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Qualified Mortgage Rule

The Enchanted Qualified Mortgage Rule and the Not-So-Safe Safe Harbor

 

About The Author

 Jonathan Kunkle is president of GuardianDocs, the document services division of Denver-based LenderLive Network™ Inc. He can be reached at [email protected].

The Enchanted Qualified Mortgage Rule

 


 

Due to the variability in how income is calculated, it is probably safe to say that there isn't a lender today who has a 100-percent, litigation-proof, documented loan file."

What do Harry Potter's Ministry of Magic and the Consumer Financial Protection Bureau (CFPB) have in common? Neither seems to be anticipating developments that are pretty obvious to the rest of us. In the case of the Ministry of Magic, it didn't anticipate that He-Who-Must-Not-Be-Named would return, while Dumbledore and Harry Potter certainly did. Similarly, nearly one year ago, CFPB director Richard Cordray said he did not anticipate a rise in litigation stemming from his agency’s Qualified Mortgage (QM) rule that took effect in January of this year. So perhaps, just like Dumbledore and Harry Potter's plight, the safe harbor of QM may end up being a seven-novel saga.

QM's safe harbor against litigation is valid provided a loan meets the minimum thresholds for debt-to-income and the Truth in Lending Act's (TILA's) "ability to repay" (ATR) requirements. CFPB's QM provides two classifications: rebuttable presumption (for higher-priced loans) and safe harbor (for all otherwise qualifying loans). In both cases, there is a direct avenue for challenge if the points and fees thresholds were not met. However, the safe harbor is designed to pre-empt any question to the underwriting standards and ATR qualifications of a loan meeting the QM designation. Nevertheless, in reality, neither protects the creditor from borrowers—or more likely their attorneys—challenging the ATR calculation. Most likely this challenge will occur when the loan goes into delinquency.

In fact, a fair and potentially "killer" question from a borrower, in either class of Qualified Mortgage loan, would be to ask the mortgagee: "Prove conclusively that you complied with ATR and Qualified Mortgage criteria and underwriting standards on my loans." This question is a great risk to every lender. To further compound the issue, this is truly a litigation threat that is difficult to quantify since the courts have yet to see and opine the effectiveness of QM's rebuttal and safe harbor. Today, the QM protection for most lenders is like that elusive door that Harry Potter can never quite get to in his dreams. It’s out there, but no one is quite sure of its meaning.

"Qualified Mortgage can provide the originator a safe harbor, but they're never really safe. There are foreclosure defense attorneys in the country just waiting for the opportunity to spring their trap on the lending industry. That trap is: 'Prove to me my borrower could afford this loan,'" said Paul Schieber, a partner with the law firm Stevens and Lee.

Under the rebuttal presumption, higher-priced, covered QM transactions are only presumed to be ATR compliant. A consumer with this brand of QM mortgage loan has the clearest path to question the lender's ATR and, therefore, QM protections, because the rule openly permits it. However, even if the loan is not higher priced, there are no limitations prohibiting borrowers (or their counsel) from questioning if their loan meets the QM standards, typically via litigation. A borrower'’s argument will be that the lender engaged in unfair or deceptive practices, which will likely win favor in the courts.

What happens if you can't prove the borrower's ability to repay? Likely we will see a reversal of that loan's QM status and, with it, a lender's safe harbor. This litigation could lead to a significant claim. Can you feel that scar aching now, Harry?

Schieber further added, "We can expect that as soon as the first QM loan goes into default, the immediate course of action will be to claim the loan did not meet the QM standards. I also expect to see litigation even past the three-year timely payment standard; likely when that occurs we'll learn how defensible that tranche of the safe harbor really is."

Venturing further into the defense against dark arts, lenders can expect this to happen on every defaulted loan in non-judicial states. "Creating a litigation event in a non-judicial foreclosure effectively extends the foreclosure proceedings out tremendously, creating the same timelines as that of a foreclosure in a judicial state. Even if successful in defending the case, that litigation will extend any foreclosure timeline by months or years," stated Schieber.

Best Practices that Don't Require Wizardry


 

So what can lenders do to protect themselves?

First, the most important thing a lender can do is to have a fully documented file and retain it for a minimum of three years. The file must be organized so that an independent observer can clearly ascertain that ATR standards were met.

The problem is that a well-documented file doesn't recreate how the denominator in the Qualified Mortgage equation was determined. Any  industry veteran knows that there is not, nor has there ever been, a standard that is used to calculate income. And income, of course, is used to determine ATR's back-end ratio (or DTI).

Today, we see many underwriters using a legal pad and a calculator to create the income figure. More sophisticated lenders, meanwhile, rely on spreadsheets that accommodate for wage and non-wage earnings, recurring and non-recurring income/expenses, and other anomalies found when reviewing the hundreds of pages of tax transcripts, tax returns, pay stubs, and bank statements. Just saving the spreadsheet to document income does not mean that there is consistency as to how the income was determined or the accuracy of that calculation, as the teams performing QC can attest.

QM can provide the originator a safe harbor, but they're never really safe. There are foreclosure defense attorneys in the country just waiting for the opportunity to spring their trap on the lending industry. That trap is: 'prove to me my borrower could afford this loan.'"

Paul Schieber, Stevens and Lee

The ATR guidelines themselves do little to crystallize the calculations beyond the guidelines already published by the GSEs. For example, Appendix Q requires the lender to evaluate the financial strength of the business operated by a self-employed consumer. "Annual earnings that are stable or increasing are acceptable, while businesses that show a significant decline in income over the analysis period are not acceptable." That makes sense, but what constitutes "stable" or "significant?"

Similarly, in considering overtime and bonus income, "A period of more than two years must be used in calculating the average overtime and bonus income if the income varies significantly from year to year." How many different rationales and interpretations of those rationales are possible? How will a judge rule based on this wording? What happens once the court rules against a recurring bonus or commission? Can anyone say, "Headmaster Dolores Umbridge?" And the CFPB's proposed post-consummation cure for DTI miscalculations (wherein the lender would be responsible for buying down the debt or reducing principal to achieve an acceptable DTI) is akin to Umbridge's "I shall not tell lies" punishment on Harry.

Our analysis on a large population of already closed and funded loans showed that at least one in five had an income calculation discrepancy. More importantly, of those loans with income discrepancies, more than 10 percent of the incorrect calculations were of a grievous variety. In these cases, there were many that could justly be recategorized as non-QM because of the recalculated ratios and affordability. In speaking to our clients about this risk, each agreed that they weren't doing enough to first correctly calculate the borrower's income and, secondly, properly document how that figure was calculated. At any point in the future, the first question the opposing attorney will ask will be the same one we used to dread from our math teachers: "Show me your work."

Proper documentation has to include the math behind the calculation; an explanation of what was included and why; and an explanation of what was not included and why. Moreover, to prove the lender is not using deceptive practices, that math has to be the same on each and every loan file manufactured. The second question that attorney is going to ask is, "Prove to me that you calculated the income of my client in the same manner you used on other loans." If there is a discrepancy, there will be further burden on the lender to prove each variation of the calculation was correct.

Due to the variability in how income is calculated, it is probably safe to say that there isn't a lender today who has a 100 percent, litigation-proof, documented loan file. In fact, one top-three bank revealed to us that they calculate a borrower's income no less than seven times before the loan is closed, and then at least once more if that loan is selected for a quality control review. And, prior to close, the multitudes of calculations are repeated if any one of them results in a different income amount. It is no wonder the industry's cost to produce a loan has increased by more than 250 percent in the last few years. And, worse yet, eight-plus calculations per loan still does not eliminate the risk a borrower will claim they could not afford their loan.

Bad things happen to good people and some loans will go delinquent, even when underwritten to today's stringent standards. Our industry's challenge is to have an indisputable means in which we can prove that when that loan was made, the borrower absolutely could afford it. Not even Harry's invisibility cloak can save us from the litigation we may see.

 

This piece originally appeared in the November 2014 issue of MReport, available now.

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