by Fredric J. Gooch – General Counsel/VP Compliance, DocuTech Corporation
The Dodd-Frank Act was enacted to as a response to the financial crisis of the late 2000’s. Part of the blame for this crisis was a perceived lack of responsibility for the quality of securitized loans by loan originators. In an attempt to make originators responsible for the quality of the loans they originate, Congress passed Section 941(b) of the Frank-Dodd Act. This act requires securitizers of asset backed securities, including mortgage loans, to retain a portion of the credit risk for the assets that the securitizer packages into the securitization for sale to others. A portion of the credit risk was defined as meaning not less than 5%. The act provides for an exception for assets that are underwritten according to specified underwriting standards. The requirement to retain a portion of the credit risk is often referred to as the “skin in the game” provision because it is designed to make originators retain responsibility for a portion of the loans they originate, thus increasing the amount of skin they have in the game.
For the mortgage industry, a matter of the utmost importance with the new regulation is how loans may be qualified to be exempted from this provision. The act directs the regulatory agencies to implement an exemption for “qualified residential mortgages” or QRMs. These loans are categorized as mortgages with underwriting and product features that historical loan performance indicates a lower risk of default. Securities backed by QRMs are not subject to any risk retention provision.
The agencies have issued a proposed rule implementing conditions that must be met for a mortgage to qualify as a QRM and be exempt from the risk retention requirements. The agencies issued the proposed rule after evaluating historical loan data to identify underwriting characteristics of loans that have performed well over time. The rule prohibits QRMs from having “nontraditional product features” that add risk and complexity to mortgage products. Some of these prohibited features include negative amortization, interest only payments and significant interest rate increases.
The proposal implements strict underwriting standards as follows:
- Maximum front-end debt to income ratio of 28%
- Maximum back end debt to income ratio of 36%
- Maximum loan to value ratio of 80% for purchase loans
- Maximum loan to value ratio of 75% for straight refinance transactions
- Maximum loan to value ratio of 70% for cash-out refinance transactions
- Down payment requirement of 20% for purchase transactions
- Borrowers may not have any 60 day delinquencies
Mortgage insurance must not be considered when calculating the loan to value ratios for the underwriting standards because the act directed the regulators to consider whether mortgage insurance reduces the risks of default in drafting their rules.
The proposed rule has an exemption for any government guaranteed securitizations which exempts those assets from the risk retention requirements. This means that loans sold to Fannie Mae, Freddie Mac or insured by the FHA or VA would not be subject to the rule and would automatically be considered QRMs.
The rule contains several forms of risk retention that would be acceptable to qualify as retaining the required amount of aggregate credit risk. The agencies have tried to propose options that would allow securitizers to retain the risk while not restricting the flow of credit to consumers. Some of these options include vertical, horizontal, L-shaped interest, seller”™s interest and representative samples. For more details on the risk retention options the reader is encouraged to review the details in the proposed regulation.
The proposed rule has garnered much criticism from the mortgage lending community which argues that the rules are too strict and will cause a restriction in the amount of credit that will be available to otherwise qualified borrowers, or will cause a dramatic increase in interest rates. Many have commented that the proposed rule will limit the role of independent mortgage banks and community lenders who do not have the assets to hold such a large amount of loans in their portfolio despite having long histories of originating safe and well underwritten mortgages. They urge the regulators to consider a borrowers entire credit history before determining whether risk retention is warranted on a loan, such consideration might allow for borrowers with a long history of meeting their credit obligations to have lower downpayment requirements.
This proposed rule could have far reaching impact into the mortgage lending industry if enacted as presently drafted. Most believe it will restrict the flow of credit to quality borrowers and increase interest rates. The agencies have encouraged interested parties to review the rule and submit comments before the June 10, 2011 deadline. The rule can be found at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20110329a1.pdf.
For the mortgage industry, a matter of the utmost importance with the new regulation is how loans may be qualified to be exempted from this provision. The act directs the regulatory agencies to implement an exemption for “qualified residential mortgages” or QRMs. These loans are categorized as mortgages with underwriting and product features that historical loan performance indicates a lower risk of default. Securities backed by QRMs are not subject to any risk retention provision.
The agencies have issued a proposed rule implementing conditions that must be met for a mortgage to qualify as a QRM and be exempt from the risk retention requirements. The agencies issued the proposed rule after evaluating historical loan data to identify underwriting characteristics of loans that have performed well over time. The rule prohibits QRMs from having “nontraditional product features” that add risk and complexity to mortgage products. Some of these prohibited features include negative amortization, interest only payments and significant interest rate increases.
The proposal implements strict underwriting standards as follows:
- Maximum front-end debt to income ratio of 28%
- Maximum back end debt to income ratio of 36%
- Maximum loan to value ratio of 80% for purchase loans
- Maximum loan to value ratio of 75% for straight refinance transactions
- Maximum loan to value ratio of 70% for cash-out refinance transactions
- Down payment requirement of 20% for purchase transactions
- Borrowers may not have any 60 day delinquencies
Mortgage insurance must not be considered when calculating the loan to value ratios for the underwriting standards because the act directed the regulators to consider whether mortgage insurance reduces the risks of default in drafting their rules.
The proposed rule has an exemption for any government guaranteed securitizations which exempts those assets from the risk retention requirements. This means that loans sold to Fannie Mae, Freddie Mac or insured by the FHA or VA would not be subject to the rule and would automatically be considered QRMs.
The rule contains several forms of risk retention that would be acceptable to qualify as retaining the required amount of aggregate credit risk. The agencies have tried to propose options that would allow securitizers to retain the risk while not restricting the flow of credit to consumers. Some of these options include vertical, horizontal, L-shaped interest, seller’s interest and representative samples. For more details on the risk retention options the reader is encouraged to review the details in the proposed regulation.
The proposed rule has garnered much criticism from the mortgage lending community which argues that the rules are too strict and will cause a restriction in the amount of credit that will be available to otherwise qualified borrowers, or will cause a dramatic increase in interest rates. Many have commented that the proposed rule will limit the role of independent mortgage banks and community lenders who do not have the assets to hold such a large amount of loans in their portfolio despite having long histories of originating safe and well underwritten mortgages. They urge the regulators to consider a borrowers entire credit history before determining whether risk retention is warranted on a loan, such consideration might allow for borrowers with a long history of meeting their credit obligations to have lower downpayment requirements.
This proposed rule could have far reaching impact into the mortgage lending industry if enacted as presently drafted. Most believe it will restrict the flow of credit to quality borrowers and increase interest rates. The agencies have encouraged interested parties to review the rule and submit comments before the June 10, 2011 deadline. The rule can be found at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20110329a1.pdf.