The Board of Governors of the Federal Reserve System (the “Board”) on May 11, 2011 published a proposed rule1 concerning implementation of the ability-to-repay requirements imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Act”). Comments on the proposed rule may be submitted to the Board at http://www.federalreserve.gov on or before July 22, 2011.
The Act amends the Truth in Lending Act (“TILA”) to prohibit creditors from making mortgage loans without regard to the con-sumer’s repayment ability. The Act’s underwrit-ing requirements are substantially similar but not identical to the ability-to-repay require-ments for higher-priced mortgage loans adopted in July 2008 under the Home Ownership and Equity Protection Act2 (“HOEPA”). However, unlike the HOEPA rule, the proposed rule is not limited to higher-priced mortgage loans or loans secured by the borrower’s principal dwelling. The proposed rule’s broader scope applies to all consumer credit transactions secured by a dwelling, including principal and non-principal dwellings (but excluding an open-end credit plan, time-share plan, reverse mortgage or temporary loan). The proposed rule also (i) implements the Act’s limits on prepayment penalties; (ii) requires lenders to retain evidence of compli-ance with the rule for three years after a loan is made and (iii) provides standards for complying with the ability-to-repay requirement.
The Act prohibits a lender from making a mortgage loan unless the lender makes a reasonable and good faith determination, based on verified and documented information, that the borrower will have a reasonable ability to repay the loan.
The proposal provides four options for complying with the ability-to-repay requirement:
- First, a creditor can meet the general ability-to-repay standard by originating a mortgage loan for which the lender con-siders and verifies the following eight un-derwriting factors in determining repay-ment ability and for which the mortgage payment calculation is based on a fully indexed rate: (i) current or reasonably expected income or assets; (ii) current employment status; (iii) the monthly payment on the mortgage; (iv) the monthly payment on any simultaneous loan; (v) the monthly payment for mort-gage-related obligations; (vi) current debt obligations; (vii) the monthly debt-to-income ratio and (viii) credit history.
- Second, a lender can originate a “qualified mortgage,” which provides special protection from liability under the Act (a “Qualified Mort-gage”). The Board noted that the Act is unclear on whether this protection is intended to be a “safe harbor” from the repayment ability requirement or merely a “rebuttable presumption of compli-ance” proposing two alternative approaches. One alternative operates as a legal safe harbor and defines a Qualified Mortgage as one in which (i) the loan does not contain negative amortization, interest-only payments or balloon payments or a loan term exceeding 30 years; (ii) the total points and fees do not exceed 3% of the total lien amount; (iii) the borrower’s income or assets are verified and documented and (iv) the underwriting of the mortgage (a) is based on the maximum in-terest rate in the first five years; (b) uses a pay-ment schedule that fully amortizes the loan over the loan term and (c) takes into account any mortgage-related obligations. The other alterna-tive provides a rebuttable presumption of compli-ance and defines a Qualified Mortgage as includ-ing the criteria in the “safe harbor” alternative plus the following additional criteria: (i) the bor-rower’s employment status; (ii) the monthly pay-ment for any simultaneous loan; (iii) the bor-rower’s current debt obligations; (iv) the total debt-to-income ratio and (v) the borrower’s credit history.
- Third, a creditor can refinance a “non-standard mortgage” into a “standard mortgage” (i.e., one that does not provide for negative amortization, interest-only payments or balloon payments and that has limited points and fees). This is intended to encourage streamlined refinancings designed to quickly refinance a borrower out of a risky mortgage and into a more stable product. Under this option, the lender does not have to verify the borrower’s income or assets.
- Fourth, a small lender operating predominantly in rural or underserved areas can originate a bal-loon-payment Qualified Mortgage. This option is intended to accommodate community banks that make balloon loans to hedge against interest rate risk by permitting such lenders to make a bal-loon-payment Qualified Mortgage loan, as long as the loan term is five years or more and the pay-ment calculation is based on the scheduled peri-odic payments (excluding the balloon payment).
Impact of the Proposed Rule on Residential Mortgage Lenders and RMBS Investors
There are several reasons why the proposed rule will fundamentally change the playing field for residential mortgage lenders.
- Scope of Liability. The liability for originating a loan that does not satisfy the proposed rule is substantial. Assignees of such loans may also be subject to liability. In addition to the usual TILA remedies, there are enhanced civil remedies and the state attorneys general are authorized to bring actions for violations of the ability-to-repay rule for a three year period. A violation of these ability to pay requirements may also prevent a lender from foreclosing on a defaulting borrower. As described above, unlike prior ability-to-repay requirements, the scope of this proposed rule is very broad and applies to all residential mortgage lending.
- Safe Harbor versus Rebuttable Presumption. In light of the substantial potential liability for non-compliance, a safe harbor for Qualified Mortgages will therefore be very attractive to mortgage lend-ers and assignees of those mortgage loans (in-cluding purchasers of whole loan pools and RMBS investors). The definition of Qualified Mortgage may come to define the scope of all mortgage loans originated in the United States. The scope of the definition and how difficult it is to measure compliance may have a significant impact on the availability and price of mortgage credit for all types of borrowers. A poorly drafted definition with requirements that are difficult for diligence firms to measure would be a significant setback for the mortgage industry, and, in turn, potential borrowers. Embedded in this definition is the scope of what constitutes “points and fees” and whether a specific debt-to-income ratio should be set. Each of these elements of the definition will have a substantial impact on the industry. More-over, there is a significant issue that needs to be resolved in the final rules: whether satisfying the requirements of a Qualified Mortgage was in-tended by Congress to be a safe harbor from the ability-to-repay requirement (a much better stan-dard for lenders) or merely a presumption of compliance that may be rebutted by the bor-rower. If it is a safe harbor, the lender would only be liable if (i) the borrower proves that the loan is not a Qualified Mortgage and (ii) the lender was not able to prove that the loan meets the ability-to-repay test. With the presumption of compliance alternative, the borrower can rebut the presump-tion of compliance with evidence that the loan did not meet the ability-to-repay test.
- Uncertainty Surrounding the Consumer Financial Protection Bureau (“CFPB”). The proposed rule was drafted by the Board but jurisdiction for pre-paring and implementing the final rule passes to the CFPB on July 22, 2011 when comments are due. Drafting a final rule will be one of the first tasks of the CFPB and it is difficult to predict at this point how the CFPB will proceed. In particu-lar, it remains to be seen whether the CFPB will agree with the background analysis conducted by the Board that supports its drafting of the pro-posed rule or with the thrust of the proposed rule.
- Qualified Mortgage versus QRM. The definition of Qualified Residential Mortgage (“QRM”) will cre-ate a class of mortgage loans exempt from the risk retention requirements proposed under the Act (“Risk Retention Requirements”). The QRM requirements are the subject of a separate rule-making proceeding that now has a comment deadline of August 1, 2011 (See our May DechertOnPoint “Risk Retention Proposal for Resi-dential Mortgages Comes into Focus”) The Act specifies that the definition of QRM may not be broader in scope than a Qualified Mortgage. To-gether these two definitions will determine the shape of the RMBS market and it is essential that the definitions fit together in a way that preserves the flow of mortgage credit and makes measuring compliance straightforward.
Key Issues to Consider
The following is a list of key issues that participants in the residential mortgage securitization market should consider.
- Definition of Qualified Mortgage. The two proposed alternatives have very different re-quirements. The requirements for the presump-tion of compliance alternative essentially require the lender to satisfy the same burdens as would be required under the ability-to-repay test. We expect that residential mortgage lenders will want to either express a view on the proposed alterna-tives or propose a new approach. For example, they may want to comment on whether the final rules should specify a particular debt-to-income ratio.
- Effect of Satisfying Definition of Qualified Mortgage. We expect that residential mortgage lenders will want to comment in support of a true “safe harbor” from compliance with the ability-to-repay test so there is more legal certainty sur-rounding the issue of avoiding liability for non-compliance.
- Points and Fees Test. The Board has proposed two alternative approaches to determining the maximum amount of points and fees that may be charged to a borrower under the Qualified Mort-gage definition. Within the subject of points and fees, there are also questions as to what should be included or excluded from the test regardless of which alternative is chosen.