Alert November 27, 2012

A Summary of Proposed Qualified Mortgage, Qualified Residential Mortgage and BASEL III Category I Mortgage Requirements

Goodwin Procter recently hosted 75 CEOs and senior managers from middle market and community banks across the region at the inaugural Northeast Banking Symposium.  The full-day conference, “Strategic Innovation in a Challenging Environment,” was sponsored by the Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island and Vermont Bankers Associations.  The event focused on the strategic importance of managing innovation and technology to address challenges faced by banks serving middle market and local communities.

At the Symposium, Goodwin Procter provided attendees with a written analysis of the substantial regulatory and related business challenges in the post-Dodd-Frank Act environment faced by banks that offer residential mortgages, given the confluence of the Qualified Mortgage, Qualified Residential Mortgage and Basel III standards.  The analysis is provided below.  An integral part of the analysis is the accompanying chart, entitled “Comparison of Qualified Mortgage, Qualified Residential Mortgage and Basel III Category I Requirements.”  The analysis and chart, which we encourage you to read and retain as a reference, were prepared by William E. Stern, Michael Whalen and Grant F. Butler of Goodwin Procter’s Banking Practice Area.

Early versions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) contained provisions that would have obligated lenders to offer consumers “plain vanilla” mortgage loans with limited terms and features.  As enacted, the Dodd-Frank Act contains no such explicit requirement, but it does impose several constraints that, in combination with proposed revisions to the risk-based capital framework for financial institutions, may lead to the same result.

As explained below and in the accompanying summary chart, the Dodd-Frank Act amended the Truth in Lending Act by imposing substantial potential liability on lenders that make mortgage loans other than “qualified mortgage” loans designed to comply with an “ability-to-repay” requirement.  Further, lenders that originate loans for securitization will need to take into account the Dodd-Frank Act’s risk retention requirement and the related exception for “qualified residential mortgageloans, and even lenders that do not originate mortgage loans with the intent of selling them to a securitizer may need take these requirements into account to preserve their ability to later sell the loans in the secondary market.  Lenders that originate or buy loans for their own portfolios will also need to consider new capital requirements that impose higher risk-weights and result in higher capital charges on mortgage loans which do not qualify as “Category 1 mortgage loans” under the proposed Basel III framework.

Chart Comparing Qualified Mortgage, Qualified Residential Mortgage
and Basel III Category I Requirements
  • “Qualified Mortgage” Standard:  The requirement that a borrower demonstrate ability to repay a mortgage loan is a centerpiece of the mortgage reforms in the Dodd-Frank Act.  Specifically, Title XIV of the Dodd-Frank Act precludes a creditor from making a mortgage loan unless the borrower has ability to repay the loan, but it also provides special protection from liability if the mortgage loan is a “qualified mortgage” loan that does not contain certain risky terms and features and meets certain underwriting requirements and points and fees limitations.  A creditor that violates the ability-to-repay requirement may be subject to substantial liability, including the sum of all finance charges and fees paid by the consumer, actual damages, statutory damages in an individual or class action, and court costs and attorneys’ fees.  In addition, a consumer may assert a violation of the ability-to-repay requirement as a defense to foreclosure by recoupment or set off.  The proposed rule released by the Federal Reserve Board before the transfer of its rulemaking authority under the Truth in Lending Act to the Bureau of Consumer Financial Protection (the “CFPB”) provides a safe harbor or presumption of compliance with the ability to pay requirement to creditors that originate loans falling within the narrow definition of “qualified mortgage.” The CFPB has indicated it may finalize the ability-to-repay rule in January 2013.
  • “Qualified Residential Mortgage” Standard:  Following the recent financial crisis, there were widely held concerns that inappropriate underwriting practices and misaligned incentives between lenders and securitizers, on the one hand, and investors on the other hand, contributed to the collapse of the securitization market and the broader financial crisis.  The Dodd-Frank Act attempts to address these concerns by requiring securitizers to retain at least 5% of the credit risk of assets sold or transferred to third parties through a securitization.  A securitizer may be able to satisfy this obligation by allocating a portion of its risk retention requirement to an originator in certain circumstances, which may result in secondary market purchasers imposing risk retention requirements on banks and other lenders that originate loans for secondary market sale.  Securitizations comprised solely of mortgages loans that meet a “qualified residential mortgage” loan standard to be defined by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Secretary of Housing and Urban Development and the Federal Housing Finance Agency are not subject to this retention requirement.  The Dodd-Frank Act provides relatively little guidance on the requirements for a qualified residential mortgage loan beyond reciting certain underwriting and product features that may result in lower default risk and that the agencies are required to consider and requiring that the definition of qualified residential mortgage loan be no broader than the definition of “qualified mortgage” loan.  The agencies have released a proposal that defines a “qualified residential mortgage” loan more narrowly than the currently-proposed definition of a “qualified mortgage” loan.  These agencies are expected to finalize the qualified residential mortgage loan definition early next year.
  • Basel III Risk-Based Capital Framework:  The federal banking agencies have proposed revised risk-based capital rules that would implement the Basel III framework, including by raising capital requirements related to mortgage loans.  In general, these rules would assign higher risk weights to residential mortgage loans with higher loan-to-value ratios calculated in the manner required by the rule.  Further, the rules divide mortgage loans into two categories: “Category 1” mortgage loans that comply with certain prudential requirements that would qualify for lower risk-weights; and “Category 2” mortgage loans that do not meet these requirements and that would be subject to higher capital requirements than Category 1 mortgage loans.  In addition to requiring higher capital levels for certain mortgage loans, the proposed rules would treat early default clauses and premium refund clauses as credit-enhancing representation and warranties, which means that any loan sold with such representations or warranties would be subject to a 100% credit conversion factor for the life of such representation or warranty.  In response to significant comments from industry, members of Congress and state regulators, the federal banking agencies have extended the expected time line for finalizing revisions to the risk-based capital rules.  Consequently, a revised or final version of the new risk-based capital rules is not expected until well into 2013.
  • The chart accompanying this summary sets forth the key requirements of the “qualified mortgage” loan safe harbor, the “qualified residential mortgage” loan exception from the risk retention requirement, and the requirements for a “Category 1” mortgage loan that would qualify for a lower risk weight than other types of mortgage loans.  The chart denotes in bold text which proposed rule establishes the most restrictive requirement.

Individually, each of the requirements described on the chart has the potential to tighten credit markets by imposing higher underwriting standards on particular types of lenders and limiting the types of mortgage credit these lenders may offer.  Combined, by covering a variety of lenders in various circumstances as well as secondary market purchasers, the effect of these rules is likely to be even more dramatic and may operate to effectively constrain mortgage credit in the United States to all but the most “plain vanilla” of mortgage products that satisfy the requirements of all three rules.