QUESTION
How do I offer Non-QM mortgages to Self-Employed Borrowers in my local
market and still manage the risks?
ANSWER
There are two main risks to address. First is the legal/regulatory
risk. I am forced to defer into the future the discussion of how to manage this
risk. There are no clear answers due to the lack of any state and federal
regulatory enforcement actions or case law and judicial precedents with Non-QM
loan products designed for the Self-Employed. The issue arises from the subset
of Self-Employed Borrowers who are unable or unwilling to submit 2 years of
1040s and sign a 4506T for lenders to verify their income using the traditional
methods as outlined in QM Ability to Repay (ATR) regulations.
So that leaves us with the second risk, the one risk we can manage
today: the credit risk. Let's begin by defining in our credit policies the
benchmark mortgage risk, using the average rate of foreclosure to compare and
adjust the risk of foreclosure to keep this product within acceptable risk
levels. Your benchmark product is a 30-year fixed rate loan to finance the
purchase or rate & term refinance of a single family, detached property
with a max 80% LTV/CLTV, a FICO Floor of 700, a max DTI of 43% (or less), full
documentation as defined by Ability to Repay (ATR) regulations, and 3 months of
cash reserves. This loan will have an average foreclosure rate of 1.3%. [Moody's Analytics, March 11, 2011]
And,
speaking of "pricing," use your Fannie/Freddie 30-year fixed rate
pricing.
The challenge is how do you manage the risk of loss in foreclosure when
you waive the requirement for 2 years 1040s and a signed 4506T? The answer is
you manage it by managing the layering of risk for this loan product. This is
done by adjusting your credit policy for this product to arrive at an expected
foreclosure rate at or below your benchmark loan policy. This Alt Doc product
could be called a "24-month Bank Statement Loan" or a "Collateral
Loan". When you move to Alt Docs, the incremental foreclosure risk
increases 3 times or 300% to 3.9%; a level that is unacceptable. You want to
lower this risk to below 1.3%, your benchmark average foreclosure rate.
At 70% LTV/CLTV, the average foreclosure rate is 0.2%. [Moody's Analytics, March 11, 2011] With Alt Docs,
the average foreclosure rate increases 3 times that average, to 0.6%, well
below the benchmark product risk profile defined in your credit policy above.
An average foreclosure rate of 0.6% vs 1.3% for the benchmark leaves you a good
margin for error.
Three additions to this Alt Doc credit policy are: 1) a max 36% DTI, to
allow for greater borrower discretionary income to support a higher standard of
living, as many of these loans will be Jumbo's, 2) a 6 months cash reserves,
and 3) a max 65% LTV/CLTV (viz., I have heard this number cited many times over
in my mortgage banking career as "the LTV breakeven at foreclosure").
So, let's recap this new credit policy for your "self-employed alt
doc loans": owner-occupied, single family, purchase or rate & term
refinance, max 65% LTV/CLTV, 700 FICO Floor, max 36% DTI, and 6 months
reserves. You may also want to ask the borrower to sign a well worded "Affidavit
of Borrower's Ability to Repay" as part of a future legal defense, if
needed.
Market this product to your self-employed customers and in your local
lending market(s). It is best to price this product to your benchmark full doc
product above. Why? We have managed the risk with credit policy, not pricing.
And, hold these loans in your portfolio. Or, as I like to say, "eat your
own cooking".
If you do not have a loan portfolio (mortgage banker or broker), you
will need to price this loan at 100-200 BP higher interest rate, based on your
investor's pricing, and follow that investor's product guidelines (max LTV of
50-60%?). You will need balance sheet $$$ Capital for your 5% "risk
retention," as these loans will sooner or later be sold into the Wall
Street capital markets in a Private MBS.
Make sure your warehouse bank is on board, unless the loan is approved,
closed, and funded by the investor (including the LE & CD). Set up a loan
loss reserve (min. 20 BP of the UPB?). Lastly, negotiate the R&W in the
Purchase and Sale Agreement limiting your fraud/misrepresentation liability to
only the documents you verify. Otherwise you are making a 30-year R&W and will
be liable for legal costs and any foreclosure losses (as we have seen, property
values can rise and fall over time, changing your risk profile). This product
will be a huge challenge for non-depositories.
Remember, you still have a yet-to-be-quantified regulatory and legal
risk. Happy lending!
Ben Niles
Director/Client Relations
Lenders Compliance Group
