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Subprime Makes a Comeback, Despite Dodd-Frank's Impediments

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An avowed goal of the elephantine Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the contraction of available credit to residential mortgage borrowers. Borrowers with blemished credit have seen the shrinkage of credit available to them, and Dodd-Frank has reversed a decades-long federal mandate of increasing residential home ownership.

For those borrowers impacted by restricted credit access, budding non-Qualified Mortgage niche products are leading the reemergence of a nonprime residential market. This, in turn, is augmented by stabilizing housing prices and a more discernible demand for credit by consumers.

The centerpieces of Dodd-Frank relating to residential mortgages, the Ability-to-Repay rules promulgated by the Consumer Financial Protection Bureau and the six federal regulators’ final Credit Risk Retention rule, create powerful incentives for lenders to lend to borrowers with the highest credit.

The drafters of the statute, longtime critics of the residential mortgage industry, believed that in the go-go years preceding the financial crisis too many lenders recklessly extended mortgage credit to consumers on terms that they did not understand and in certain instances, could not repay.

Implicit in the drafters’ reasoning is that too many irresponsible consumers were assuming the arduous task of homeownership, which was beyond their means.

Under the risk retention rules, a sponsor of a securitization (or originator) of residential mortgage-backed securities not backed solely by qualified residential mortgages must retain a collective retained interest in the securitization of not less than 5%. Subject to certain exceptions, the rules prohibit the sponsor from helping or transferring this retained interest.

Although the risk retention rules permit the sponsor and the originator to allocate the 5% retained risk between each other, few parties except for real estate investment trusts, certain hedge funds and depository institutions will be able to hold such retained risk.

The final rule became effective Feb. 23, 2015, but asset-backed securities collateralized by residential mortgages must comply with the rule beginning on Dec. 24, 2015.

For securities backed entirely by residential mortgages, the prohibitions of transfer or sale (without the requisite risk retention) would expire beginning five years after the date of closing, if and when the unpaid principal balance of the mortgages has been reduced to 25% of the unpaid principal balance at closing, but in no event later than seven years after the transaction closes.

Further, under Dodd-Frank, a Qualified Residential Mortgage could be no broader than a Qualified Mortgage, and in earlier proposals, the qualified residential mortgage contained a number of additional criteria not found in qualified mortgages, such as a 20% down payment and front-and-back-end debt-to-income requirements.

Fortunately, with certain exceptions, in the final risk retention rule, the six regulators aligned the qualified residential mortgage.

Nevertheless, under these rules, in order for a securitization pool to qualify for the QRM exemption from risk retention, the residential loans in the pool must exclusively consist of qualified residential mortgages and be not currently more than 30 days past due.

Despite these impediments, a niche market of non-QMs/non-QRMs are arising from the acute credit needs of the residential mortgage markets with hedge funds, certain banks and real estate investment trusts leading the way.

A prerequisite for the emergence of this market will be higher interest rates: lenders will not assume more expansive legal risks and credit costs without higher rewards.

Nevertheless, in spite of the impediments created by Dodd-Frank, and the unusually low interest rates that have characterized the residential loans markets in the past several years, credit demand, especially among nonprime borrowers, will swing the pendulum in favor of a more robust lending environment, and will likely entail amendments to the existing Dodd-Frank regime.

Parties have an enormous incentive to originate loans that meet the criteria of a Qualified Residential Mortgage. Furthermore, while these rules apply only to securitizations and not to transactions involving whole loan sales, many originators will not stray from the parameters of the qualified residential mortgage criteria because they will want to ensure that their loan product is ultimately eligible for securitization.

Stephen Ornstein is a partner at Alston & Bird LLP.

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