Using RS Edge to Quantify the Impact of The QM Patch Expiration
Using RS Edge Data to Quantify the Impact of the QM Patch Expiration
A 2014 Consumer Financial Protection Bureau (CFPB) rule established that mortgages purchased by the GSEs (Fannie Mae or Freddie Mac) can be considered “qualified” even if their debt-to-income ratio (DTI) exceeds 43 percent. This provision is known as the “qualified mortgage (QM) patch” or sometimes the “GSE patch.” It has become one of the most important holdouts of the Dodd-Frank Act and an important facilitator of U.S. lending activity under looser credit standards. The CFPB implemented the patch to encourage lenders to make loans that do not meet QM requirements, but are still “responsibly underwritten.” Because all GSE loans must pass the strict standards for conforming mortgages, they are presumed to be reasonably underwritten–notwithstanding sometimes having DTI ratios higher than 43 percent.
The QM patch is set to expire on January 10, 2021. This phaseout has spawned concern over the impact both on mortgage originators and potentially on borrowers when the patch is no longer available and GSEs are less apt to purchase loans with higher DTI ratios.[1]
We performed an analysis of GSE loan data housed in RiskSpan’s RS Edge platform to quantify this potential impact.
The Good News:
The slowdown in purchases of high-DTI loans is already occurring, which could partially mitigate the impact of the expiration of the patch.
We used RS Edge to analyze the percentage of QM loans to which the patch applies today. From 2016 through the beginning of 2019, Fannie and Freddie sharply increased their purchases of loans with DTI ratios greater than 43 percent, with these loans accounting for over 34 percent of Fannie’s purchases as recently as February 2019 and over 30 percent of Freddie’s purchases in November 2018 (see Figure 1).
Figure 1: % of GSE Acquisitions with DTI > 43 (2016 – 2019)
Our data shows, however, that Fannie and Freddie have already begun to wind down purchases of these loans. By the end of 2019, only about 23 percent of GSE loans purchased had DTI greater than 43 percent. This is illustrated more clearly in Figure 2, below.
Figure 2: % of GSE Acquisitions with DTI > 43 (2019 only)
As discussed in the December 2019 Wall Street Journal article “Fannie Mae and Freddie Mac Curb Some Loans as Regulator Reins in Risk,” the wind-down could be related to the GSE’s general efforts to hold stronger portfolios as they aim to climb out of conservatorship. However, our data suggests an equally plausible explanation for the slowdown Borrowers generally exhibit a greater willingness to stretch their incomes to buy a house than to refinance, so purchase loans are more likely than refinancings to feature higher DTI ratios. Figure 3 illustrates this phenomenon.
Figure 3: Most High-DTI Loans Back Home Purchases
The Bad News:
The bad news, of course, is that one-fifth of Freddie and Fannie loans purchased with DTI>43% is still significant. Over 900,000 mortgages purchased by the GSEs in 2019 were of the High-DTI variety, accounting for over $240 billion in UPB.
In theory, these 900,000 borrowers will no longer have a way of being slotted into QM loans after the patch expires next year. While this could be good news for the non-QM market, which would potentially be poised to capture this new business, it may not be the best news for these borrowers, who likely do not fancy paying the higher interest rates generally associated with non-QM lending.
Originators, not relishing the prospect of losing QM protection for these loans, have also expressed concern about the phaseout of the patch. A group of lenders that includes Wells Fargo and Quicken Loans has petitioned the CFPB to completely eliminate the DTI requirements under ability-to-pay rules.
Figure 4: % of DTI>43 Loans Sold to GSEs by Originator
We will be closely monitoring the situation and continuing to offer tools that will help to quantify the potential impact of the expiration.
[1] Consumer Financial Protection Bureau, July 25, 2019.[/vc_column_text][/vc_column][/vc_row]
Fannie Mae and Freddie Mac Launch New Uniform Mortgage-Backed Security (UMBS)
Today, Fannie Mae and Freddie Mac begin issuing the long-awaited Uniform Mortgage-Backed Security (UMBS). The Federal Housing Finance Administration (FHFA) conceived of this new standard in its 2012 “A Strategic Plan for Enterprise Conservatorships,” which marked the start of the Single Security Initiative (the history of which is laid out in the graphic below).
RiskSpan produces FHFA’s quarterly performance reports, most recently published Wednesday, May 29, which will support the agency’s oversight of the UMBS. The FHFA uses this report to monitor prepayment performance of passthroughs issued by Fannie and Freddie. These reports provide market participants with additional transparency on prepayment behavior alignment. They also allow the FHFA to monitor and address differences in conditional prepayments rates (CPR) between the two issuers and to align programs, policies, and practices that affect the cash flows of “To-Be-Announced” (TBA)-eligible Mortgage-Backed Securities (MBS).
The importance of RiskSpan’s contributions to the FHFA’s efforts are highlighted in Bloomberg’s May 30 article, “A $4 Trillion Plan Could Make or Break Dreams of U.S. Homebuyers”.
Fannie Mae’s New CAS REMIC: Why REITs Are Suddenly Interested in CRT Deals
Fannie Mae has been issuing credit-risk-transfer (CRT) deals under its Connecticut Avenue Securities (CAS) program since 2013. The investor base for these securities has traditionally been a diverse group of asset managers, hedge funds, private equity firms, and insurance companies. The deals had been largely ignored by Real Estate Investment Trusts (REITs), however. The following pie charts illustrate the investor breakdown of Fannie Mae’s CAS 2018-C06 deal, issued in October 2018. Note that REITs accounted for only 11 percent of the investor base of the Group 1 and Group 2 M-2 tranches (see note below for information on how credit risk is distributed across tranches), and just 4 percent of the Group 1 B-1 tranche. Things began to change in November 2018, however, when Fannie Mae began to structure CAS offering as notes issued by trusts that qualify as Real Estate Mortgage Investment Conduits (REMICs). The first such REMIC offering, CAS 2018-R07, brought about a substantial shift in the investor distribution, with REITs now accounting for a significantly higher share. As the pie charts below illustrate, REITs now account for some 22 percent of the M-2 tranche investor base and nearly 20 percent of the B-1 tranche.
What Could Be Driving This Trend?
It seems reasonable to assume that REITs are flocking to more favorable tax treatment of REMIC-based structures. These will now be more simplified and aligned with other mortgage-related securities, as Fannie Mae points out. Additionally, the new CAS REMIC notes meet all the REIT income and asset tests for tax purposes, and there is a removal on tax withholding restrictions for non-U.S. investors in all tranches. The REMIC structure offers additional benefits to REITs and other investors. Unlike previous CAS issues, the CAS REMIC—a bankruptcy-remote trust—issues the securities and receives the cash proceeds from investors. Fannie Mae pays monthly payments to the trust in exchange for credit protection, and the trust is responsible for paying interest to the investors and repaying principal less any credit losses. Since it is this new third-party trustee issuing the CAS REMIC securities, investors will be shielded from exposure to any future counterparty risk with Fannie Mae. The introduction of the REMIC structure represents an exciting development for the CAS program and for CRT securities overall. It makes them more attractive to REITs and offers these and other traditional mortgage investors a new avenue into credit risk previously available only in the private-label market.
End Note: How Are CAS Notes Structured?
Notes issued prior to 2016 as part of the CAS program are aligned to a structure of six classes of reference tranches, as illustrated below:
Two mezzanine tranches of debt are offered for sale to investors. The structure also consists of 4 hypothetical reference tranches, retained by Fannie Mae and used for allocation of cash flows. When credit events occur, write-downs are first applied to the Fannie Mae retained first loss position. Only after the entire first loss position is written down are losses passed on to investors in mezzanine tranche debt – first M2, then M1. Loan prepayment is allocated along an opposite trajectory. As loans prepay, principal is first returned to the investors in M1 notes. Only after the full principal balance of M1 notes have been repaid do M2 note holders receive principal payments. Beginning with the February 2016 CAS issuance (2016-C01), notes follow a new structure of seven classes of reference tranches, as illustrated below:
In addition to the two mezzanine tranches, a portion of the bottom layer is also sold to investors. This allows Fannie Mae to transfer a portion of the initial expected loss. When credit events occur, both Fannie Mae and investors incur losses. Additionally, beginning with this issuance, the size of the B tranche was increased to 100 bps, effectively increasing the credit support offered to mezzanine tranches. Beginning with the January 2017 CAS issuance (2017-C01), notes follow a structure of eight classes of reference tranches, as illustrated below: 
Fannie Mae split the B tranche horizontally into two equal tranches, with Fannie Mae retaining the first loss position. The size of the B1 tranche is 50 bps, and Fannie Mae retains a vertical slice of the B1 tranche.
