Increased lending risks to consumer mortgages prompt a shift in regulatory landscape
Published on December 1, 2021 by Venkatesh Krishnamurthy and Rajeev Hota
The US consumer mortgage market has been completely overhauled with the implementation of new rules and regulations since the 2008 global financial crisis.
The pandemic’s impact on the financial services sector and debt levels was also severe, with borrowers and lenders affected differently. For individual homeowners, mortgage debt is the single largest source of debt. This has had a large impact on their finances and ability to stay solvent through wage decreases or wage losses. For lenders, residential mortgages are the most significant assets on their balance sheets; their profitability and liquidity have been affected largely by changes in residential mortgage originations, repayment schedules and default rates. Maintaining a healthy global residential mortgage market is, therefore, critical for countries to recover from the effects of the pandemic.
Is borrower behaviour vulnerable to lenders’ risk?
Yes. The pandemic effected a sharp turnaround in the borrower’s journey — from loan origination through servicing and paying off debt. Inherent risks for lenders and servicers are operational, credit and compliance risks. The pandemic has made consumers move quickly to a fully digital world, presenting challenges to lenders:
- Cybersecurity risks and fraud: Digitalisation of banking systems has witnessed several data breaches, as opposed to instances of phishing previously. Digitalisation gives hackers access to sensitive information that can be used to easily manage wire theft
- Lack of an effective control mechanism: In view of the regulatory changes to ensure health and safety amid the pandemic, lenders are engaging more than ever in e-closing of transactions. This requires continuous refining of processes and building an effective control mechanism
- Communication challenges: Another challenge for lenders is interacting with borrowers virtually, as opposed to face to face. Technology enables borrowers to apply for loans digitally, and lenders now need to focus on ways to train their staff who engage with borrowers to make sure communications are compliant, effective and accurate
Prompting a shift in the regulatory landscape:
Recent changes in lending patterns have led to a number of issues for lenders. The Consumer Financial Protection Bureau (CFPB) and other federal agencies responsible for formulating and enforcing mortgage regulations have taken the following preventive measures to control the damage:
- Qualified mortgage (QM): A mortgage that meets requirements for lender protection and secondary-market trading under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The requirements are based on an analysis of a borrower’s ability to repay. The analysis ensures that the borrower has not taken loans where monthly debt payments exceed 43% of their pre-tax income
- Real Estate Settlement Procedures Act (RESPA): The RESPA was sanctioned by Congress and stipulates that buyers and sellers be given details of all settlement costs related to home buying to increase transparency
- Borrowers facing a financial crunch: Several federal and state protections have been established to provide relief for mortgage borrowers facing a financial crunch due to the pandemic. These include the Coronavirus Aid, Relief, and Economic Security (CARES) Act and other federal and state foreclosure moratoria
- Borrowers otherwise affected by the pandemic: The 2021 Mortgage Servicing COVID-19 Rule came into effect on 31 August 2021. This details the servicing of mortgage loans under Regulation X and Regulation Z. The 2021 Rule includes temporary provisions as follows:
- Ensures that the affected borrower has an opportunity to apply for loss mitigation before the lender forecloses the loan
- Ensures the ability of servicers to offer borrowers certain COVID-19-related loan modifications without a complete loss-mitigation application
- Provides timing requirements on when servicers should renew reasonable diligence efforts to obtain complete loss-mitigation applications from certain borrowers
- Minimum mortgage requirement for a Federal Housing Administration (FHA) loan:
- Down payment: FHA loans require a 3.5% down payment with a 580 or higher credit score, and funds can be sourced from employers, close friends, family members or charitable organisations. The down payment requirement spikes to 10% with a credit score of 500–579
- Mortgage insurance: FHA borrowers are required to pay two types of FHA mortgage insurance. The first is an Upfront Mortgage Insurance Premium (UFMIP) of 1.75% of the loan amount and the second is the annual Mortgage Insurance Premium (MIP) that ranges from 0.45% to 1.05% of the loan amount, which is then divided by 12 and added to monthly payments
- Credit score: Borrowers can have a credit score as low as 500–579 with a 10% down payment. Homebuyers making a minimum 3.5% down payment will need a score of at least 580
- Employment: FHA loan income requirements look at the source of a borrower’s stable income and require continuous employment for the past two years
- Income: There are no income limits for FHA loans. However, borrowing power is limited to the FHA maximum loan limit cap of USD356,362 in 2021, compared to USD548,250 for conventional loans in most parts of the country
- DTI ratio: For FHA loans, the front-end DTI ratio is 31% at a maximum level, while the back-end DTI ratio is capped at 43%
- Cash reserves: FHA loan qualifications generally do not require maintenance of cash reserves unless the borrower is buying a two- to four-unit home or is trying to qualify with a lower credit score
- Occupancy: A one- to four-unit home financed with an FHA loan must be the borrower’s primary residence for at least the first year after buying it
- Property types: With FHA financing, the borrower can buy a one- to four-unit home in a subdivision or an FHA-approved condominium project, or a cooperative unit or a manufactured home that is permanently attached to a foundation
- Home appraisals: FHA loans require an appraisal regardless of the down payment
On top of these measures, it is recommended that lenders and servicers analyse the current situation and make changes to the lending landscape to control emerging risks. Furthermore, due to changes in borrower behaviour and a complete shift to digitalisation, lenders are forced to innovate and embrace developments in technology to achieve operational efficiency.
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About the Authors
Venkatesh Krishnamurthy has over 15+ years of experience in Commercial Real Estate (CRE). At Acuity Knowledge Partners, he currently co-leads CRE client engagement based out of US and is actively involved in hiring, building collaterals, client management, training and quality control of deliverables. He holds a MBA (Finance) and a bachelor’s degree in Commerce.
Rajeev Hota has over 16+ years of wide experience in Real Estate Mortgage products and processes including end to end pre and post-closing lending activities. At Acuity Knowledge Partners, he leads the Commercial Lending Real Estate space including client engagement. He is actively involved in business development, client pitches, road shows, hiring, and training & development. He holds a MBA (Finance) and a bachelor’s degree in Commerce.