“The first few deals to come out are probably going to have a small minority of QM loans and possibly a few non-QM loans,” says Clayton's Scott McNulla.

Lenders have begun making mortgages under new rules designed to ensure that borrowers can repay their debt, and rating agencies are finalizing assessments of how risky these loans are. But it remains to be seen how such loans will be securitized, and how much appetite investors have for such deals.

The ability-to-repay (ATR) rule became effective Jan. 10, and RMBS containing mortgages subject to it (qualified mortgages, or QM) as well as those falling outside it (non-QM) are no doubt on the drawing board if not in the works, as issuers run out of earlier loans to securitize.

Scott McNulla, head of compliance for due-diligence services at securitization-analytics firm Clayton, noted that mortgages originated on or after Jan. 10 began closing in February, and so under normal circumstances they could have made it into RMBS deals by April. The RMBS life cycle may be taking a bit longer as the market digests the changes. “But we would expect to see some of these loans in the next deal or the deal after that,” McNulla said.

The $3.4 billion in RMBS issued as of late April, including $1.6 billion of private label deals backed by prime jumbo mortgages, pooled loans that were applied for before Jan. 10.

Fitch Ratings, Standard & Poor’s and Kroll Bond Rating Agency (KBRA) have published their final criteria, and the consensus so far appears to be that the rating agencies have taken a reasonable and workable approach. Heavyweight Moody’s Investors Service must still finalize its criteria.

“It’s giving a bit more clarity on how the likely credit enhancement levels will change based on the type of collateral (whether QM or non-QM),” said Chris Haspel, partner and head of capital markets at de novo mortgage originator Fenway Summer and previously the CFPB’s senior expert in residential mortgage servicing and securitization. “It’s very helpful for market participants trying to figure out how they’re going to assess it.”

QM mortgages must meet criteria specified by the regulation (see graphic) to be designated as either safe harbor loans or rebuttable-presumption loans. The two are distinguished by the latter holding an annual percentage rate exceeding the prime rate by more than 1.5% and potentially greater liability for issuers.

Safe harbor loans shield lenders from borrower claims that they did not comply with ATR requirements, and borrowers only have recourse if they can show loans didn’t satisfy the QM criteria. With rebuttable presumption loans, borrowers can challenge whether lenders complied with the ATR rule, but they must show that after paying their mortgages and other debts they had insufficient residual income to meet living expenses, based on the available information when they signed the loan documents.

Non-QM mortgages comprise riskier loans that once fit into the subprime or Alt A categories—currently out-of-favor terms—as well as high-credit-quality prime loans that may contain interest-only [IO] or other features presumed risky. There are no bright-line regulatory criteria defining non-QM loans, and instead they must be reviewed against lenders’ ultimately more nebulous guidelines, increasing liability risk for issuers.

“There is no prescribed number [such as for QM loans]; just the guidelines lenders identify as their thresholds,” McNulla said. “That can still be litigated, so you don’t have a safe harbor or rebuttable presumption like you do with QM loans.”

The litigation factor is key because whether a borrower’s litigation is successful or not, any related costs must be paid for by the securitization trust, hurting investors’ returns. The same applies to non-QM loans, which borrowers can argue didn’t comply with ATR requirements. For those loans, the rating agencies generally require additional borrower- and loan-related data, scrutinize lenders’ ability to comply with the rules, and assess third-party diligence companies’ review processes and their compliance with ATR.

So what exactly will the first deals including mortgages subject to the ATR rule look like, given the varying levels of liability the different mortgages will pose to issuers?

“The first few deals to come out are probably going to have a small minority of QM loans and possibly a few non-QM loans inside there,” McNulla said; the bulk of these transactions will be made up of mortgages originated before Jan. 10.

Investors remembering the fall out from the mortgage crisis, however, may seek greater purity. David Lyle, managing director and head of residential mortgage credit at Invesco Mortgage Capital, said he anticipates initial deals containing only the safest of the safe QM loans.

“I think it needs to be the QM safe harbor loans and not the higher cost [rebuttable presumption] QMs,” Lyle said. He anticipates that RMBS deals comprising solely QM rebuttable presumption loans or non-QM loans arriving later, perhaps in 2015.

Lyle noted that, had they been originated after the rules took effect, at least some of the jumbo loans in recent securitizations from issuers such as Redwood Trust, J.P. Morgan and Credit Suisse would have been categorized as non-QM loans because they have features such as IO that cast them out of QM territory, but they can nevertheless be strong credits. Even so, he said, such loans are unlikely to be sprinkled into deals otherwise comprising safe harbor QM loans anytime soon, and even including rebuttable presumption QM loans may be problematic.

“Fundamentally and from a credit perspective they may be strong credits and don’t cause additional concerns from a risk standpoint, but they’re potentially a concern from a liquidity standpoint,” Lyle said.

“If you’re buying a bond and looking to trade it later on, there may be a smaller number of investors who will be comfortable with [deals containing less than safe harbor loans]. There are still some very conservative investors who may just stay ‘no.’”

That may change after the rules have been tested.

“It would be helpful to see some of those cases come to court to get some clarity on how the rulings shake out and help quantify the risks,” Lyle said.

When that happens, investors’ concerns may be quickly dispelled. Stephen Ornstein, a partner at Alston & Bird, noted that while the rebuttable presumption can be litigated, it won’t be easy.        “The borrower would have to show the lender knew the borrower didn’t have enough residual income to live on after the mortgage payments, and that’s going to be a hard standard,” Ornstein said.

Despite containing loans falling outside the QM realm, Redwood and other issuers have typically found more than sufficient demand from investors. However, the qualified residential mortgage (QRM) rule, proposed by the major financial regulators, will eventually require RMBS issuers to retain risk in transactions with non-QM loans, giving them “skin in the game,” but not those that are pure QM. The regulators reproposed the rule last fall, permitting issuers to retain either 5% of the most subordinate portion of the RMBS deal, or a 5% “vertical slice,” from the triple-A tranche down through the unrated portions.

There’s been little indication a final rule is imminent, and it wouldn't impact securitizations until a year after it’s finalized, “But the current draft of the rule says if there are any non-QRM loans in the pool, then the whole deal is subject to risk retention,” said Stephen S. Kudenholdt, a partner at Dentons. “A lot of commenters asked for there to be a blend or averaging concept, but so far there doesn't appear to be one.”

In that case, issuers using securitization as a financing mechanism, mainly banks, may choose to securitize only QM loans, to avoid tying up capital.

“We’re seeing a reluctance by big banks to originate non-QMs, although I suspect in their private banking operations they’ll continue to do some for good customers and keep them in their portfolios,” Kudenholdt said.

Redwood has been the most regular issuer RMBS since the financial crisis and its business plan includes retaining the subordinated portions of deals, so it likely would already fulfill QRM requirements that emerge. And so would nonbank financial institutions with similar strategies, such as private equity firms, setting up a divide between different types of lenders.

“I wouldn’t be surprised if the first RMBS deals with non-QM collateral have a majority of QM and some very safe [non-QM] in there as well,” Haspel said.

He added that Fenway Summer plans to hold the bottom part of the credit stack, similar to Redwood, and that it’s planning to originate loans with low loan-to-value ratios and high FICO scores, but with IO or other features that would fall outside QM status.

he full impact on the RMBS market may take time to play out. The rating agencies, for example, distinguish between judicial and non-judicial states and in general attach greater risk to the former, since their existing legal frameworks will facilitate borrowers’ introducing ATR-related litigation to stave off foreclosures.

Lyle said the issue will become more relevant when more securitizations of riskier rebuttable presumption QM and non-QM are inked, because their higher rates of delinquency and default will have greater impact on deals’ cash flows. “Then we’ll see investors paying more attention to the judicial vs. non-judicial state concentration,” he said.

Ornstein said a plus for lenders is that class action suits stemming from the new rules are unlikely, given litigation will focus around the facts and circumstances of individual loans. However, fair lending issues stemming from the Fair Housing Act could emerge. “If you’re making only ATR loans, but excluding portions of the populace, a question could arise regarding whether your lending practices are unwittingly creating a disparate impact,” he said.

In addition, there are almost certainly sleeper issues that could unexpectedly impact issuers, the shapes of their deals, and the impact on investors. Matthew Yoon, a partner at Dentons, pointed to the loan originator compensation rule under Truth in Lending Act (TILA), noting it is outside the QM and ATR rules but could nevertheless result in unexpected liabilities if loan originators hadn’t complied with it.

“When you’re an issuer buying big pools of mortgages from many different sources, it’s difficult to ascertain whether the originators of those loans have complied with the rule,” Yoon said.

The currently weak private-label RMBS market will likely draw out the ATR rule’s impact, and the market shows little sign of strengthening—in April S&P reduced its 2014 private-label RMBS volume forecast by 40%, to $15 billion. Lyle said part of the reason for the market’s slow-motion recovery is the lack of supply, stemming in part from banks choosing to hold the loans on their books.

“Really easiest things to strengthen the private-label market would be for the banks to soften their bid, or Fannie Mae and Freddie Mac to reduce their jumbo-loan limits,” Lyle said, adding, “But that’s not going to happen soon.

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