010-2013. Some originators that focus in that market will have no choice but to originate non-QM loans, as borrowers who rely less on salaried incomes are difficult to fit into the QM underwriting process. All borrowers, too, may find the costs of getting a loan may increase in 2014 even without additional rate increases. The costs related to the additional processes and work originators must take on
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How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New AbilityTo-Repay Rules?
to comply with the rule will ultimately pass down to the borrower. Ironically, originators will need to watch these costs carefully, as they may increase points and fees which will determine whether a loan can be considered a QM. Any declines in origination volumes will have pass-through effects on non-agency private-label security volumes. The assignee liability that comes with the rule may result in higher loss severities, and higher-rate products with little or no protection from liability will be the most sensitive under the new rule. Private-label securities volumes will also depend on whole-loan pricing for QM or non-QM loans relative to securitization pricing. Lastly, the qualified residential mortgage (QRM) rule--which addresses securitization risk retention by the issuer--is not yet final but may also play a role in origination and securitization volumes. In the current environment, issuers have been retaining subordinate bonds to tap higher yields. But if the market shifts away from this dynamic and QRM forces issuers to retain risk they otherwise would have avoided, non-QM volume could drop as well.
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