Recent interest-rate decreases have led to a resurgence in the mortgage market, with refinance activity up sharply from levels a year ago. But lenders have underwriting on their minds for reasons other than increased application volume.

The CFPB recently affirmed that it intends to allow the so-called GSE Patch to its Ability-to-Repay/Qualified Mortgage Rule to expire in early 2021. This has home loans executives and their advisors assessing their underwriting obligations in a world without this heavily utilized compliance safe harbor. In advance of the elimination of the patch, the Bureau is requesting comments regarding potential changes to the Rule and the Qualified Mortgage definition.

The elimination of the GSE Patch introduces unwelcome uncertainty to the industry, particularly in light of the limited guidance from the Bureau and the courts regarding compliance with the Rule for non-QM loans. To its credit, the CFPB appears to recognize this and have a genuine interest in amending the Rule. We encourage lenders to respond to its request for comment and propose changes to keep the Rule viable after the patch expires.

The Ability-to-Repay Rule

The Ability-to-Repay/QM Rule was born out of the Government’s response to home-lending abuses that contributed to the 2008 financial crisis. The Rule implements the Dodd-Frank Act’s prohibition on no-documentation or low-documentation mortgage loans, which it enacted by adding to TILA a provision that mandates documentation of income and assets and an assessment of the applicant’s ability to repay: “no creditor may make a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan…” 15 U.S.C. § 1639c(a)(1). The Act prescribes the information that the lender must consider, including credit history, current income, expected income, current obligations, debt-to-income ratio or residual income, and other financial resources, and it requires verification of these items through third-party documentation.

Violation of TILA’s Ability to Repay requirements can result in civil liability, in addition to potential regulatory action. Lenders can be on the hook for damages in the amount of the finance charges and fees paid by the borrower, as well as the borrower’s attorney’s fees. Borrowers have three years from origination to file suit against lenders, but they can assert an Ability-to-Repay violation at any time in a collection or foreclosure action to obtain an offset to what they owe.

Qualified Mortgages

Dodd-Frank created a category of loan known as a “Qualified Mortgage” that receives a presumption of compliance with the Ability-to-Repay requirements. For loans with APRs that do not exceed the average prime offer rate for comparable transactions by specified thresholds, the Rule provides a complete safe harbor—in other words, the loan is deemed to comply with the Act.

Qualified Mortgages have specific product features, such as substantially equal periodic payments—with allowances for adjustable-rate or step-rate mortgages, loan terms of 30 years or less, points and fees below specified limits, and a total monthly debt-to-income ratio for the borrower of 43 percent or less. In addition, Qualified Mortgages must be underwritten using specific requirements for income and assets promulgated by the Bureau in Appendix Q to Regulation Z.

The GSE Patch

When the Rule took effect, the Bureau created an alternative path to Qualified Mortgage status that did not require lenders to meet all of the requirements noted above. The CFPB’s implementing regulations granted temporary Qualified Mortgage status to loans originated in accordance with Fannie Mae and Freddie Mac guidelines and that were eligible to be purchased or guaranteed by those government-sponsored enterprises, without regard to debt-to-income ratio or many other requirements. Known as the “GSE Patch,” this temporary exemption is set to expire on January 10, 2021, for loans originated after that date.

The home loans industry has heavily relied upon the safe harbor created by the GSE Patch to avoid regulatory and litigation risk when originating new loans and to facilitate secondary-market transactions. Without the patch, loans must meet the 43 percent debt-to-income requirement in order to receive Qualified Mortgage status. This exposes a significant proportion of home-loans originations to legal and regulatory uncertainty that, to date, the industry largely has been unwilling to bear. As the CFPB recently noted, “a robust market for non-QM loans above the 43 percent DTI limit has not materialized as the Bureau had predicted when it promulgated the Rule.” In fact, the Bureau estimates that the Rule has eliminated between 63 and 70 percent of non-GSE eligible, high-DTI home-purchase loans.

Guidance to Industry

A contributing factor to the market’s lack of enthusiasm for non-QM loans is the limited guidance from the Bureau and the virtually non-existent guidance from the courts regarding what a compliant loan looks like. The Bureau’s small-entity compliance guide for the Rule gives some general considerations, pointing to whether the underwriting standards used “have historically resulted in comparatively low rates of delinquency and default during adverse economic conditions,” whether the borrower paid on time for a “significant time” after origination or recast of an adjustable-rate mortgage, and whether the lender applies its underwriting standards consistently.

To see what the courts have said regarding the Ability-to-Repay Rule, we surveyed state and federal court opinions applying the Rule since its 2014 effective date. We found a very limited number of cases and almost none engaging with the Rule on the merits. A federal court in Ohio was the exception—that court noted the DTI ratio in its case was below 43 percent as determined by the lender, and that the lender properly relied upon the separation agreement documenting his spousal-support income and tax returns documenting his rental income.

As you might expect, courts do look to actual loan performance when evaluating an Ability-to-Repay claim. The U.S. Court of Appeals for the Sixth Circuit upheld summary judgment against a borrower, observing that the borrower’s payments in full for more than six years demonstrated he was able to meet the loan’s requirements at closing. Similarly, a federal court in Wisconsin rejected a borrower’s attempt to invoke the Rule, noting that the borrower had never missed a payment. Other courts have focused solely on the borrower’s lack of evidence supporting a failure to comply with the Rule. One federal court simply granted summary judgment to the lender because the plaintiff had not presented sufficient evidence to overcome the presumption of compliance.

Calls for Amendment to the Rule

The CFPB appears to recognize that the Rule needs significant enhancements to remain viable once the GSE Patch goes away. The Bureau’s currently pending request for comment indicates that it is open to potential changes to the Qualified Mortgage definition that will provide lenders greater assurance that they won’t face undue legal or regulatory risk in their loan originations. Lenders have suggested numerous changes, including:

1. increasing the debt-to-income limit for QM status above the current 43 percent ratio;
2. allowing for consideration of residual income, i.e., money projected to be left over each month after payment of debts, in addition to debt-to-income ratio; and
3. providing underwriters greater flexibility for consideration of self-employment income, seasonal or irregular income, or asset depletion as sources of payment.

Lenders have also suggested giving non-QM loans retroactive Qualified Mortgage status if the borrower has not been delinquent in the two or three years following origination or, for adjustable-rate loans, recast.

We encourage lenders and servicers to share their input on this important change. Comments are due to the CFPB by September 16, 2019. In the meantime, and going forward, lenders should consult with their trusted legal advisors to mitigate risk and avoid unforeseen liability.

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