Will the Qualified Mortgage Rule Kill the Subprime Mortgage?

Giving borrowers more legal rights to challege lenders in court makes the loans more difficult to originate. Image: Fotolia

Subprime mortgages are likely to become harder to make and more expensive to sell based on the new qualified mortgage rule.

Under the rule, which was released Thursday by the Consumer Financial Protection Bureau, consumers with a "higher-priced" mortgage would have more legal rights to challenge a lender in court.

As a result, lenders said such loans will be less likely to be underwritten or sold at a decent price.

"The rule is certainly going to make it tougher and more expensive" to sell subprime loans, said Doug Rossbach, vice president and head of the financial services network at the consulting firm Northfield Highland. "Could a secondary market evolve outside those guidelines? It could, but it's going to be expensive to the borrower."

Once identified with the predatory lending that ran rampant in the lead up to the housing crisis, most subprime loans now are simply mortgages for low-income borrowers, those with weak credit, or jumbo loans.

While policymakers intended to crack down on alternative mortgages that required little to no verification, it is not clear they want to squeeze out all subprime mortgages, particularly for lower-income borrowers.

"If we were a lender that did have subprime mortgages, we would have to give long consideration to the risk that you inherit that has to be built into the cost of originating the loan," said Stewart Larsen, executive vice president of the mortgage unit at the $63-billion-asset Bank of the West in San Francisco. "That particular cost component is not good news for the public that need that type of financing."

Under the rule, the CFPB defines a "higher-priced" mortgage as a loan that is between 150 to 650 basis points above the prime rate. For example, if the current average prime rate is 3.5%, the CFPB would classify loans with more than a 5% rate as a higher-priced mortgage. But because of the artificially low interest rates, observers say even the so-called higher-priced loan thresholds are low.

"I'm sorry, that may be a higher priced loan but I don't recall anyone getting a subprime loan for 5% fixed" before the crisis, said Don Lampe, a partner at Dykema law firm. "It's not a historically expensive mortgage."

Such loans would have only a "rebuttable presumption" under the qualified mortgage rule, weaker than a full safe harbor enjoyed by prime loans.

Both Lampe and Larsen agreed that the rule would have a significant impact on specialty lenders with a niche in jumbo or low-income mortgages who do not fall under the exemptions that the CFPB is offering to lenders in rural areas.

However, some banks can use their private banking unit as an "alternative" to write and hold jumbo mortgages outside of the QM rule, said Joe Lynyak, a partner at Pillsbury Winthrop Shaw Pittman LLP. Consumers with jumbo mortgages "are not going to be very likely to sue the lender because this is the type of customer you would like to have," he said.

The CFPB said most of the loans now underwritten would be considered qualified mortgages and that qualified prime loans have stronger legal protections.

"The bureau believes, based upon its analysis, that under the rule, the vast majority of loans originated today can meet the standards for a qualified mortgage so long as creditors follow the required procedures, such as verifying income, assets, and debts," the CFPB said in an emailed response. "We also believe that the rule will not restrict creditors' ability to make responsible loans, both within and outside the qualified mortgage space."

The CFPB showed some leniency in allowing loans greater than its 43% debt-to-income cap to still be considered a qualified mortgage if it would meet underwriting standards of Fannie Mae and Freddie Mac or the federal government for up to seven years (or until Congress passes housing finance reform, whichever happens first).

"The rule was defined more liberally than most of us in the industry expected," said Rossbach, a former senior vice president at Wells Fargo Home Mortgage. "At this point, the CFPB does not want to have an impact on the economy by forcing lenders to make mortgages no one can get."

It's also uncertain if the subprime market, which is already weak, will be further damaged by the QM rule, observers said.

"There has been a lack of lending in that [subprime] space but the bureau's position is that it's unclear whether that is because of this type of rule or a host of other factors like the economy, other regulations and other capital initiatives," said David Luigs, counsel in the banking group at Debevoise & Plimpton LLP. "Only time will tell on how this is going to play out and there are enough other moving parts that it's hard to assess them all in isolation."

Only 5% of the mortgage volume today would fall outside of the QM rule's safe harbor protection based on CFPB data, according to a report released Thursday by Guggenheim Partners.

But observers agreed that the level of appetite for both banks and investors in the secondary market remains to be seen once the rule takes effect next January.

In the rule, "some of these defenses given to subprime borrowers have no time limit and apply to assignees so there is a real concern about, if subprime lending returns, will lenders keep it in their portfolio instead?" Luigs said. "And whether or not purchasers will be willing to buy them given the claims a consumer can assert in a foreclosure case under the ability-to-repay rule."