Are Non-QM Loans the New Subprime?

Though many have feared the recent uptick in nonqualified mortgage loans (non-QM loans) could indicate another crisis is on the horizon, according to research released by Morningstar today, these worries aren’t yet warranted. As Morningstar’s report put it, “nonqualified mortgages are not the new subprime.”

According to Morningstar, it’s a common misconception that any loan that doesn’t meet qualified mortgage designation is equal to a subprime loan—and that it poses the same risk to the market.

“This comparison is over simplistic,” Morningstar reported. “Non-QM loans do not share the characteristics of the subprime mortgages that led to the financial crisis. The QM designation, which the Consumer Financial Protection Bureau developed more than three years ago, does not de facto equate to strong credit. Conversely, non-QM loans do not always indicate more problematic credit or excessive risks.”

Unlike subprime loans—which often required no documentation of income—most underwriters “thoroughly examine proof of income” in non-QM applications. Not only does this make these loans less risky but, according to Morningstar, it actually means defaults are “rare.” Often, borrowers simply have inconsistent income that can’t be verified via QM standards.

“Even when a mortgage is designated non-QM, the lender must document the borrower’s ability to repay the loan. The ATR rule, implemented in 2014 under the Dodd-Frank Act, requires the lender to determine that the borrower can repay the loan by considering underwriting factors such as income, assets, monthly payments, debts, DTI or residual income, and credit history. This requirement essentially eliminates the possibility for stated income loans with little or no documentation, which were common before the crisis. Therefore, today’s loans secured by primary residences and second homes (ATR rules do not apply to investment properties) have lower potential of fraud and improved underwriting quality than pre-crisis subprime loans.”

Taking into account FICO scores, loan-to-value ratios, and debt-to-income ratios, the majority of non-QM borrowers would qualify for most mortgage programs—including those at Fannie Mae and Freddie Mac.

“Securitizations of non-QM loans do not contain high concentrations of low FICO, high LTV, or high DTI loans,” Morningstar reported. “Based on this data, non-QM loans are not the new subprime loans of yesteryear.”