OREANDA-NEWS. Residential mortgages in US RMBS with material exceptions to the income documentation standards required to achieve Qualified Mortgage (QM) status will likely be penalized with both higher default and higher loss severity assumptions, according to Fitch Ratings.

The combined penalty could increase loss projections by 1.3 to 2.0 times that of a similar non-QM loan with documentation that meets the QM standard. The amount of the adjustment will depend on the specific program's guidelines, compensating factors and the lender's history.

To date, the small number of non-QM loans that have been included in US RMBS have been very high credit quality. This is despite some attributes that disqualified them from QM status, such as an interest-only feature or a debt-to-income ratio in excess of 43%. Nonetheless, they have generally followed the income documentation standards prescribed for QM loans in Appendix Q of the Ability-to-Repay rule.

Identified deviations from Appendix Q have thus far been minor and, in most cases, unintentional. For non-QM loans with immaterial deviations from Appendix Q, Fitch has not adjusted its standard non-QM default and loss severity treatment from that described in the its criteria report for QM and non-QM loans. Examples of documentation deviations Fitch has deemed immaterial are missing signatures or dates on tax returns as long as the 4506 forms are obtained, or self-employed borrowers that have provided two years of full income tax returns but did not provide an updated mid-year profit and loss (P&L) or balance sheet.

However, a number of potential issuers have inquired about the treatment of non-QM loans with deviations from appendix Q documentation standards that are programmatic and more substantial than those described above. The most common example is a loan program for self-employed borrowers that relies on bank statements, rather than tax returns, to determine income.

Fitch believes such programs would be more vulnerable to borrower claims that the loan violated the Ability-to-Repay rule than loans underwritten with documentation standards that met Appendix Q. Consequently, Fitch would likely increase the claims probability and claims success rate from those described in its published criteria. If Fitch assumed twice the claims probability and twice the success rate of those claims, loss severity would increase 1.1 to 1.2 times that of a non-QM loan with standard documentation. (For example, a 50% loss severity projection for a non-QM loan could be revised to roughly 55-60% if underwritten with alternative documentation).

The relative adjustment to the probability of default for material deviations from Appendix Q would likely be greater than the loss severity adjustment. A self-employed borrower underwritten with bank statements would likely be treated as 'Low' or 'Limited' income documentation by Fitch. Based on the historical performance of borrowers qualified with non-Full income documentation, the probability of default would likely be increased 1.25 to 1.75 times that of a non-QM borrower underwritten with standard documentation. Combined with the loss severity adjustment, the total loss adjustment could be in the range of 1.3 - 2x for loans with material deviations from Appendix Q