When Congress took on the task of regulating the excesses of the mortgage industry, it ostensibly wanted to prevent a recurrence of the housing bubble. To that end, they passed the Dodd-Frank finance reform. One of the provisions of Dodd-Frank was to establish a “qualified mortgage” that establishes the parameters of what constitutes a “safe” mortgage product unlikely to cause another housing bubble. To this end, they solicited advice from various sources to come up with an appropriate set of standards.
In Preventing the Next Housing Bubble, the final chapter of the book, I addressed what it would take to prevent another catastrophe like we witnessed over the last decade. It has a series of parameters similar to the recently issued guidance on what constitutes a qualified mortgage:
Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:
- 1. All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
- 2. The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
- 3. The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
- 4. The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.
The key provisions are documenting income and requiring qualification based on an amortizing mortgage and a reasonable percentage of a borrower’s income. Liar loans and the Option ARM were the primary culprits that inflated and destabilized the housing market, and an abdication of debt-to-income standards ensured these loans would fail. The new standards for a qualified mortgage successfully addressed these issues.
Regulators issued new mortgage rules on Thursday designed to prevent a return to lending practices that cratered the housing market and brought the financial system to its knees during the past decade. Here’s a look at some frequently asked questions:
What is a qualified mortgage? Congress amended federal lending laws in 2010 to give greater legal rights to borrowers who get mortgages they can’t afford. The new law, part of the Dodd-Frank financial-regulation overhaul, said if banks made a qualified mortgage—one that meets certain easy-to-identify criteria—regulators and courts would presume that lenders had reason to assume a borrower could repay.
When do the new rules take effect? In one year.
What is the Consumer Financial Protection Bureau’s role? Congress left it to the agency to spell out the definition of a qualified mortgage.
Do qualified mortgages have a minimum down payment or credit score requirement? No. Instead, the rules focus primarily on documenting a borrower’s ability to make monthly payments.
Minimum down payment requirements may still be coming.
What kind of loans won’t be qualified mortgages? Certain product types are excluded, including interest-only loans that don’t require principal payments, and loans where the principal balance rises over time.
Interest-only loans and Options ARMs are specifically prohibited. This is a huge step in the right direction. These loans aren’t being underwritten today because they failed in such large numbers, but lenders will forget their folly in time, so regulations which ensure lenders cannot dodge financial responsibility for underwriting them is critical to preventing them from returning.
Beyond that, banks must verify a borrower’s income, credit, and employment.
Verifying people make what they say they make seems like a no-brainer, but as we saw during the bubble, lenders didn’t have any brains.
Borrowers who take out jumbo mortgages, or those too expensive for government backing, can have no more than 43% of total debt as a share of their pretax income.
Limiting debt-to-income ratios is also key to preventing future housing bubbles. In all three of our previous housing debacles, debt-to-income ratios rose to unfathomable and usustainable heights.
Will lending standards get tighter, looser, or stay the same? It’s too soon to tell and there are diverse opinions on this point. David Stevens, the chief executive of the Mortgage Bankers Association, said the debt-to-income requirements for jumbo mortgages could tighten standards for those loans, which have already become much harder to get. “It will restrict credit on the margin over the current environment and that’s something we cannot afford,” he said.
Lenders are praying for looser standards on jumbo loans so they can clear out the shadow inventory now concentrated in move-up markets. Each lender is looking to another to step up and take on the risk — and inevitable losses — that will come from looser credit standards at the high end. Since this is a completely private money market, lenders have no way to pass the buck to the US taxpayer, and this loan market has been moribund for the last six years. Limiting debt-to-income ratios is another nail in the coffin of the jumbo market.
Mark Zandi, chief economist at Moody’s Analytics, has said that the rules are likely to lock in today’s stringent income-verification and credit standards. That would keep in place a lending regime that many top policy makers, from Federal Reserve Chairman Ben Bernanke to Treasury Secretary Timothy Geithner, have said may be too tight.
Halleluiah! The so-called tight lending standards are merely a return to the sane lending standards that existed before the bubble. Locking in sane lending standards will help ensure we don’t inflate another bubble. Those that would benefit from another bubble will continue to whine about tight standards, most notably realtors who consider any standards as a barrier to collecting another commission.
Others say the rules should provide certainty that lenders have been craving and encourage them to ease their standards, though non-qualified mortgages could carry higher costs for borrowers. The new rules should help convince private mortgage investors “that it’s safe to come back in the water,” said John Taylor, chief executive of the National Community Reinvestment Coalition.
Certainty about standards is always helpful to any market. Lenders will be eager to underwrite qualified mortgages, but they won’t be eager to stray beyond the bounds any time soon.
Will banks make loans that aren’t qualified mortgages? Lenders can make loans not considered qualified mortgages, but most say they won’t, at least initially, given the legal liability Fannie Mae and Freddie Mac are also unlikely to bundle such loans into securities.
At first, there will be no loans that are not qualified. Eventually, some lender seeking profit will underwrite loans on the fringes and hold them on their own balance sheets. In time, a secondary market for these loans will return, but investors will be much more cautious this time around as they realize their collective delusions about house prices never going down were not reality.
Still, Mr. Taylor says that over time, a market should develop for non-qualified mortgages. “Where there’s money to be made, and where it’s clear that something illegal or predatory is not occurring, there will be a market for it because there will be a better rate of return,” he said.
Will certain loans become harder to get? Yes. Many exotic mortgages that proliferated during the subprime heyday have disappeared; they are now less likely to come back. Lenders also may be more reluctant to make other loans that have been popular in more expensive housing markets and among affluent borrowers, such as interest-only mortgages.
Interest-only loans are not popular among “affluent” borrowers. They are a necessary evil in inflated markets where buyers are desperate. If these loans were banned outright, prices would remain tethered to amortizing mortgage payments with lower loan balances. Interest-only loans do nothing other than inflate prices.
Whether such loans will be securitized may depend on how ratings agencies interpret the potential costs of the new rules.
Are there certain lenders that will be at a disadvantage because of the rules? Most qualified mortgages will have a 3% cap on the amount of fees and origination costs that lenders can charge. Mortgage brokers are concerned that the way in which that rule is implemented could hurt their business model.
In addition, mortgage units run by home builders and real-estate brokerages could be hit because any costs from affiliated services that they offer—say, title insurance or legal settlement services—would count towards that 3% cap. If borrowers get those services from third parties that aren’t owned by the brokerage, then the costs don’t count towards the cap. Builders often encourage buyers to use their affiliated services, saying they’re more convenient. But consumer advocates have long worried that the practices are anticompetitive and can lead them to pay higher fees.
Expect to see more lenders push for affiliated services outside of the loan contract to circumvent the 3% cap.
What happens if a borrower decides his loan is unaffordable? Borrowers can sue the lender or the investor for damages. Banks that prove they met the qualified mortgage definition will have a greater shield from liability for loans that carry a prime rate, and a smaller shield on high-cost loans, which are typically made to subprime borrowers.
Hopefully, this will spare us a lot of lawsuits from those unscrupulous borrowers who want to game the system. Lenders know they are hosed if they stray from the guidelines, but they should also know they are safe if they stay within them.
What’s more interesting about the qualified mortgage rules is what was left out. What about regulating down payments?
The new rules, however, don’t address the contentious matter of whether borrowers should be required to make a minimum down payment when taking out a mortgage. The consumer agency focused instead on making sure that lenders conduct thorough vetting, or “underwriting,” to make sure consumers have the financial capacity to handle the mortgage payments.
But new down payment requirements are still possible, as part of yet more mortgage rules that are expected to be issued by a broader team of federal regulators. This group, including the Federal Reserve, the Federal Deposit Insurance Corporation, the Department of Housing and Urban Development and the Federal Housing Finance Agency, is developing rules to help manage lender risk, by making sure lenders and borrowers, respectively, have the right incentives to make and repay sound home loans.
One way to give borrowers “skin in the game,” as the saying goes, is to demand a significant down payment. Proposals have been floated for requirements of 10 percent or as much as 20 percent. The idea is that if borrowers have a fair amount of their own money invested, they’ll be less likely to walk away from a loan.
This will continue to be a contentious debate. I think we will see 3.5% down payment loans at the FHA basically forever. I also think we will continue to see down payments as low as 5% loans insured by the GSEs with private mortgage insurance. However, I also think the qualified residential mortgage rules yet to be announced will have a 20% down payment requirement to protect taxpayers and encourage a stable real estate market.
At least I hope so.
The Option ARM will go down in history as the biggest mistake in residential lending ever. The delinquency rates and resulting default losses will far exceed any other type of loan product because of its obvious instability. The former owner of today’s featured property took out a $464,000 Option ARM at the peak with a 1% teaser rate. He held on longer than most, but he too finally succumb to the toxic effects of this awful loan product.
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$394,900 …….. Asking Price
$342,000 ………. Purchase Price
12/18/2002 ………. Purchase Date
$52,900 ………. Gross Gain (Loss)
($31,592) ………… Commissions and Costs at 8%
$21,308 ………. Net Gain (Loss)
15.5% ………. Gross Percent Change
6.2% ………. Net Percent Change
1.4% ………… Annual Appreciation
Cost of Home Ownership
$394,900 …….. Asking Price
$13,822 ………… 3.5% Down FHA Financing
3.51% …………. Mortgage Interest Rate
30 ……………… Number of Years
$381,079 …….. Mortgage
$124,268 ………. Income Requirement
$1,713 ………… Monthly Mortgage Payment
$342 ………… Property Tax at 1.04%
$325 ………… Mello Roos & Special Taxes
$99 ………… Homeowners Insurance at 0.3%
$397 ………… Private Mortgage Insurance
$334 ………… Homeowners Association Fees
$3,210 ………. Monthly Cash Outlays
($324) ………. Tax Savings
($599) ………. Equity Hidden in Payment
$15 ………….. Lost Income to Down Payment
$69 ………….. Maintenance and Replacement Reserves
$2,372 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$5,449 ………… Furnishing and Move In at 1% + $1,500
$5,449 ………… Closing Costs at 1% + $1,500
$3,811 ………… Interest Points
$13,822 ………… Down Payment
$28,530 ………. Total Cash Costs
$36,300 ………. Emergency Cash Reserves
$64,830 ………. Total Savings Needed