As we hurtle towards the go-live date for the Financial Conduct Authority’s (FCA) new mortgage rules on 26 April, the UK mortgage industry is on a mission.Lenders are focused intently on trying to ensure that everything is ready in time to deliver a smooth transition between one set of procedures and another – out with the old and in with the new, as it were.
It is tempting to see the inexorable march of regulation as a difficult journey, and easy to forget that we are not alone in undertaking it. Similar changes are being played out not only across Europe (partly delivered through the directive on credit agreements relating to residential property), but also in America.
In this article, CML takes a quick look across the pond at new rules that went live on 10 January in the US. These are the "ability-to-repay" rule, and the "qualified mortgage" rule. They were outlined under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which became federal law on July 21, 2010. The detail was subsequently designed by the prudential regulator, the Consumer Financial Protection Bureau (CFPB).
Background to the new rules
Analysts agree that the underlying root of the global financial crisis lay in the unhappy combination of US sub-prime mortgage lending and complex financial derivatives.
By repackaging poor quality debt into widely-sold securities that appeared far more robust than implied by the underlying assets, financial markets and investors were lulled into seeing risk through rose-tinted spectacles – until the financial crisis of 2008.
While the crisis did indeed become global, it’s also fair to say that it was “born in the USA”.
Since then, the risk mood has changed and the reverse swing of the regulatory pendulum has been extreme.
Here in the UK, we see this played out in the form of the demise of the Financial Services Authority and its rebirth into the "twin peaks" regulators of the Financial Conduct Authority and the Prudential Regulation Authority under the auspices of the Bank of England. We see it played out in the form of the Bank’s new financial policy committee with an armoury of new tools at its disposal. And, in our own neck of the woods, we see it played out in the form of the final detail of the mortgage market review (MMR) as well as enhanced capital requirements.
In the US, the “ability-to-repay” rule and the “qualified mortgage” rule are just some of the ways in which new post-crisis regulation is playing out.
The "ability-to-repay" rule
Under the “ability-to-repay” rule, the key concepts are going to look very familiar to a UK lender, as they are very similar to the concepts of the affordability assessment under the MMR. The CFPB describes them in these terms:
Mortgage borrowers must provide ample financial documentation; lenders must verify the documents.
In order to be approved for a particular home loan, the borrower must have sufficient income and assets to repay the loan.
Lenders must measure the borrower’s ability to repay the principal and interest over the long term, not just during an introductory period when the rate might be lower.
Looking in detail at the rule, the CFPB requires lenders to look at eight underwriting items:
current employment status;
current income or assets;
monthly payment for the home loan;
monthly payments on other loans related to the property (such as a second mortgage);
monthly cost of other mortgage-related obligations (such as property taxes);
other debts the borrower has (credit cards, car payments, etc); and
monthly debt-to-income ratio, or residual income after all monthly debts have been paid.
In addition, a reliance on the promotion of ‘teaser' rates is prohibited. The mortgage rate shown to a borrower cannot mask the true cost of the loan. Additionally, lenders cannot measure the borrower’s ability to repay the loan based on a teaser rate. They must measure ability to repay over the long term.
There is an interesting exemption for some re-financing. Exceptions to the underwriting rules can be made for home-owners who are trying to re-finance out of a risky mortgage and into a more stable loan. According to the CFPB, the term ‘risky’ can refer to loans with interest-only payments, adjustable interest rates, or negative-amortization features (where the principal balance grows over time). Lenders that are re-financing a home-owner into a more stable, standard mortgage can do so without going through the extensive underwriting procedures required by the ability-to-repay rule.
The "qualified mortgage" rule
The "qualified mortgage" (QM) concept goes a good deal further with some additional specific restrictions on lending characteristics. Initially, before the rules came in, there had been some speculation that lending might effectively become restricted to a QM-only market, but this does not seem to be the case in practice. While lenders generally have to hold their non-QM loans on balance sheet, rather than being able to pass them on to Fannie Mae and Freddie Mac, the combination of consumer demand and lender appetite seems to be ensuring that a market in non-QM lending will continue to exist.
Nevertheless, the QM rule is likely to exert significant influence on the US mortgage market. Notable features of a QM loan include:
Limits on "upfront points and fees". In this context, ‘points and fees’ are additional costs charged by the lender during mortgage application, processing and loan completion. The QM rule puts a limit on these, including fees used to compensate mortgage brokers and loan officers. Generally speaking (but with some exceptions), the points and fees paid by the borrower must not exceed 3% of the total amount borrowed.
Limitations on loan features. The CFPB will not allow any of the following features within a QM loan: interest-only loans; negative-amortization loans; terms beyond 30 years; or most "balloon" loans, where there is a large payment at the end of the repayment term (though some smaller lenders in ‘rural or under-served areas’ may still make such loans).
Limits on debt-to-income ratios. In general, no more than 43% of gross income can be spent on total debt-servicing each month for the mortgage loan to be considered QM-compliant. The lender must assess this over a forward period of five years.
By meeting the criteria of a qualified mortgage (QM), lenders receive some degree of legal protection against borrower lawsuits. The level of protection they receive will depend on the type of loan they make. In essence, there are two types of qualified mortgages:
Safe harbor". This one gives lenders the highest level of legal protection. These are lower-priced loans, typically granted to consumers with good credit histories (less risk). If the borrower subsequently ends up in default/foreclosure, the lender would be considered to have legally satisfied the "ability-to-repay" rule. However, borrowers could still challenge the lender in court if they feel the loan falls short of the other QM parameters.
Rebuttable presumption". These are higher-priced loans that are typically granted to borrowers with lower credit scores. In this context, ‘higher-priced’ refers to a loan with an interest rate that is more than 1.5% higher than the current prime rate. Lenders who grant these types of mortgages will receive a type of legal protection known as rebuttable presumption, which offers less protection than the safe harbor explained above. If borrowers end up facing foreclosure, they could still win an ability-to-repay lawsuit if they can prove “the creditor did not consider their living expenses after their mortgage and other debts.”
Reading about the new US mortgage rules is a bit like reading about the fantasy version of Oxford described in Philip Pullman's fiction. It's very much, but not exactly, like the world we know. For a UK lender, there are some notable differences - albeit along with a general sense of déjà vu - between the new ability-to-repay/QM rules and the MMR.
In the US, there is arguably a more limited emphasis on the lifelong aspects of affordability assessment than in the UK (Ian Ayres on the Freakonomics website notes the limitation and suggests that it is a reason why QM "misses the mark"). As a consequence, there also appears to be less ensuing concern with knock-on effects, such as the consequences of lending into retirement.
On the other hand, the QM concept, with its notion of additional legal protection for lenders, is outside the parameters of the UK regulatory approach.
However, what will be interesting will be to see how both the US and the UK markets react and adapt to the new affordability-focused rules. Will those who warn of the negative consequences of tighter lending parameters, that will keep some creditworthy consumers out of the market, be proved right - in either market? Or will this be an example of prime opportunities being taken to deliver targeted lending in niche markets outside the main flow, as others in both markets suggest? Although we will have to wait and see, it will be interesting to check in from time to time to see what’s happening on the other side of the Atlantic, as well as on our own shores.