United States: Favorable Treatment Of Mortgage Loans Under Dodd-Frank: A Comparison

In the wake of the financial crisis, mortgage-related reforms enacted as part of the Dodd-Frank Act or established under the Basel capital process have created four different classes of residential mortgage loans that are entitled to some kind of favorable treatment. These classes are (i) "qualified mortgages" for Truth in Lending Act purposes; (ii) "qualified residential mortgages" for the purpose of the risk retention requirements in securitizations; (iii) "Category 1" mortgages for the purpose of assigning risk weights under Basel capital requirements; and (iv) mortgages underlying residential mortgage-backed securities that may qualify as "Level 2B assets" for the purpose of the "liquidity coverage ratio" (LCR). Given these different purposes, the criteria for specialized treatment vary. The result is a patchwork of requirements that substantially increase the complexity of the mortgage origination process and the secondary market.

In an effort to simplify these four sets of requirements so that lenders and secondary market participants can make informed decisions, the attached tables compare the four different approaches to favored mortgage loans on a side-by-side basis, including the types of loans and their terms that are eligible for preferred treatment and the underwriting requirements. Any given loan could qualify for special treatment under one approach but not under others. Indeed, with the exception of the rules for qualified residential mortgages, which must take into account the rules for qualified mortgages, there has been no effort to reconcile the different regimes, which are as follows:

  • Qualified Mortgages. Title XIV of the Dodd-Frank Act includes a provision that requires a creditor to make a reasonable good faith determination that the borrower has the ability to repay the loan. Under rules adopted by the Consumer Financial Protection Bureau (CFPB) in January 2013, creditors are entitled to either a safe harbor or a presumption against a claim of a violation if they originate a qualified mortgage (QM), depending on the annual percentage rate (APR) for the loan. The regulations define a QM (the "ATR Rule"). Also in January 2013, the CFPB proposed exemptions from the rules. The CFPB analysis in the final rule is complex: there are three different paths to QM status.
  • Qualified Residential Mortgages. Section 941 of the Dodd-Frank Act requires the securitizer of any asset securitization (including any securitization of residential mortgage loans) to retain 5% of the credit risk of the underlying pool of assets. The retention rule does not apply, however, to qualified residential mortgages (QRMs). In 2011, the primary federal financial regulatory agencies proposed criteria for a QRM; these rules have not been finalized. Section 941(b) requires that QRMs be defined no more broadly than QMs. The QRM criteria are not as comprehensive as those for QMs, but we assume that where the QRM proposal is silent, the QM rule would apply.
  • Category 1 Mortgages. Drawing on capital standards developed by the Basel Committee on Banking Supervision (BCBS), the federal banking agencies proposed three sweeping sets of capital requirements in June 2012. One of the proposals, the Standardized Approach Proposal (based on the standardized approach in Basel II), contains a series of calibrated risk weights for residential mortgage loans. These calibrations are based on the loan-to-value ratio (LTV) of the loan and whether the loan is a Category 1 or a Category 2 loan. Category 1 loans are deemed less risky than Category 2 loans, and the Category 1 loans share some of the characteristics of mortgage loans now risk-weighted at 50% that have been "prudently underwritten." The capital charges on Category 1 loans are materially smaller than those on Category 2 loans.
  • High Quality Liquid Assets. An important innovation in the Basel III capital framework is the introduction of a liquidity coverage ratio - a requirement that a banking organization maintain sufficient "high quality liquid assets" (HQLA) to satisfy all of the organization's obligations over the coming 30 calendar days. The latest version of the LCR released by the BCBS in January 2013 allows a banking organization to include a limited amount of certain residential mortgage-backed securities (RMBS) in its HQLA. Qualifying RMBS (and other assets) are referred to as Level 2B assets. The Level 2B eligibility requirements in the Basel standards include certain prerequisites for the mortgages in the pool that supports the securitization, plus an external credit rating of AA or better. The federal banking agencies have committed to adopt the LCR, but section 939 of Dodd-Frank will block them from adopting the AA rating requirement. In its place, they will have to substitute other creditworthiness factors. One possibility is that the U.S. regulators will look to the rating agency criteria for RMBS ratings, which include the review of certain features of the individual underlying mortgage loans. The rating agencies do not have uniform or hard-and-fast rules for evaluating the credit risk of RMBS or the underlying mortgages, but, working from informal sources, we propose some criteria that we believe would enable RMBS to qualify for Level 2B.

Attached are two tables: Table I summarizes the loan features and payment terms that distinguish mortgage loans that are eligible for favored treatment from those that are not. Table II sets forth the underwriting criteria - "ability to repay" for QMs - that a creditor must use to qualify its loans for favorable treatment.

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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Anna Pinedo
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