Dave Parker: Rebounding Non-QM Market Requires Quality Review to Mitigate Risk

Dave Parker is Chief Product Officer for LoanLogics, a Jacksonville, Fla.-based provider of loan quality technology for mortgage manufacturing and loan acquisition. He is responsible for defining and executing the vision and direction of the company’s product portfolio and designing new solutions for the industry’s current challenges. He has more than 30 years of experience in mortgages and technology. Inquiries can be sent to LoanLogicsInfo@LoanLogics.com.

Before the COVID-19 pandemic turned our worlds upside down, the housing market couldn’t have seemed stronger. Not only were low interest rates driving a healthy refi and purchase business, but there was more variety in the types of mortgage options than we’ve seen in years.

Of course, this all changed in mid-March. Our industry was forced to transition to work from home and companies initiated health and safety protocols to keep both their teams and consumers safe. But one of the biggest impacts was the sudden disappearance of non-QM loans and a complete loss in appetite for expanding the credit box.

Today, that picture is starting to turn around. The non-QM market is making a recovery and, with continued demand from borrowers, changes to the current QM lending rule and the approaching expiration of the QM patch, is likely to stay on the rebound. As a new range of products come to the market, the question now becomes, how can the mortgage industry ramp up and ensure loan quality for lenders, servicers and investors?

Gaining Clarity on Non-QM Loans

The benefits of non-QM loans were made clear prior to the pandemic, which is why these loans started to become so popular. Not all borrowers fit into the conventional loan box, but that doesn’t mean they aren’t safe credit risks.

For example, many borrowers with minor credit events often have trouble qualifying for mortgages under traditional lending criteria, but they may have significant income and assets that make them low risk borrowers. Non-QM loans also provide alternative financing solutions for self-employed borrowers and business owners that can keep lenders from losing out on potential opportunity.

Prior to the pandemic, non-QM loans performed exceptionally well as a whole. That’s because they are not anything like the subprime loans that helped sink the housing market back in 2008—they were made based on sound underwriting reviews that may have expanded the envelope, but still gave proof that borrowers had the ability to repay.

According to CoreLogic, the total market for non-QM loans comprised only about 4 percent of all loan originations in 2018, but it was still growing, with new products such as high debt-to-income (DTI) loans with limited document requirements being introduced. There was excitement, too, that the decision to let the GSEs’ QM patch expire—which allowed QM loans with DTIs up to 50 percent—would open up more non-QM loan opportunities.

That largely came to a halt in March, when the pandemic triggered an enormous wave of job layoffs, mortgage forbearance requests and the likelihood of mortgage defaults. Facing a crisis in liquidity, non-QM lenders and investors called time-out and the market evaporated almost overnight. Since then, however, the housing market has proven to be more resilient than everyone thought – no doubt because the crisis was health-driven, not caused by widespread bad acting or irresponsible underwriting.

Since the summer, the outlook began to change as several prominent non-QM lenders and investors pushed the reset button on their businesses. But in that cautious reversal and the current economic environment, the importance of manufacturing non-QM loans with quality is even more of a priority.

Understanding the Risks

Once again, excitement is brewing among originators and investors for non-QM loans. For the non-QM market to remain healthy, however, quality and compliance are extremely important. As product expansion grows, originators will need careful pre- and post-close reviews to identify defects and the potential causes for those problems. The ability to address these issues and minimize any eligibility defects becomes even more challenging as new products are introduced to the market and changes are implemented to the QM lending rule.  

While non-QM lenders must still meet Dodd-Frank requirements to ensure borrowers have the ability to repay their loans, the non-standard nature of these products represents another layer of risk. Anytime DTI levels are raised, FICO requirements are lowered, or other factors that expand the credit box are allowed, risk is increased at least to some degree and a rise in defaults may become more likely.  

In addition, even though loan originators have some level of protection as long as they manufacture loans within approved guidelines, just like any other type of loan, defects make non-QM loans subject to the added risk of repurchase. Non-QM sellers with a history of repurchase requests or continued quality issues may find their pricing impacted and even fewer investors willing to buy their loans in an already narrow market.

Investors, too, now have more skin in the game than they did before the housing crisis, which makes it critical for them to ensure the loans they buy are accurate and well-underwritten. This focus on quality control is even greater for non-QM investors who may expect 100 percent pre-close reviews on non-QM loans to help mitigate risk.

An accurately manufactured non-QM loan, barring any unforeseen change in the borrower’s circumstance, should stand the test of time and could benefit from the CFPB’s proposal to create a new category of “seasoned QM” loans. Seasoned QM loans are defined as first-lien, fixed-rate covered transactions that meet certain performance requirements over a 36-month seasoning period while held in a portfolio. For banks holding them, these loans could hypothetically be sold on the secondary market at better pricing than non-QM loans sold immediately after origination.

Mitigating the Risks

Non-QM loans use compensating factors to offset weak factors in a borrower’s credit profile. The difficulty is that there are no real standards for evaluating non-QM loan risk, and some factors are easier to offset than others. If a borrower’s credit score is below 640, for example, a lower LTV ratio and a greater amount of reserves could be used as compensating factors. For self-employed borrowers, bank statements instead of tax returns can be used to show income and assets that qualify for non-QM loans. To help mitigate risk, re-verifications during the production process become very important to confirm income and assets prior to close.

The impact of the pandemic, perhaps creating even greater need for non-QM lending, has created other risk factors. Lenders must deal with constantly changing loan guidelines and requirements, and as they try to originate loans as quickly as possible, they may face a rise in eligibility defects, adding another layer of risk to already risky non-QM loans. Borrowers who may qualify for a loan one day might not qualify the next due to pandemic related issues.

Without real standards to evaluate risk in non-QM loan products, minimizing controllable risk becomes a priority. A comprehensive loan quality process is one way to ensure that mistakes and errors are minimized. This begins with the validation of loan file data to ensure its accuracy and consistency across all systems and mortgage documentation. This is crucial, not only for the completion of pre- and post-closing quality reviews, but also for other types of reviews, such as TRID and HMDA compliance.

The key for all parties involved in the manufacturing and selling of non-QM loans is leveraging technology and digital labor to perform this data validation and automate the time-consuming, cost-prohibitive and error-prone processes of extracting data from documents and checklist driven, highly manual loan file reviews. When combined with sophisticated rules and algorithms, machine learning tools, and validated datasets, the tasks traditionally performed by processors, underwriters and loan auditors can be completed in a fraction of the time and with much greater accuracy, making 100 percent pre-closing review possible.

Automation has far-reaching benefits for originators, servicers and investors, including the ability to accelerate processes. For example, in the origination process, new digital technologies enable lenders to import documents from borrowers and, within seconds, classify them and extract data for use in other risk analysis systems. This not only enables faster processing but can result in faster underwriting decisions when more data is accessible more quickly in the process. When combined with automated rules, these tools can also empower lenders to make an unlimited number of pre-close checks during loan production to ensure non-QM loans still meet guidelines as investor requirements change.

They also help servicers and investors. When purchasing servicing rights and onboarding loans, or buying non-QM loan portfolios, automation can be used to eliminate the process of manual due diligence reviews. Instead, the audit tests required in pre-purchase reviews can mostly be done through automation using validated data and with condition clearing orchestrated through portal technology, significantly increasing turn-around to funding back to sellers.

And for all participants, automated, digital labor reduces the burden on staff and frees up underwriters and auditors to look at more complex loan files, while the majority of loans speed through their systems. Ultimately, more pervasive use of digital labor will remove the subjectivity from loan decisions and improve investor confidence.

The bottom line? Non-QM loans have returned and once again represent a significant source of business, but it doesn’t have to be at the expense of additional risk. With the right approach – and the right technology – the industry can ensure non-QM loans are manufactured with quality and are as healthy for business as they are for the entire housing market.

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at msorohan@mba.org; or Michael Tucker, editorial manager, at mtucker@mba.org.)