The Dodd-Frank legislation is poised to take effect after the 2012 election. One of the law's elements is the creation of the Consumer Financial Protection Agency. That was the brainchild of Elizabeth Warren, who now is a 1-to-10 favorite to become the next Democratic senator from Massachusetts. A key regulation that's set to be implemented by the agency is the "QM Rule," short for qualified mortgage. That's a scheme designed to prevent banks from engaging in predatory lending. It establishes a set of government criteria that lenders have to abide by to make sure borrowers have the ability to repay the loan. The metrics scheduled to go into effect are pretty strict. It's legal for banks to write loans that don't comply. But that makes them liable to civil penalties, and potentially criminal ones. Like most laws being implemented these days, banks can be hit with sanctions under some conditions even if they do comply with the letter of the law.
Enough high quality borrowers have been in the market to keep Ellie Mae's growth intact up to this point. In the September quarter the average FICO score of the loans processed by the company was 750 (top 40%) with an average 22% of the purchase price down. More than half of those loans were refinancings. The average FICO score of the rejected loans was 700. A score like that used to go through almost automatically. The expectation was that credit standards would loosen somewhat in 2013 and beyond, opening up a trove of potential refinancing business. Rising new and existing home sales promised to reinforce the trend, both directly and by boosting home values. Combine that with Ellie Mae's market share dominance and rising revenue per transaction, and the outlook was bright.
Barack Obama is a 1-to-3 favorite to win re-election. Elizabeth Warren's rules are likely to be enacted. And while the mortgage market may not turn down, the upside potential could be diminished. These rules will affect everybody in the industry, not only Ellie Mae. In the long run it's possible the company's competitive position could benefit. We doubt the regulations will be of any genuine help, though. Still, we think Ellie Mae will continue to fare well over the next several years. Investors with long term gains and oversize positions might want to reduce positions, nonetheless, to manage risk and beat the imposition of higher capital gains taxes next year.
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