When Governor Romney brought up the seemingly obscure issue of "qualified mortgages" during the first presidential debate, it underscored the importance of this forthcoming regulatory definition.
The Dodd-Frank Act's provisions for QMs and Qualified Residential Mortgages attempt to force a nice, neat public policy solution on the market to address a multitude of sins committed during the housing boom. But as we approach the Jan. 21 deadline for a definition of QM, pinning down a set of attributes increasingly looks harder than perhaps the drafters of Dodd-Frank envisioned.
The CFPB is in the awkward position of having to make a tradeoff between protecting consumers from contemptible lending practices and limiting their availability to mortgage credit. In the end, with regulators' hands tied by legislation, whatever the CFPB decides to do is likely to be a suboptimal solution for the mortgage industry.
The QM provisions attempt to ensure that borrowers are not put into homes they cannot afford by offering some measure of legal protection to lenders that properly assess the ability to repay. The mortgage industry has been squarely behind establishing a rule providing a high degree of legal protection in the form of a safe harbor from being sued if a loan meets the QM standards. But if those standards are set too narrowly, the fear is that mortgage credit will be artificially restricted.
This critical public policy dilemma hinges on defining what is meant by a borrower's ability to repay the mortgage obligation. According to some press reports, a bright-line maximum debt-to-income ratio of 43% seems to be favored as one of several criteria prescribed by Dodd-Frank in setting the ability-to-repay standard. According to Federal Housing Finance Agency data, about 85% of borrowers in 2010 and 2011 would meet this standard, thus providing a broad definition to the market. But applying a few rules such as a maximum DTI to define QM would oversimplify the underwriting assessment of borrower capacity to repay the obligation and in may be policy overkill.
Among other considerations, to meet the definition of QM, lenders must document a borrower's income. In fully documenting a loan, if a lender has strong processes and controls in its underwriting department to verify income, employment and assets, a determination of a borrower's ability to repay should not be a problem. After all, lenders had been doing just that for decades leading up to the boom, using industry standard debt-to-income ratios of 28% for housing debt alone and 36% for all debts, among several underwriting tests.
Without a safe harbor, the argument goes, lending may be restricted if the contingent legal liability isn't substantially reduced. Yet the industry didn't need a safe harbor before for there to be an adequate, or in the case of the boom years, excessive amount of credit to be available. Low and no-doc loan programs defaulted at multiples above fully documented loans, controlling for other risk factors, and have been a major focus for repurchase litigation activities due to the lack of attention to proper underwriting of the loan. In other words, requiring a lender to fully document a borrower's income reduces the industry's repurchase risk.
In the two years since the enactment of Dodd-Frank, the very existence of a QM rule has introduced unnecessary uncertainty into mortgage markets when a return to prudent underwriting standards by the industry significantly addresses the ability-to-repay issues that surfaced during the housing bust. In fact, through regulatory edict, fear or other motivations, mortgage lending standards have returned to plain-vanilla underwriting.