Part V. Where Does Non-Agency Mortgage Lending Go From Here? AKA Goodbye "NonQM"?

Its been several months since we discussed Part III of this series. The reason for the delay was that we had to do a deep dive on compliance rules in order to set the stage for where Mortgage Lending may go in the future. Since the laws dictate what's possible, its important to understand both what they were and, since there was a major change to QM rules on 10/1/2022, what they are now. Under QM 1.0 rules there was a clear(er) line between what was QM vs what was NonQM. Add in the wrinkle that under the "QM Patch", any GSE loan was QM even if it didn't follow the rules and you'll understand why many people believed QM meant agency and, therefore, non-agency meant NonQM.

We've spent the last several months debunking the QM = Agency theory and walked through the new QM 2.0 rules to show both why non-agency loans can be QM and, why calling non-agency products "NonQM" has been devastating to private lenders. If you fail to comprehend that QM 2.0 rules make any loan possible for QM, you'll fail to innovate and adapt.

The main rule we've been discussing is Dodd-Frank. Under Dodd-Frank there are two major pieces that almost work hand-in-glove: Regulation Z (QM rules) and Credit Risk Retention (QRM rules). Below is visual aide to assist in comprehension:

Hopefully that flow chart is easy to follow but I want to draw your attention specifically to the QM 1.0 vs 2.0 rules:

Under the QM 1.0 rules (officially ended 10/1/2022), loan programs had to follow specific underwriting criteria benchmarked to FHA underwriting standards (Appendix Q). Since GSE loans would NOT be QM under 1.0, they were exempted by the rules via the "QM Patch". This is why Government and GSE loans came to dominate 80-90% of all residential loans. To put this in perspective, during 2020, one single top 10 non-bank lender originated more loans in a quarter (some in only a month) than the entire Non-Agency ("NonQM") market originated in its best year.

After the mandatory compliance date for QM 2.0 (10/1/2022), three major things happened. First, Appendix Q was removed from the QM test. This means any set of guidelines can be QM. To avoid confusion, several sets of guidelines were included in the QM test that are "safe harbor" guides. The punchline to the first change is that all prior "NonQM" guidelines under 1.0 can technically be QM guidelines under 2.0. So if you have a covered loan (not exempt/business purpose), bank statement income, asset qualification, full doc + asset depletion, 1099, etc. ALL can technically be QM. Do you see why this is so hard to understand if everyone calls their products "NonQM"?

The second major change is the 43% DTI cap was removed and replaced by a Price Based Threshold (APOR test). This is designed to focus more on the interest rate than the percentage of income being used to qualify a borrower. While this is a much better approach, in my opinion, it means that if your rates are too "high" your loan will be NonQM.

The third change, which the GSEs adopted over a year ago, was that the QM Patch was retired and instead the GSE guidelines were added to the QM Safe Harbor set (once again making them all QM, unless exempt).

The key summary here is that product features and/or interest rates will be the main factor in why/if a loan is NonQM. So if you add interest only, go over a 30 year term, charge too many points or offer too "high" of an interest rate your loan is NonQM; your loan is not NonQM simply because it didn't use FHA guidelines anymore.

Now moving onto the right side of the flowchart, you'll see that nothing technically changed on the Credit Risk Retention Rule BUT since the QRM rule is linked to the QM rule, something material DID change. Under QM 1.0 rules, the GSE eligible loans were NonQM or exempt, however if the GSEs securitized the loan it was automatically QRM & QM (due to the QM Patch) yet if a private issuer securitized an exempt loan it was not QRM (even if it was agency eligible). Non QRM loans require 5% risk retention, GSE securitizations require 0%. Going forward, prior "Non QRM" loans like bank statements can be QRM under 2.0 rules and both products (agency eligible QM and agency ineligible QRM) can be securitized in the private markets with 0% risk retention. This allows originators to securitize their production with significantly less capital required (in theory).

If any of the above is still confusing, I would highly recommend you look through the last several months of articles and posts on my LinkedIn homepage. I have dedicated many pieces to these topics and have gone into great detail to help you understand where we are and how we got here. Assuming you are tracking, we will now go into "What next?".

What Next?

If my crystal ball is working, here's what I expect to happen.

Someone is going to start doing bank statement loans and full doc non-agency loans as QM. This is either going to be the GSEs or the private sector. The private sector is generally not incentivized to do things that lower interest rates or improve liquidity (as it hurts returns), but it may pull in new investors and capital that is more comfortable with QM loans and wants to arbitrage between agency rates and non-agency. If I had to bet, I would say the GSEs win this one. Why?

In Parts I-IV of this series we discussed the major "problems" with Non-agency: Hedging, a lack of underwriting standards, cost to produce, all the diligence needed, etc. The fastest way to solve all those is simply have the GSEs update their guidelines to include these types of qualification and voila! Safe Harbor QM. If this happens, small NonQM lenders will be left fighting over a very small population of loans (only the ones that fail the 3% points and fees test, can't qualify to the agency alt guides, have loan terms over 30 years, interest only, etc.). The problem here is that the most likely outcome, if GSEs get involved, is that the rates GSE will provide will be so much better than the NonQM rates that taking a 40 year term or an interest only (or both) likely won't reduce the payment vs the GSE option, so what's the point?

The CFPB is talking about how to apply more technology to lending (read the commentary on QM 2.0 changes on the CFPB website) and the FHFA is worried about access to credit and improving technology.

Since both of those topics are getting a lot of attention, its easy to see how a case could be made either via "affordable" initiatives or simply adapting to the new workforce (self-employed, gig workers, etc.) could allow the GSEs to expand their guides to incorporate those types of borrowers. Additionally, since the "nonqm" lenders have simply refused to harness technology in any meaningful way (see sections II and III of "How to Fix Non-Agency Lending"), the ability for a lender to use the AUS, automated conditioning, and loan delivery functions would be an easy sell on the Tech + Access to Credit front. On top of this, Freddie recently announced how their AIM system will read digital asset statements (bank statements) to look at cash-flow and make better/more informed AUS decisions. They are using Plaid, Finicity, etc. to do this work so its easy to see how they are not far from simply doing bank statement income using this tech (all this has been available for the private lenders/issuers to take advantage of for many years yet most still have a "bank statement" desk staffed with humans to do income calculations).

The alternative would be for the Non-Agency universe to get together and follow some of the guidance I put out surrounding the Non-Agency Alliance concept. A self-policing/oversight board, outside of the MBA, which works to get a safe harbor non-agency guideline set incorporated into QM 2.0 and then utilize the AUS/ULDD concepts under a proprietary AUS (I've built one in the past or get one of the GSEs to do it for them, like they do for Ginnie loans). Once these pieces are in place, we simply have to realize that the GSEs are insurance companies. So an insurance company would provide a "wrap", re-insurance would step into the space as well, and alternative execution options could be developed from there. The added benefit here is that the ALM profile of this product fits with insurance money. For more details or ideas check out the ACIS side of the CRT playbook. For those of you selling whole loans to insurance companies, you'll want to root for this as well. If secondary mark-to-market pricing goes up (or rates go down), you'll be able to use this to negotiate better whole loan pricing.

In either case, the other piece of the QM test that needs to be addressed is the "Points & Fees" (P&F) test. I've written an entire article on why we are seeing this test keep borrowers from getting loans. The summary is that the P&F test was essentially built for a "high premium" environment. Since we've never had a mortgage market with large G-Fees, substantial LLPAs and little/no premium, something is going to have to change. Either the LLPAs will have to be reduced, the G-fees cut, or the Fed/GSEs/Some other quasi Government sponsor is going to have to be allowed to buy agency RMBS. We simply can't expect things to "go back to how they used to be pre-2008" when pre-2008 there were very few LLPAs, much lower G-fees, the GSEs bought MBS AND there was no P&F test (no QM test). If we expect to be able to harness the guideline side of QM (removing Appendix Q), the P&F will need to be addressed to keep loans from being NonQM simply because borrowers had to pay points up front, instead of financed for 30 years.

The last piece I'll get into is where the other asterisk is on my flow chart. The 5% risk retention. Note that while the QM side of GSE vs Private is now "aligned" with 0% risk retention, the exempt side is not. The GSEs can still securitize exempt loans with 0% while the private sector has to retain 5%. I dedicated an entire article on this subject earlier this month, so please take a look at how I used the regulation itself to make the case for changing this. The punchline is that the exempt underwriting quality would go up if the rule was changed and this is one of the carve-outs the rule provides for making such an exception.

If the exempt side changes to allow certain subsets of exempt loans to have 0% risk retention, many potential DSCR loans will go the 0% route (likely under more full doc style) and thus fewer DSCR loans will be left for the rest of the universe.

In summary, my hope is not that the GSEs swallow up more of the lending market. In fact for the last several years I have been pushing all of these changes in the non-agency market so that they would be ahead of the curve. If I am right, its highly possible the small, dedicated NonQM lenders won't make it. There simply won't be enough true "nonqm" production to survive and the loans that get done under QM 2.0 (bank statements, etc.) will simply come down to who has the most efficient and lowest cost to produce. This would be a small windfall for the big agency lenders (if the GSEs get involved) but would put tremendous stress on smaller non-agency shops left to fight over fewer and fewer loans. It is my hope that the industry comes together to collaborate on guides, tools, compliance rules and oversight to use technology to beat the Government at its own game and put some healthy competition in the market. Additionally, it would be great to get some insurance/reinsurance competition against the rating agency PLS models as well. There are alot of arbitrage opportunities between g-fees, LLPAs, and rating agency draconian credit enhancement/model assumptions.