Bankers’ View: Thoughts on Qualified Mortgages and Basel III

12-30-13-Emily.pngThe Consumer Financial Protection Bureau’s ability-to-repay rules go into effect on January 10, 2014, and many community bank heads believe that the qualified mortgages (QM) required by the law will have a negative impact on their bank’s business strategy.

Mark Field, president of Liberty, Illinois-based Farmers Bank of Liberty, with $85 million in assets, thinks the new rule could prompt consumer lawsuits against community banks, targeting those that offer non-qualified mortgages.

“The CFPB tells us, ‘Oh, it’s OK, go ahead and make a loan even if it’s not QM’,” Field says, but “what a bank would be doing in that case is painting a big target on its bank.”

Bank Director polled 24 chief executive officers of community banks by phone in December 2013, asking for their insight on the regulatory issues facing their banks in 2014. When asked about the impact of QM on their institutions, half of those polled feel the impact will be negative, forcing changes to the bank’s mortgage business strategy. Twenty-nine percent expect to see little impact on the way they do business. Community bankers were also asked about how they plan to prepare for the Basel III standards in 2014.

When asked for his opinion on QM, Field believes the rules are too restrictive, and will result in harm to the very consumers the new rule aims to protect, like those in his rural community. “My main office is in a town of 600 people. We try to help people, and there are times when it makes perfectly good sense to help someone with a home loan based on things you know,” he says. “They’re removing the bank’s ability to use the borrower’s character [and] the personal knowledge that the loan officer has of the situation or the borrower.”

“The net effect will be that they will hurt more consumers than they will help by implementing these rules,” says Field. “Most community banks were not the cause of the mortgage meltdown.”

The home loans offered at Farmers Bank of Liberty are typically balloon mortgages with three-year terms, which stay in the bank’s portfolio. The bank’s mortgages are funded by certificates of deposit, which, due to consumer preference in the continued low interest rate environment, typically mature within 12 months. The CFPB will temporarily allow balloon mortgages for banks with less than $2 billion in assets that do fewer than 500 first lien mortgages per year, but the agency requires a term of at least five years for a balloon mortgage to be a qualified mortgage. Field says that places the bank at odds with regulators like the Federal Deposit Insurance Corp. that have renewed concerns about interest rate risk.

“The CFPB is forcing us to do one thing, and the FDIC and the Fed and the OCC [Office of the Comptroller of Currency] are beating banks down [in] the other direction. So I don’t know what the net effect will be, [whether] banks will have to scale back on their portfolio loans in order to monitor their interest rate risk,” Field says.

A survey by the Independent Community Bankers of America (ICBA) conducted in February of 2013 found that 73 percent of community banks offer balloon mortgages. Most community banks offer balloon mortgages that don’t have the onerous terms that got balloon mortgages such as bad rap before the financial crisis. Community bankers typically refinance the loans without fees at the end of the three- or five-year terms.

In the meantime, will the new international standards for bank and thrift capital, Basel III, be a hardship for community institutions, who have to get ready next year? Almost all banks and thrifts except those with more than $250 billion in assets were given until January 1, 2015, to comply with the capital standards, and all community bank CEOs polled by Bank Director in December say they’re ready. However, feeling ready and being ready may be two different things. Field feels that his bank is prepared for Basel III, though he remains uncertain about the capital conservation buffer of 2.5 percent, which the standards require on top of the 8 percent minimum total capital requirement. The buffer will be phased in beginning in 2016. According to the FDIC, banks not meeting the buffer could be penalized and certain payments, like dividends, could be restricted.

Regal Financial Bank, a $102-million asset institution based in Seattle, Washington, is ready for Basel III, says Randy James, the bank’s chairman and CEO, but he thinks many community banks may be caught unprepared. “If they’re not preparing for it, I think they’ll be caught short. It’s very difficult for a community bank to change its [capital] ratios quickly,” he says. “If they’re close, if they think they’re scratching by the guidelines, then I think they need to be better prepared.”

Regulatory Punch List of Top Priorities for Bank Directors

8-26-13-Wolters.pngIn today’s banking world, exams are tougher, the supervisory focus is on fairness to consumers, data is heavily scrutinized and consequences for failing to mitigate risks are more severe than ever. It is incumbent upon bank directors to stay in front of high risk areas and make sure their institutions can survive and thrive in this challenging environment. I put together my punch list of some of the top challenges I see facing the industry to provide guidance on where you will want to focus.

Get Serious about Complaint Management
The Consumer Financial Protection Bureau (CFPB) continues to amass an unprecedented public database of complaints against specific financial institutions. The CFPB’s complaint system is informing many of their decisions about whom to examine and how to regulate. In the face of this, banks should strive to improve their own internal complaint systems. You don’t want those complaints going to the bureau. You want them coming to the bank so you can solve them.

Be Extra Vigilant When Choosing and Managing Vendors
Regulators are looking more closely at the way banks choose and manage their vendors and are holding banks responsible for the faults of their vendors. In fact, recent enforcement actions from the CFPB resulted in a combined $101.5 million in fines plus $435 million in restitution for the financial firms based on flaws in the way the banks monitored their vendors. Additionally, the CFPB issued a bulletin in April 2012, with the message that banks are responsible for any faults of the vendors they work with.

Don’t Let the Ease of Social Media Make Things Difficult
In the social channel, which demands quick responses, an outsider may see what he perceives to be a run-of-the-mill consumer complaint and hastily respond in a way that causes more trouble. Be sure to monitor social media activity continually in real time.

Don’t Wait for Clarity from Regulators—Monitor, Test and Correct Fair Lending Issues Now
The recent OCC order that hit a bank for discriminating against white males may have taken some bankers off guard, and moved several to demand more clarity from regulators. But in this enforcement heavy environment, the best option is for banks to heavily monitor, test and correct, when necessary, all of their credit products now.

Solidify a Regulatory Reform Process
In our Regulatory & Risk Management Indicator survey in June, we asked bankers which regulatory concerns keep them up at night, and 46 percent said regulatory reform—referring to new rules stemming from the Dodd-Frank Act and the CFPB. Make sure your bank can address three primary questions relating to compliance programs:

  1. What are the laws and regulations you are subject to across all the jurisdictions in which you operate?
  2. Are you confident you are complying with all of these laws and regulations?
  3. Can you prove it to third parties (e.g., board members, investors, regulators and other stakeholders)?

Leverage Technology to Adjust to Onslaught of New Rules
Once upon a time, when a bank had an enforcement action of a significant deficiency, the first thing senior management used to say was: Where is our chief compliance officer? How did this happen? Now the question is going to be: Where is our chief technology officer? Why didn’t technology come up with the means to implement these changes in a more effective, efficient and compliant way? If technology and compliance aren’t talking to each other, they need to get together.

When it Comes to Auto Lending, Be in the Driver’s Seat
The CFPB is cracking down on interest rate markups that automobile dealers add to the cost of car loans. If they’re done in a discriminatory manner, then the bank is responsible. The CFPB recently released a bulletin that said lenders must enhance their oversight of auto dealers with which they do business after a recent investigation revealed disparities in interest rates charged to minority borrowers versus non-minorities. The bigger-picture problem for banks is that the regulatory scrutiny requires them to monitor the loans being made by all of the auto dealers they work with. That’s sometimes more than 1,000 dealers. The CFPB is hoping that lenders will voluntarily place compensation restrictions on dealers.

Watch out for UDAAP
The Dodd-Frank Act adds an “A” (which stands for abusive) to UDAP—turning the Federal Trade Commission’s provisions into “unfair, deceptive or abusive acts or practices.” A lot of it depends on the consumer’s ability to understand what is being presented to them. The gap between what is presented to customers and how they perceive what they get as well as its value is where the danger appears to lie. From the moment that a deposit or mortgage product or service is developed and the process begins, compliance folks have to have a seat at the table. I recommend that banks perform some testing to be sure the information being conveyed is perceived by the consumer the way it was meant to be. If there is a complaint, and that complaint goes to the bureau, the lender is going to have to be prepared to defend his ability to provide a product that was not unfair, that was not deceptive and certainly was not abusive.

Gear up for New Mortgage Rules
Several new mortgage rules are on their way from the CFPB. Among the new rules is the QM, or qualified mortgage (ability-to-pay) rule, a provision related to high-cost mortgages, a rule impacting loan officer compensation, new servicing standards, an escrow rule about impounding accounts and tax insurance, an appraisal disclosure rule and another appraisal guideline related to high-cost mortgage. Even now that the QM rule is final and going into effect in January, the industry still has to focus on the qualified residential mortgage (risk-retention rule) and its impact on mortgage lending and the secondary market. For much of the industry, setting up systems to comply with QM is a big concern. Also, we still must find out how all these different rules conflict with each other. It will certainly be a challenge.

How Will the CFPB’s New Mortgage Rules Impact the Market?

Starting in January of 2014, the mortgage market could be in for some major changes. In an effort to protect consumers, the Consumer Financial Protection Bureau has issued final rules for a qualified mortgage (QM), providing safe harbor for lenders who issue such mortgages. Mortgages that don’t qualify could expose lenders to lawsuits from borrowers. We asked a panel of attorneys to address the following question.

 “How will the Consumer Financial Protection Bureau’s new final rule on qualified mortgages – including the requirement that lenders ensure that borrowers have the ability to repay their loans – impact the mortgage market? ”

Podvin_John.pngThe reality of this rule will likely be that if a borrower does not fit within the box of a qualified mortgage, then the cost of credit will be much higher, if that person can find a lender who will lend the money. The QM rule is just one of several rules that need to be digested and integrated (some of them have not been finalized yet) in order to understand the full impact on the mortgage market. Once all these rules are finalized, institutions will need to look at the costs versus the benefits of offering mortgages and servicing mortgages in the new environment and make informed business decisions concerning whether and to what extent they should continue making residential mortgage loans in a profitable manner.

 John Podvin, Haynes and Boone, LLP

Veta_Jean.pngNonaka_Michael.jpgWhile mortgage lenders may not be thrilled with every provision in the CFPB’s new rule on qualified mortgages, most would agree that the rule provides much-needed certainty in an area that has been subject to debate and criticism. The rule’s safe harbor for qualified mortgages and the ability-to-pay standards give lenders a clear sense of what is required. This, in turn, hopefully will lead to increased mortgage lending. At the same time, the perceived heightened risk for non-qualified mortgages may make the secondary market even more skittish about these loans, thus driving more lenders to focus primarily, if not exclusively, on qualified mortgages.

— Jean Veta and Michael Nonanka, Covington & Burling, LLP

Lenet_Sara.pngDouglas-McClintock.jpgAlthough there are many valid reasons for the CFPB to provide incentives to lenders to make less risky loans and ensure a borrower’s ability to repay, the new rules might well disproportionately affect low-income and middle-income borrowers, which could lead to separate issues, such as fair lending and Community Reinvestment Act issues. Lenders will need to find the right balance in order to comply with the CFPB’s new rules and protect themselves from potential liabilities and penalties for noncompliance by making qualified mortgages, while still addressing the needs of their communities. Although the impact of the new rules on the mortgage market is not yet known, it should be noted that the mortgage market has already changed significantly since the subprime mortgage crisis, with increased regulation and lending standards, so the effect of these new rules is likely not to be as drastic as it would have been before the crisis, although it will certainly affect the mortgage market in a variety of ways.

— Sara Lenet and Doug McClintock, Alston & Bird

Marlatt_Jerry.pngThere can be little doubt that the Dodd-Frank Wall Act, particularly Title XIV?on mortgage reform and anti-predatory lending, was designed to reduce the availability of mortgage credit. One of the themes of Dodd-Frank is that undisciplined underwriting standards in the sub-prime mortgage market created or contributed to a bubble in housing prices by making excessive mortgage credit available. It is not a surprise then that the Consumer Financial Protection Bureau’s new rule on qualified mortgages will rein in mortgage credit in the private sector. The bureau itself has expressed the concern that its rule “could curtail access to responsible credit for consumers.”

In a very complex rule, the bureau tries to draw a line between responsible and irresponsible credit. The result leaves private sector creditors with significant compliance challenges and litigation risk. In recognition of the possibility that the rule will overly restrict mortgage credit, the bureau has built in a transition period in the hope that it will “help insure [sic] that sustainable credit will return in all parts of the market over time.” What seems clear is that there will be a sustained period of significantly reduced mortgage credit.

— Jerry Marlatt, Morrison & Foerster LLP

Lamson_Don.pngThe market is resilient and will respond to the new requirements, but there is a danger that the requirements concerning repayment ability will by their nature constrict access to credit for those who may need it the most.

— Don Lamson, Shearman & Sterling LLP

It is possible that when the rule becomes effective in January 2014, lenders may be reluctant to make loans that do not qualify for the Qualified Mortgage (QM) safe harbor. Non-QM loans will carry significantly higher litigation risks and may be more difficult to securitize. According to the bureau, as of 2011, non-QM loans would have amounted to about 22 percent of the market. In order to ease the transition to the new rule, the bureau is permitting lenders to obtain QM treatment for loans that would be eligible for purchase by Fannie Mae or Freddie Mac while they remain in conservatorship. Over time it is possible that the rule will result in a substantial reduction in the availability of mortgage credit.

— Robert Ledig, Dechert LLP