Monday, September 9, 2013

Broker v. Lender: Lender's Perspective - Trying to Make Sense of QM Pricing Model

The Qualified Mortgage (QM) points and fees and Higher Priced Mortgage Loan rule (HPML) threshold calculation looks like an MC Escher drawing where you go around an infinite staircase.  While brokers face QM comp issues, lenders have an even more daunting challenge: trying to calculate allowable discount points, LLPAs, MI, and LO Comp, and still keep loans below HPML thresholds.  In anticipation of the January, 2014 QM and Loan Originator Compensation Rule (LO Comp) implementation dates, the industry as a whole struggles to make sense of the regulatory scheme.

Lenders face even greater challenges with the conundrums and complexities of the rule in its implementation. The HPML adds wrinkles to the equation.  Even with a clear understanding, a practical solution to meeting both a borrower's financing needs and maximizing lender compensation may represent two incompatible objectives.

The Objective:  A Qualified Mortgage

Remember, the whole point behind this set of pricing exercises is to limit lender liability.  QM removes the borrower's ability to pursue a claim that the lender did not consider his or her ability to repay under the Qualified Mortgage Ability to Repay Rule (ATR).  As long as the loan meets Appendix Q requirements a court necessarily might dismiss the action. However, with an HPML, the lender loses rebuttal presumption exposing himself to risk if a borrower chooses legal recourse to challenge the mortgage.  Even if all other elements of ATR fall into line, the lender still takes risk when exceeding HPML thresholds because of the borrower's right to challenge.  Of course, the lender can still rebut the borrower's assertion but must prove ATR conclusively. (** See Blog Comment Below - attorneys may find a way around rebuttal presumption.)

When trying to parse out the various permutations of QM and HPML, it helps to look at specific examples. The biggest concern for many is the effect of the Loan Level Price Adjustments (LLPA) on the cost and rate structure. Since LLPAs are secondary market loan sale eligibility fees, and not specifically profit or pricing gain, it seems unfair, to lenders and borrower alike, to have had them included in the calculation of points and fees. One potential solution: "adjust out" the loan level pricing by adding to the coupon rate - effectively buying out the LLPA upfront cost.  While for brokers the regulatory scheme may simply limit fees and create triggers for HPMLs, for lenders the rules create a minefield of quandaries.

Quandary 1:  What is the price?

If you cannot see the embedded spreadsheet above, then click on the link to the right.

To determine whether a loan will trigger HPML and how much discount you can charge to offset LLPAs, you need to work backwards into a price in a calculation similar to borrower pre-qualification.

You may download a copy of this spreadsheet to work on by clicking here.  If you have found another resource, feel free to share it and we will post it on our updates page.

Until you have loan level price adjustments factored in you have no way of knowing the final price of the loan, and no way of knowing whether you can charge an adequate discount to offset the LLPA. Naturally, you can always increase the interest rate, tantamount to buying out the LLPA fees.  But this may be of little comfort if it triggers HPML.

Quandary 2:  Limits to Buy-ups and Prepays?

If the most you can charge, net of compensation, is two discount points (provided you keep your rate within 1% of the Average Prime Offered Rate (APOR)), a higher LTV, lower credit score borrower could potentially price himself out of the lenders rebuttal presumption for QM.  It may not be possible to charge enough fees to cover all of the upfront cost of the LLPAs.  To deal with this the lender may solve this problem by "buying up" the rate to "zero out" or minimize the upfront LLPA.

The problem: The buy-up/buy-down cost formulation has always had an options seller's position built in. From par, buying down the rate with points costs progressively more and buying up the rate yields progressively less.  The more you are out of the money, the less that option is worth (or the more the insurance costs).  You may essentially "run out of rope" as you move up coupon rates to offset the cost.  This is particularly true on ARM loans, which offer a much more restricted rate "buyup".

Buy-Up Rate to Reduce LLPA Fees - it gets expensive and you eventually run out of rope.

Quandary 3:  Bought up the rate, now the loan is HPML

Secondary has always experienced the added prepayment risk from loans priced with high yield spreads. The higher the coupon relative to the market, the higher the prepay rate. Lenders offset this risk by adding prepayment penalties.  However, if the coupon is high enough to make the loan an HPML you may not be able to offset with a prepayment penalty because the Higher Priced Mortgage Loan rule prohibits these features.

This calculation shows how compensation, when combined with LLPAs for even moderately priced loans can create HPML Status.  In addition, high LLPAs can create HPML loans by their very nature.  Will the market accept the risk of not having presumptive rebuttal status?

Quandary 4:  You can't get there from here - APOR's artificiality

The regulatory scheme seems to imagine the mortgage market as some sleepy backwater drifting along oblivious to the machinations of global credit markets.  A loan with steep LLPAs already looks like a candidate for triggering HPML status.  The features of the APOR as an index calculation can make avoiding this impossible.

The APOR index looks at last week's data.  Because of this, depending on when an originator looks to lock a loan, APOR's relation to current market can be as much as two weeks old.  In addition, because this survey represents a range of lender pricing we don't know the extent to which the surveyed rate has been impacted by hedging strategies and pricing concessions.  One only needs to look at the rate surveys posted in local daily newspapers to see how bottom fishing originators may skew this data.

Because we confer QM status at the time of lock-in, the APOR index, with market conditions moving as they have in the past year, could potentially create a pipeline of HPMLs for loans with even moderate LLPAs.

Brokering Doesn't Sound so Bad Now...

Considering this complexity, the broker's limit of 3% compensation seems like an attractive option for avoiding issues in the regulatory scheme instead of the inverse.  Again, we ask the question:  Does mini-correspondent solve the broker's problem, or just add a set of additional problems.  For lenders, who carry the risk of liability, the questions are more dire than compensation.

When we overlay the pricing reality against the regulatory construct of QM, it seems clear that many more loans will achieve HPML status than originally conceived.  Will the market for these transactions shut down and add further inertia to a fledgling economic recovery?  Or will lenders accept the risk of no rebuttal presumption and continue make HPMLs.  During the 80's lenders originated 95% LTV loans using qualifying ratios of 25/33.  Certainly, if there is a place for HPMLs, they will have very restrictive guidelines.  

Thursday, September 5, 2013

Broker v. Lender: The Drive to Mini-Correspondent - Rational Response or Over-Reaction?

The question over Broker Compensation causing loans to be classified as HPML has caused some disruption in the business. It is at the heart of a movement driving current mortgage brokers to adopt the lender business model by becoming "mini-correspondents" to avoid adverse selection. The question posed: Is this a real cause or imagined? If it is real, is it worth the correspondent risk for brokers?

The Issue

On the face of it, the confluence of two rules does appear to create a problem. The first rule - The Truth-in-Lending Higher Priced Mortgage Loan rule (HPML) - requires that loans exceeding a certain interest rate have a number of consumer protections. The interest rate trigger which drives this provision involves calculating the Annual Percentage Rate (APR) which takes into account upfront and monthly lender fees. This calculation is compared to the Average Prime Offered Rate (APOR) which is a WEEKLY index compiled by Freddie Mac in what's known as the Primary Mortgage Market Survey. The rule considers any loan exceeding this calculation by 1.5% a Higher Priced Mortgage Loan requiring extra due diligence and disclosure. To this point all mortgage industry participants must play by the same rules. The conflict occurs when the Truth-in-Lending Originator Compensation Rule is considered.

The second rule creates the problem. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) initiated reforms to the Truth-in-Lending Act, known as the Anti-Steering Rule (LO Comp). This rule constrained loan originator compensation to 3% of the loan amount.
The possibility of triggering Higher Priced Mortgage Loan requirements is exaggerated on mortgage broker originated transactions potentially limiting borrower choice.
In reality, a very small sliver of loans could create a comparative disadvantage. To start with, only those in which the loan starts out as marginally HPML triggered could be an issue. This is the case when you have PMI, MIP or a lot of overlays. In these cases, lenders will run a nearly equal risk of triggering HPML requirements. Once you do have this higher APR present, then you must more carefully measure the transaction. Only then do you have to consider the magnitude of the broker's compensation and its effect on APR - the larger the broker's compensation, the more likely to trigger HPML relative to the same lender's transaction.

Consequences - Limited Choices for Consumers = Higher Costs

For consumers, the compliance risk associated with HPML means fewer lenders willingly offer these loans. Brokers, who can provide alternatives and drive down costs, may be selected out of comparison if the transaction falls into the narrow range of transactions that would be considered HPML if originated by a broker but not by a lender.

In this case you can see how, with a higher APR to start with, the liklihood of triggering HPML requirements is exacerbated by the inclusion of the originator's compensation.  This inclusion exaggerates the APR of the broker originated transaction, which could limit borrower choices in seeking home financing, ultimately costing consumers more.  

But how much of an injury is this?

Take a rational view of the HPML requirements and you realize these already exist in the non-HPML world. Most lenders require escrows, particularly on loans with MIP or PMI, which are the loans most likely to be HPML. We always have to give borrowers copies of appraisals. We already consider ability to repay on all transactions. The limitations on loan types - no prepayment penalties, negative amortization or balloons, are already considered for most of the industry's loans. How is a broker limited if a loan should be categorized as HPML? The truth: the broker doesn't experience a negative impact.

Most of the consequences of tagging a mortgage as HPML have already been incorporated into other requirements - ability to repay, Qualified Mortgage, Appraisal Independence.

The Rush to Correspondent

As a mortgage service provider, there are legitimate reasons to elevate your business to correspondent:

  • An investor offering a specialty product ONLY through correspondent channel 
  • The ability to control generating closing documents locally and improve service delivery 

But when measured against the substantial risks correspondents take, is it really worth it simply to avoid this one small regulatory wrinkle? The NAMB has provided a great TWO PAGE overview of the risks associated with small firms taking on correspondent responsibilities.

  • Repurchase risk 
  • Audit risk 
  • Compliance risk 
  • Liquidity risk 

Slow Down There Big Fella! 

For brokers the APOR/APR issue seems to be problematic, but the broker starts at a lower APR then adds fees. How likely are you to trigger HPML on most transactions that you wouldn't trigger if you were a lender? Small chance - you have same overlays/MI, etc. It is not worth taking on correspondent risk to avoid the relatively rare occasion when a broker transaction would carry an APR so much higher than a lender transaction to trigger HPML. Plus, borrower paid transactions are excluded from this entire debate. Plus, what really happens when a loan becomes HPML? You can't have prepays balloons or negam, you have to qualify, and you have to give the borrower a copy of the appraisal, right? WE DO THAT ANYWAY!

Tell me if I'm wrong. The furor is causing a lot of disruption among small brokers. Much of this concern has been caused by wholesalers who want to differentiate their service offering, so have stirred the pot over this debate.  Warehouse lenders have also chimed in on the importance of having a warehouse line.

Holy Secondary Conflict, Batman!

There are bigger problems with the HPML rule. APOR is set once a week. We have seen major fluctuations in pricing to the upside, and when this happens simple market movement can cause EVERY LOAN IN YOUR PIPELINE to be HPML. Maybe the day is here where we simply assume each loan will be HPML, and move forward from there. We are doing it anyway.

Additional Resources

Bankers Online HPML Checklist - You can document that you determined whether a loan was HPML or not, and then what you did to comply.