From a policy perspective, achieving a sensible balance between the two errors should be a clear objective of any underwriting bright-line standard. We may have missed the opportunity to apply such an approach to QM's debt-to-income test, but the QRM loan-to-value threshold could be set while comparing the costs of both Type 1 and Type 2 errors. Figuring the costs from Type 2 errors is somewhat easier since it entails determining the credit losses under differential LTV rules. The trickier part of the exercise would be in computing the economic and social costs of any Type 1 errors under different LTV thresholds, but economists are well equipped to make such estimates. Once the costs associated with both error types are quantified along LTV scenarios, regulators could then determine at what LTV threshold the costs of both errors are minimized.
Certainly there is an element of judgment even in this process. But standards that fail to balance the costs of both types of policy errors lead to suboptimal policy.
Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.
