'1,000 Shades of Non-QM': Home Lenders Court Niche Borrowers
Nonstandard. Atypical. Irregular. One-off.
These are just a few of the terms that mortgage lenders have coined to describe loans that do not meet the Consumer Financial Protection Bureau's definition of an ultra-safe "qualified mortgage."
Since the CFPB's mortgage rules went into effect in January, some mortgage lenders and investors have been desperately trying to figure out how to originate loans that fall outside the definition.
Non-QM loans offer lenders the potential to earn the kind of profits last seen during the heady days of subprime lending. At a time when loan volumes have plummeted, lenders can charge consumers significantly higher mortgage rates for these products. The profit potential would be even greater if the loans eventually get pooled together, securitized and sold to investors.
"Mortgage bankers are looking to find other sources of business in order to remain profitable or to get back to profitability," says Michele Perrin, a principal at Perrin & Associates, a warehouse lending advisory firm in Tustin, Calif. "Everybody is looking for financing for non-QM loans."
Many lenders are wading into the non-QM space by initially offering loans to self-employed borrowers, foreign nationals and borrowers with blemished credit from a past short sale or foreclosure. Some lenders also are focusing on specific property types like condominiums that do not meet standards set by Fannie Mae or Freddie Mac.
"There will be 1,000 flavors of non-QM like 1,000 shades of gray," says Brian Hale, the CEO of Stearns Lending, in Santa Ana, Calif. "I believe all lenders will have to do some portion of their volume in the non-QM space. It's easy to race in and there's no shortage of demand because there are an awful lot of customers that don't fit the QM box."
But non-QM loans come with significant legal risks. The "ability to repay," rule, a crucial provision of the Dodd-Frank Act, requires that lenders consider eight specific underwriting factors to verify the borrower's income.
Failure to do so can result in possible criminal liability, fines of $5,000 per day, enforcement actions by federal and state agencies, and civil and class action lawsuits by individual borrowers. Borrowers have three years to bring a legal action against a lender for potential violations of the ability to repay rule and also can raise a defense to a foreclosure years down the road.
Lenders are dividing the market into various niches that they deem safe enough to compensate for legal dangers. Most are identifying well-qualified borrowers with ample assets but income that might be difficult to document.
"I think you'll find that non-QM loans are pristine loans otherwise that could be challenged on the ability to repay rule," says Raymond Natter, a partner at the law firm of Barnett Sivon & Natter, who conceded that "nonbank lenders might be more comfortable with a riskier business model."
Of course, the nation's top banks originally claimed they would not make any non-QM loans, but they all have continued to make interest-only jumbo mortgages to wealthy borrowers. Such loans are held on bank balance sheets and tend to have very low default rates. Interest-only loans are excluded from being considered ultra-safe "qualified mortgages" because borrowers often face payment shock once they are required to start paying principal, typically after five to seven years of paying just interest.
Non-QM lenders are replicating the playbook of banks that naturally gravitated toward interest-only and jumbo loans to borrowers with lots of reserves and income.
"They're not making an IO loan to a part-time Wal-Mart worker who lives paycheck to paycheck," says Michael Kime, the chief operating officer at W.J. Bradley Mortgage, a Colorado lender. "Banks feel grounded to defend the non-predatory nature of the loan. How do we identify underserved markets, make responsible loans and have enough of them to get…deal flow?"
This month, W.J. Bradley will start originating nonagency condo loans. Many condominiums are tied up in litigation or have too many unoccupied units that make them ineligible for sale to Fannie Mae or Freddie Mac. Mortgages on certain mixed-use commercial and residential properties also can't be sold to the government-sponsored enterprises and exemplify the types of niche non-QM loans W.J. Bradley will originate from now on, Kime says.
"We're wringing our hands at the opportunity," he says. "How do we parlay the same logic a bank is using into a nonbank securitization?…The real issue is ability-to-repay: Are you [the lender] behaving in a predatory manner or are you originating assets to reasonable borrowers?"
A handful of lenders and investors are lining up to originate nonagency, non-QM loans. They include Caliber Home Loans, an Irving, Texas, lender owned by private equity firm Loan Star Funds, and Legg Mason Inc.'s bond firm Western Asset Management, which plans to buy non-QM loans from lenders.
Perrin is working with non-QM lenders including some hard-money lenders that are offering short-term financing at rates ranging from 11% to 13% to individual investors who are buying and flipping properties. The biggest hurdle, she says, is trying to get warehouse lines of credit.
"Warehouse lenders do not want to be anywhere near the origination piece of the transaction," says Perrin. "They do not want to be potentially sued and most of these firms believe attorneys will be lining up to sue non-QM lenders."
Some warehouse lenders are considering creating special purpose entities that would serve as a buffer between them and the originating lender as a shield from being sued, Perrin says.
Non-QM lending is still in the very early stages and many lenders believe it will evolve as lenders become more comfortable with the litigation risk.
"You're going to have non-QM, it's just another asset to throw in there along with reperforming and nonperforming securitizations," says Michele Patterson, a senior director at Kroll Bond Rating Agency.
Still, the lack of a secondary market take-out for lenders, the dearth of available capital and historically low interest rates, which make the risks harder to justify, are all headwinds for non-QM loans.
Finding a catchy moniker also would help.
"We started internally calling these nonprime loans but that has a connotation of subprime, and you can't call them alt-A because of the stigma," says Kime, referring to alternative-A, a boom-era subcategory of loans that had less than full documentation and lower credit scores but higher loan-to-value ratios.