Regulators capitulate to lending industry lobbyists
Aligning two sets of mortgage rules established for different purposes, regulators provide room for lenders to make bad loans without risk retention.
In a complete victory for lending industry lobbyists, the Qualified Residential Mortgage rules match the Qualified Mortgage rules. The Dodd-Frank law was designed to have two levels of defense against lenders underwriting bad mortgages. The broader Qualified Mortgage rules were designed to protect the banking system, and they provide considerable leeway for lenders to make bad loans. The Qualified Residential Mortgage rules were supposed to restrict lending within the QM framework to prevent lenders from making bad loans allowed within QM. By making these two rules match, regulatory agencies failed to comply with the intent of the legislation and set up a system where lenders have too much latitude to make bad loans.
The Dodd-Frank financial reform law required bureaucrats to draft rules for Qualified Residential Mortgages. Loans that conform to the standards defined can be sold into the secondary mortgage market without restriction. Loans that do not conform require the lender to retain 5% of the capital risk on their own balance sheet. Fortunately, this is not the only protection in the system preventing lenders from originating bad loans and passing the risk off to others. All securitized mortgages have put-back provisions that allow the servicers to force the originating lender to buy back the loan if the borrower defaults. However, for a loan to be put-back to the lender, there must be defects in underwriting, and if the underwriting standards are lax on their face, the put-back provisions alone don’t provide a check-and-balance against the relentless pressure to lower standards to increase loan origination profits.
The qualified mortgage standards are necessary to provide a barrier against excessive risk taking in the secondary mortgage market. If buyers of mortgage-backed securities lose their minds and start buying the same toxic garbage they coveted during the housing bubble, they must find an originating lender willing to underwrite that garbage and retain 5% of it on their own balance sheet. This serves as an extra safeguard in the system, and it’s intended to prevent future housing bubbles.
Soon after the housing bust, federal regulators working on repairing the mortgage market thought it was sound policy to have borrowers make sizable down payments on their new homes.
Reform was about far more than down payments. The worst loan programs of the housing bubble had teaser rates and amortization schedules with severe future payment shock. These loans proliferated because originating lenders didn’t have to retain any risk, so the Dodd-Frank law forces any lender who makes a loan outside the conforming boundaries of a qualified mortgage retain 5% of the risk on their balance sheet.
On Tuesday, the regulators completed that overhaul, but they left out any requirement for borrowers to make a down payment. The new regulations aim to strengthen the vast market for bonds that are backed with mortgages and other loans. The market is not back on its feet, despite low interest rates. But the regulators said that the new rules could set the stage for more lending.
“Finalizing this rule represents a major step forward to providing greater certainty to the housing finance market and paves the way for increased participation by the private sector,” said Melvin L. Watt, director of the Federal Housing Finance Agency, one of the regulators that adopted the rule. “Lenders have wanted and needed to know what the new rules of the road are and this rule defines them.”
The regulators left out the down payment requirement after a firestorm of criticism from bankers and consumer advocates. They asserted that such a measure could restrain the flow of housing credit, particularly to borrowers who would have to save for many years to afford a down payment.
This was an unusual alignment of interests between left and right. On the left, housing advocates wanted to eliminate barriers to the poor and minorities to temporarily possessing real estate prior to foreclosure, a condition they equate with home ownership. On the right, financial interests want to originate the broadest spectrum of loans possible and pass the risk on to hapless investors. Only the bureaucrats seemed intent on preserving the banking and economic systems and make home ownership sustainable, so they got steamrolled by the unholy alliance of political interests aligned against them.
But some financial experts are disappointed with the new rules. They contend that, over time, the exclusion of a down payment requirement could once again allow banks to stoke dangerous risks in the financial system — and then evade the pain when the losses pile up.
“This is unfortunate,” said Sheila C. Bair, former chairwoman of the Federal Deposit Insurance Corporation, another of the regulators that approved the so-called risk retention rules on Tuesday. “If the loan goes bad, you have much bigger losses with zero percent down than 20 percent down.”
In July of 2013 I lamented that Legislators failed to implement down payment requirements because the fact is that Large down payments provide stability to the housing market. But how large is large?
Studies have shown that a 20% down payment has significantly lower delinquency rates than mortgages with lower down payments. But why is that? Mostly, it’s due to “skin in the game.” People who’ve put down large down payments rarely default. In purely economics terms, people shouldn’t consider sunk costs like down payments in their decision making. However, homeowners do. People simply don’t walk away from properties where they’ve put a lot down, even if they’re deeply underwater. The decision is more emotional than logical, but coupled with the emotional desire to “own” these two forces prevent most people from strategic default even when that option is the best available to them.
There is no way to accurately measure how much skin in the game motivates people to stay and pay. Everyone knows it’s important, but with no way to accurately gauge how much is required, the forces demanding little or no down payment are winning — and for good reason — New down payment requirements could crash housing again. Unfortunately, completely eliminating down payment requirements leaves us with borrowers putting no skin in the game, and quite frankly, that’s a horrible idea.
Right now, the only low down payment mortgages that banks are making have government backing. The risk retention overhaul approved on Tuesday is intended to revive the market for home loans that do not have a government guarantee.
And the mortgage market over all is probably going to be dominated by down payment loans for the foreseeable future. Fannie Mae and Freddie Mac, for instance, guarantee about half of all mortgages that lenders make — and those two government entities typically require down payments of around 20 percent. And, currently, the mortgages that do not have government backing are nearly all to wealthy individuals, who usually make big down payments.
The aim is for taxpayers to step back from providing so much support to the mortgage market in the future. For that to happen, private investors need to buy a lot more nongovernment mortgages than they do now. The big question, however, is whether private investors will tolerate loans with low down payments. “It will really be up to the investors,” Ms. Bair said, “If they want better lending standards, it is up to them.”
During the housing bubble, ratings agencies were captured by syndicators, so these agencies often gave AAA ratings to terrible loan pools. That particular problem was resolved through regulation (I hope), so lazy investors who rely on ratings agencies shouldn’t be as likely to be duped into buying bad securities; however, allowing lenders to pass bad loans into these pools creates an additional due-diligence burden on investors that will drive up investment costs in these securities.
The group released a second proposal in 2013, removing some of the more contentious provisions—in particular, a requirement that banks must retain risk on mortgages with down payments lower than 20 percent—in response to industry concerns.
The finalized rule is more closely aligned with the Consumer Financial Protection Bureau’s (CFPB) qualified mortgage (QM) rule implemented early this year. Both rules exclude from qualification mortgages with debt-to-income ratios exceeding 43 percent, and both prohibit loans with riskier features like balloon payments or terms longer than 30 years. …
In addition to the risk retention restrictions of the Qualified Mortgage rules, the ability-to-repay rules provide borrowers recourse against lenders who put them into bad loans.
“Aligning the Qualified Residential Mortgage standard with the existing Qualified Mortgage definition also means more clarity for lenders and encourages safe and sound lending to creditworthy borrowers,” FHFA Director Mel Watt said. “Lenders have wanted and needed to know what the new rules of the road are and this rule defines them.”
The rules would have been equally clear whether they matched the Qualified Mortgage rules or not. This statement is political spin and nonsense.
Comptroller of the Currency Thomas J. Curry said securitizations can provide an incentive for lax underwriting if the weak credits can be transferred from originators to investors with no further responsibility for the loans.
“The rule we are approving today will require lenders to retain some of the risk for the loans that go into securitized pools except for home mortgages that meet the standards necessary under the qualified residential mortgage, or QRM, exception,” Curry said. “Under this rule, QRM is equivalent to QM – that is, the Qualified Mortgage rule approved by the Consumer Financial Protection Bureau.”
Industry groups were also optimistic about Tuesday’s announcement, praising policymakers’ efforts to avoid confusion by lining up QM and QRM together.
To avoid confusion? These rules would be confusing no matter how they are drawn up. Aligning them with the QM rules avoids restrictions, which is what they really want.
“This rule was required by Dodd-Frank to ensure that loans sold into the secondary market are properly underwritten, a goal which the QM rule also helps to ensure. It is appropriate and good policy to align the two,” said Frank Keating, president and CEO of the American Bankers Association.
No, it is not appropriate, and it is against the intent of the legislation; however, it’s not surprising to see the CEO of the American Bankers Association say otherwise because he is an industry shill.
“This will encourage lenders to continue offering carefully underwritten QM loans, and avoid placing further hurdles before qualified borrowers, allowing them to achieve the American dream of homeownership.”
This will encourage lenders to offer bad loans within the QM rules if they can pass the risk of loss on to inventors. As Ms. Bair pointed out, it’s up to the investors now to police themselves, and we saw how well that turned out last time.