Self-Employed Borrowers’ Income – Is the Past Necessarily Prologue?

In a new era of double-digit unemployment resulting from the COVID-19 pandemic, it may be tough for a mortgage lender to predict the amount and stability of someone’s income in order to determine qualification for a home loan. Neither past nor even present levels of income may be reliable indicators of income levels going forward, at least in the short run or until the economic dislocations are substantially behind us. That is why Fannie Mae and Freddie Mac (the “government-sponsored enterprises,” or “GSEs”) recently issued enhanced documentation requirements and considerations for verifying and predicting the income of a self-employed applicant for a mortgage loan. While the GSEs’ documentation requirements apply via contract to approved lenders/sellers, whether those requirements will morph into legal requirements under the Dodd-Frank Act’s “ability to repay” requirements is something to watch in the coming months.

Revised GSE Underwriting Requirements for Eligible Loan Purchases

A determination of whether an applicant has the ability to repay a loan from his or her income or assets is a basic component of loan underwriting – as required both by federal (and sometimes state) law, and by a lender’s investors or insurers. In addition, federal regulations prohibit a lender of closed-end residential mortgage loans from relying on any income that is not verified by reliable documentation. Predicting whether that income will continue into the future takes skill when lending to self-employed borrowers under any circumstances, and is particularly tricky during this unique coronavirus economy. The now-waning government stay-at-home orders and other quarantining efforts may or may not have affected a particular borrower’s business operations, and the scale and duration of those effects going forward are difficult to predict.

In response to that uncertainty, on May 28, 2020 Fannie Mae and Freddie Mac issued guidance requiring that self-employed borrowers must submit a year-to-date (“YTD”) profit and loss statement (“P&L”) that reports business revenue, expenses and net income. The P&L must cover the most recent prior month, and must be kept updated to within 60 days of the note date. That documentation is in addition to the GSEs’ current requirement that those borrowers submit one or two years of individual and/or business tax returns or transcripts.

Specifically, the GSEs are requiring that a self-employed borrower must also submit an audited YTD P&L. Alternatively, the borrower may provide an unaudited YTD P&L that the borrower signed, but then must also provide two recent months of bank statements from the borrower’s business account. The borrower may use personal account statements evidencing business deposits and expenses when the borrower is an owner of a small business and does not have a separate business account. However, the guidance provides that the lender must not consider as assets the bank account balances that constitute funds from the Small Business Administration’s Paycheck Protection Program or other similar coronavirus-related loans or grants.

The lender will compare cash flow information from those bank statements to the information in the borrower’s P&L. If those amounts are not reasonably consistent, the lender must obtain additional documentation (e.g., trending profit-and-loss data or additional bank statements). If the lender cannot resolve the discrepancy, that self-employment income may not be eligible for consideration.

With that understanding of net business income, the lender must then consider the extent to which the coronavirus affects the borrower’s business operations. For instance, the lender must consider whether the business is still subject to a government shut-down order, or whether the virus has affected demand for the borrower’s goods or services. The lender also must consider factors such as a supply chain break-down that may threaten inventory or raise expenses. The lender may need to obtain a business plan of modifications to address those effects. The lender also may (but is not apparently required to) obtain business tax returns to see if the business has retained earnings that may serve as a source of repayment.

The GSEs indicate that their lenders must apply the self-employment requirements described above beginning June 11, 2020, for loans with application dates on or after that date, or even sooner if possible. The additional requirements will continue to apply until further notice. (Freddie Mac’s guidance indicates that the requirements are “temporary,” but it does not provide an end date.)

Impact of COVID-19 on the Statutory “Ability to Repay” Requirements

The GSEs and their underwriting requirements cover a significant portion of the residential mortgage market, and their guidelines are often thought of as basic industry standards. That is one reason the Consumer Financial Protection Bureau (“CFPB”) defined a “Qualified Mortgage” (“QM”) under its 2014 Ability-to-Repay Rule to include GSE-eligible loans. While the Dodd-Frank Act mandated certain criteria for QMs, the CFPB’s Rule gave a temporary QM safe harbor to GSE-eligible loans, even those with debt-to-income ratios (“DTI”) that exceed 43%, which would not otherwise qualify for that protection. (That temporary protection for over-43% DTI GSE loans has become known as the “Patch.”)

However, the strict documentation requirements under that Rule or imposed by the GSEs have caused many self-employed borrowers to look to lenders offering non-qualified mortgages (“non-QMs”), as opposed to lenders offering GSE/QM mortgages. Non-QMs allow for more flexible underwriting (but with less certainty regarding compliance with the Ability-to-Repay requirements and the resulting litigation and enforcement risk). With the GSEs’ newly-enhanced underwriting requirements for self-employed borrowers, the non-QM market may attract even more of those borrowers. Still, non-QM lenders must grapple with the same difficult predictions regarding income stability going forward, and whether past income provides any indication regarding the future. The law and regulations do not require a lender to predict with certainty the amount and sustainability of a borrower’s future income, but they do require a good faith estimate. What constitutes “good faith” in this market will be a subject of continuing discussion.

While the GSEs have arguably set an industry standard for underwriting, important changes are in the works. The Patch for those over-43% DTI GSE loans is set to expire in January 2021, and the CFPB’s rulemaking to eliminate the Patch is overdue (the CFPB indicated it would be released last month). Congress, for its part, has considered extending the Patch for another 12-18 months through various COVID-response legislative vehicles, none of which has yet been successful. The CFPB is also considering a wide range of options for determining which loans receive safe harbor protection under the Rule. With the added chaos of the coronavirus recession, the extent to which lenders can look backwards in order to predict the future for self-employed borrowers is more muddled.