QRM: Proposed Definition of Qualified Residential Mortgage Rule

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On August 28, 2013, six federal agencies including the FDIC and SEC (“agencies”) released a proposed definition of the qualified residential mortgage, or QRM. According to the agencies, the QRM definition will be closely aligned with another mortgage rule announced earlier this year.

In January 2013, the Consumer Financial Protection Bureau (CFPB) finalized the similarly named qualified mortgage (QM) rule.

QM is intended to reduce the number of mortgage defaults in the U.S. by requiring full documentation and income verification, and also by preventing certain high-risk mortgage features.

The agencies now plan to align the QRM definition with the previously published QM definition. This means the qualified residential mortgage would have the same features as the qualified mortgage. Those features are outlined below.

Overview & Highlights

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) required the creation of a risk-retention rule for the mortgage industry. This rule requires lenders to retain at least 5% of the loans they sell into the secondary market where bundled and securitized mortgages are bought and sold.

But there’s an exception to this rule. Loans that meet the definition of a qualified residential mortgage (QRM) can be sold off without restriction.

QRM loans must meet certain criteria. These criteria are designed to create “safer” mortgages with a lower risk of default. They include a maximum loan term of 30 years, total points and fees no greater than 3% of the loan amount, and the prohibition of high-risk features such as negative amortization and interest-only payments.

QRM: An Exception to Risk-Retention Rules

In the wake of the housing crisis of 2008, when the nation was reeling from the effects of reckless mortgage lending, Congress passed the Dodd-Frank Act.

Among other things, this act required banks and mortgage lenders to retain 5% of the mortgage loans they bundle and sell into the secondary mortgage market. This is referred to as “risk retention,” since they are retaining some of the risk associated with long-term mortgages. Most banks prefer to sell the majority of their loans, as it absolves them of the long-term risk associated with those loans.

In response to concerns and complaints about the new risk-retention requirements, Congress created an exception to the rule. The qualified residential mortgage (QRM) is the exception. If a mortgage loan meets certain criteria, it is exempt from risk retention. This gives lenders a powerful incentive for making loans that meet QRM guidelines. It gives them a way to sidestep the 5% risk-retention rule.

Bottom line: The QRM rule creates an exception to the risk-retention requirement created by the Dodd-Frank Act, by “taking into consideration underwriting and product features that historical loan performance data indicate result in a lower expected risk of default.”

QRM Definition Being ‘Cross-Referenced’ With QM

To avoid confusion, let us recap the two mortgage rules and definitions in use here:

  • Qualified mortgage (QM) is a set of loan standards designed to reduce the risk of default. This rule was finalized by the Consumer Financial Protection Bureau (CFPB) in January 2013, but doesn’t take effect until January 2014. Lenders who make “QM-compliant” loans will be rewarded with some degree of legal protection from consumer lawsuits.
  • Qualified residential mortgage (QRM) is another set of standards giving lenders a way to circumvent the risk-retention rules mandated by Dodd-Frank. It’s an exception to a rule.

The six federal agencies who are finalizing the definition of QRM have decided to align it with the QM definition. As stated in their proposal:

“The agencies are proposing to broaden and simplify the scope of the QRM exemption from the original proposal and define ‘qualified residential mortgage’ to mean ‘qualified mortgage’ as defined in section 129C of TILA and implementing regulations … The agencies propose to cross-reference the definition of QM, as defined by the CFPB in its regulations, to minimize potential for future conflicts between the QRM standards in the proposed rule and the QM standards adopted under TILA.”

The agencies plan to align the QRM definition with the previously published QM definition. This means the qualified residential mortgage could essentially have the same features as the qualified mortgage, which are outlined below:

Qualified Mortgage Definition, According to CFPB

Since the QRM definition is now being aligned with the previously released QM rule, we must look to the previous rule as a starting point.

QM requirements are designed to “help ensure that borrowers are offered and receive residential mortgage loans on terms that reasonably reflect their financial capacity” to repay the obligation. The QM definition also prohibits loans with risky features, such as interest-only payments and negative amortization. It requires lenders to verify and document the borrower’s ability to repay, based on his/her assets, income and debts.

To meet the definition of a QM: (A) the term must not exceed 30 years; (B) points and fees generally should not exceed 3%; (C) the loan should not have risky features such as negative amortization, interest-only and balloon payments (with exceptions for small portfolio lenders).

Statistical analysis shows that these factors reduce the likelihood of borrower default, or failure to pay. That is the primary objective of the qualified mortgage (QM) rule, as well as the qualified residential mortgage (QRM) definition that is now being aligned with it.

Proposed Definition of Qualified Residential Mortgage (QRM)

Section 15G of the Securities Exchange Act (PDF), entitled “Credit Risk Retention,” requires that the definition of QRM be no broader than the QM definition. According to the multi-agency proposal:

“By proposing to align the QRM definition to the QM definition, the scope of loans eligible to qualify as a QRM would be expanded to include any closed-end loan secured by any dwelling (e.g., home purchase, refinances, home equity lines, and second or vacation homes).”

General Definition of QRM (Based on QM)

The Consumer Financial Protection Bureau (CFPB) has provided several definitions of a QM. The agencies propose that a QRM would be a loan that meets any of those definitions. These include the general QM definition, which requires loans to have the following characteristics:

  1. The loan’s term should not exceed 30 years.
  2. The loan should have regular periodic payments that are substantially equal.
  3. The loan should not have negative-amortization, interest-only, or balloon features.
  4. Total points and fees should not exceed 3% of the total loan amount (or the applicable amounts specified in the Final QM Rule for smaller loans up to $100,000)
  5. The borrower’s total debt-to-income (DTI) ratio should not exceed 43%.
  6. Lenders must verify and consider the borrower’s income and assets; current debt obligations; mortgage-related obligations; employment status, if relied upon for qualification; and alimony and child support, when applicable.
  7. The loan payments must be underwritten using the maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment is due.

Temporary Definition of QRM (Based on QM)

The CFPB has also issued a second temporary* definition of a QM loan. The agencies propose that a QRM would also include any mortgage loans that meet this temporary definition, which includes the seven criteria listed above plus the following:The loan must be eligible for purchase, guarantee or insurance by Freddie Mac or Fannie Mae, the Department of Housing and Urban Development (HUD), the Veterans Administration, the U.S. Department of Agriculture, or the Rural Housing Service.

* The temporary QM definition for loans eligible for purchase or guarantee by an Enterprise expires once the Enterprise exits conservatorship.

Exceptions for Small Creditors

CFPB has also provided additional QM definitions and amendments to facilitate lending by certain small creditors. The agencies propose that a QRM would be a QM that meets any of these special definitions. The final rule gives small creditors more underwriting flexibility when making loans (for instance, there is no debt-to-income threshold).This only applies to “small creditors that meet certain asset and threshold criteria and hold the QM loans in portfolio for at least three years, with certain exceptions (e.g., transfer to another small creditor, supervisory sales, and merger and acquisitions).”

* Loans that meet the “small creditor” QM definition are generally ineligible as QRMs for three years following consummation because they could not be sold during that time.

Not Included in the Rule: Down Payments, LTV Ratios, Credit Scores

In the original proposal, the QRM criteria included a loan-to-value (LTV) ratio of 80% or less for purchase loans. This meant borrowers would have had to make down payments of at least 20%, for the loan to be considered a qualified residential mortgage. The original proposal also required a solid credit history.

These requirements have been removed from the latest proposal.

Research and analysis have shown that credit history and LTV ratios are “significant factors in determining the probability of mortgage default,” the agencies stated. However, such requirements could seriously restrict credit for certain borrowers, which would outweigh the reduction in default risk. In other words, down payment and credit-history requirements would do more harm than good, in the big picture.

The agencies have determined that full documentation and verification of borrower income are sufficient to reduce the risk of default. So the previously proposed requirement of a minimum 20% down payment is no longer necessary.

What It All Means to Home Buyers, Borrowers

Most home buyers have never even heard of a qualified residential mortgage or QRM. But they can still be affected by it.

Lenders generally want to issue loans that meet QRM criteria. It gives them an exception to a rule they find troubling. It allows them to sell a higher percentage of their mortgages into the secondary market, thereby reducing their long-term risks. As a result, the majority of lenders will impose these guidelines upon their customers. These rules will essentially set the bar for mortgage-lending standards in the U.S.

This makes the qualified residential mortgage definition — and the now closely aligned QM definition — relevant to anyone who plans to apply for a home loan. By understanding the criteria and requirements associated with these two rules, we gain a better understanding of what it takes to qualify for a home loan in the current (and future) lending environment.

Borrowers who fail to meet these criteria will have a harder time finding a loan, when compared to borrowers who do meet the criteria. They might end up paying a higher interest rate, as well. Lenders claim that risk retention increases their operating costs. So they will likely charge more for loans that are subject to risk retention.

Financial analysts from J.P. Morgan Securities have estimated that borrowers might pay up to three percentage points more for loans that are subject to risk retention (i.e., loans that don’t meet the definition of a qualified residential mortgage).

This is why consumers need to know about the new rules. The purpose of this website is to increase awareness of the qualified residential mortgage definition and criteria.