Non-QM lending received a big boost this week when Fitch Ratings issued its criteria for analyzing residential mortgage-backed securities (“RMBS”) under the Ability to Repay (“ATR”) and Qualified Mortgage (“QM”) rules issued by the Consumer Financial Protection Bureau. It announced that it would apply a relative “credit enhancement” adjustment (i.e., extra collateralization) to non-QM loans pooled to back RMBS, but the level of credit enhancement reflects its belief that the risk of massive losses on such loans is relatively slight. In reliance upon required third-party due-diligence reviews, Fitch said that it would assume the accuracy of an originator’s designation of loans as “safe harbor” QM loans, higher-priced QM loans or non-QM loans.
Violations of the ATR requirements can lead to affirmative claims against creditors and defensive claims against assignees for potentially significant monetary damages consisting of actual damages, $4,000 in statutory damages, a refund of finance charges paid at closing and three years of interest actually paid and attorneys’ fees. Concern over the amount of such damages and the potential impact of a borrower claim on a foreclosure action has caused some lenders and purchasers to restrict their loan purchases to loans that are conclusively presumed to satisfy the ATR requirements. The lack of an active securitization market for non-QM loans, however, constrains those who want to participate in this segment of the market but want an ultimate “take out” for non-QM loans that they make, purchase or finance.
Fitch identified a number of “key ratings drivers” that informed its analysis, only some of which relate to potential performance of the loans. As a threshold matter, any transaction must include adequate representations and warranties, “robust” enforcement mechanisms and indemnification for breaches. It also will review the originators’ and aggregators’ processes for ensuring compliance with the ATR rules, both in design and in implementation. Fitch also will require additional credit enhancement for deal structures that deduct expenses from available trust funds rather than from a mortgage pool’s net weighted average coupon rate.
But the heart of the analysis relates to the likelihood of losses based on ATR violations resulting in defensive claims against assignees. A rating of a securitization is based in part on estimated cash flows on the loans backing the RMBS. Losses resulting from ATR violations would impact such cash flows unless the loan is repurchased based on a breach of a selling representation and warranty. So the key is trying to model the number of potential claims and the likelihood and severity of losses resulting from such claims. This is where Fitch took a very practical perspective.
In determining the probability of an ATR violation, Fitch first looked at the probability of default as determined by its mortgage loan loss model. It limited its analysis to defaults in the first five years of origination, which in its view excluded 40% of defaults that its model predicted would occur, although it decreased the size of this exclusion for short-term, hybrid adjustable-rate loans. It then differentiated between states that require judicial foreclosure and states that permit nonjudicial foreclosure, positing that borrowers in nonjudicial states are less likely to seek counsel and file a claim in court. Also relevant to its analysis is credit quality: it assumes that non-QM “lite” loans, such as jumbos with debt-to-income ratios only slightly above 43%, pose a lesser risk. Fitch also created assumptions for probability of resolution as a percent of challenges and anticipated legal fees to defend such challenges.
The result of this analysis is an assumption that, at least for now when there is not yet any judicial precedent that would provide additional guidance regarding ATR challenges, higher-priced QM loans and non-QM loans “…reflect a low probability/high severity scenario whereby Fitch expects a limited portion of defaulted loans to challenge ATR/HPQM status but that significant legal costs will result.” Interestingly though, it concluded that “Fitch expects loan modifications to be the most common resolution to ability-to-repay disputes for higher priced QM loans.”