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Thursday, April 6, 2017

Ability to Repay on Interest-Only Loans

What steps are necessary to minimize the risk of "rebuttable presumption" of Ability to Repay (ATR) on Interest-Only (I-O) loans?

Let's put on our risk management hats. 10 questions to ask yourself!
  1. Product Parameters? Fixed rate and/or standard hybrid arms (5/1, 7/1, & 10/1). Amortizing ARMs increases risk of foreclosure by 150-200%. Benchmark the GSE Hybrid ARMs. Managing layering of risk (Q's 2-10) will address the "ARM" risk. [Moody’s Analytics, March 11, 2011]
  2. Index, Margin, & Caps? 1 year CMT (Treasury) index (1.03% as of 3/4/17), 275 BPS margin, 2% periodic cap & 6% life cap. Prime index (4% today) adjusted monthly/quarterly does not work. Again, mimic the GSE Hybrid ARM parameters. Exceeding the GSE parameters will increase your ATR risk substantially.
  3. Loan purpose? Purchase & No Cash Out refinance only. Cash-out refinances increase risk of foreclosure by 150%.
  4. Occupancy? Owner Occupied only. Non-owner Occupancy increases foreclosure risk by 200-300%.
  5. Loan Term? Maximum 30 years. 40, 45, & 50 year terms increase interest costs and risks of mortgage debt in retirement. This will increase the future rebuttable position at a yet to be quantified cost into the future. Probably a minimum cost of $200,000-$300,000.
  6. FICO/LTV/CLTV? 700+ FICO, 90% LTV/CLTV, with MI; 680-699 FICO, 80% LTV/CLTV. Subprime increases default risk by 200-300%. 90% LTV has a foreclosure rate 150% higher than at 80% LTV. Historically, the LTV breakeven at foreclosure is 65% LTV. 20% MI only covers you down to 72% LTV.
  7. Max DTI? 38%. I-O's are not a first-time homebuyer product. 38% supports ATR. DTI > 45% increases foreclosure risk by 150%.
  8. Document Level? Full Doc and 1040/4506T for all self-employed. Reduced Doc increases risk of foreclosure by 300%.
  9. U/W Methodology? U/W @ maximum interest rate over the life of the loan (i.e., initial rate = 3.75, index + margin rounded to the nearest 1/8th). Max rate = 9.75%. Run the loan thru DU, LP AUS, or use Residual U/W Analysis to further support your ATR position.
  10. How do you define your I-O market niche? Your market niche is the "well qualified" borrower who has a good (steady) base income, good credit and wants to pre-pay the loan over 10-15 years with periodic income from commissions or bonuses.

If you sell the I-O loan instead of holding it in portfolio, make sure you are not making Representations and Warrants to the investor for the for ATR for life of loan: 3-4 years is reasonable. If you do Representations and Warrants ATR fully, set up a loan loss reserve (minimum 10 BPS) to cover this repurchase and make whole the risk.

Congratulations, you have managed layering of risk and minimized the risk of rebuttable presumption from the borrower, investor (if sold), regulators, and the plaintiff bar!

Ben Niles
Director/Compliance Training 
Lenders Compliance Group