There’s plenty of talk in the mortgage industry about whether originators should lend to borrowers outside the Qualified Mortgage (QM) rule, which was implemented in 2010 under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
While most mortgage CEOs understand the tremendous boost to profitability to be enjoyed by first-movers in the non-QM market, they are concerned about the untested risks and heightened scrutiny associated with originating loans that do not comply with the Qualified Mortgage rule. Principally, these risks stem from a lack of liability protection with a borrower over an ability-to-repay (ATR) claim. Damages associated with an ATR claim can be magnified in the case of jumbo loans, which aren’t guaranteed or securitized by Fannie Mae or Freddie Mac. A second concern is the lack of secondary markets involved in non-QM loans, as nonbank loan issuers still need to find investors willing to purchase non-QM mortgages.
 Investopedia. Jumbo Loan.
 Rachel Norvell (April 10, 2015). “CEO: The government wants you to make non-QM mortgages.” Mortgage Professional America.
To be sure, movement in the non-QM market has been lethargic in the two years since the Consumer Financial Protection Bureau (CFPB) adopted a new rule giving banks and other mortgage originators certain liability protection in non-QM lending. While this has reduced fears about lawsuits, buybacks and other financial damages, most lenders have remained hesitant about entering this market. According to various estimates, hesitation to issue non-QM loans could result in a 7 percent reduction in originations annually. In an industry issuing around $1.2 trillion in loans, that amounts to over $80 billion in lost business.
In an industry that is facing greater challenges to grow its business, banks and other mortgage lenders won’t be able to pass up on this opportunity for much longer. Consider that the Federal Reserve just raised interest rates for the first time in nearly a decade and is expected to hike rates an additional four times in 2016. Combined with rising home prices and stricter lending terms, more and more Americans will be considered “non-qualified” borrowers in 2016 than at any other time in the post-recession era. Today, even creditworthy borrowers face difficulty in securing a mortgage, given how quickly house prices have bounced since the subprime mortgage crisis and how slowly average incomes have risen, despite the jobs recovery. In fact, the gap between what the average American can afford and the median sales price on a home is much bigger than it was prior to the housing bubble. This will make it much more difficult for home loan seekers to meet the minimum debt-to-income ratio of 43 percent for a qualified mortgage under Dodd-Frank.
In this environment, non-QM loans are critical to the strength and longevity of the housing recovery. While home sales gathered pace in the latter-half of 2015, the market’s recovery has occurred in stops and starts over the past six years. For example, home sales stalled in 2014 as a result of rising mortgage rates. The average commitment rate on a 30-year fixed rate mortgage was 4.17 percent that year, up nearly 20 basis points from the previous year and over 60 basis points from 2012.
Despite early hesitation on the part of loan originators to enter the non-QM lending space, non-qualified mortgages already make up 10 to 15 percent of the residential real estate market. This figure is as high as 40 percent if you include interest-only loans. According to industry insiders, the non-QM segment of the residential loan market could reach $2 trillion over the next four years.
The benefits of non-QM loans are numerous, and most mortgage CEOs already know this to be the case. Not only can loan originators make up to 250 basis points more on a non-QM loan, they can also boost their total number of originations (recall in the last section we showed how fewer Americans will qualify for a QM loan in 2016). Additionally, the long-term impact of Fannie Mae and Freddie Mac on the U.S. housing sector has been studied at length, and many economists agree that eliminating or reducing the role of these institutions would have a net-positive impact on the U.S. economy. After all, only private money can sustain a strong, vibrant housing recovery. Adding to this is the fact that the government wants private lenders to originate non-QM loans. The Obama Administration began the process of overhauling Fannie Mae and Freddie Mac in 2013 in order to shift the burden of backing mortgages to the private sector.
Non-QM Does Not Necessarily Equal High Risk
While non-QM loans do pose more risk than qualified mortgages, they are not inherently high risk nor do they fall under the category of subprime. Rather, a non-QM loan is a type of loan that doesn’t fit into the rules associated with qualified mortgages, as defined by Dodd-Frank and the Ability-to-Repay rules. For the most part, non-QM loans require full employment, steady income and other important attributes, such as a very high FICO score. Additionally, interest-only loans that aren’t covered under QM guidelines are witnessing higher demand, especially among high net-worth borrowers. Originating loans to high net-worth investors looking to grow their investment channels outside of residential real estate certainly isn’t considered “high risk” in the traditional sense of the term.
First Movers in the Non-QM Market
Rising interest rates, stricter lending terms and a growing gap between incomes and home prices have created favorable conditions for non-QM lending. The increase in non-QM lending is placing a premium on technology and services that track ATR validations in order to identify underserved borrowers who may have spare capacity in other areas of the credit spectrum. Successful non-QM lender will need to place a large emphasis on technology and develop a protocol of open communications between the lender and the borrower. This not only gives loan originators the ability to manage ATR and risk management protocols, it also establishes stronger customer relationships.
While non-qualified mortgage lending is still in its early stages, bank and nonbank originators are dipping their toes in the non-QM loan pool. Many have pledged to continue originating interest-only loans and several others also offer non-QM jumbo loans. It may still be a while before non-QM loans become mainstream, but the general consensus reads that the time will come once the courts set the precedent for investors concerning litigation and the ability-to-repay guidelines. This could occur sooner than you think.
This article was written exclusively for GoRion.