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QM Cements the Sorry State of Mortgages for Years to Come

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Fourth in a series.

The Consumer Financial Protection Bureau's much anticipated final qualified mortgage rule confirms much of the pregame hype from industry observers. It effectively locks the mortgage market into the current state of underwriting conditions for years to come. 

Why? Because once lenders compare the $1,500 to $2,000 they make on an average loan to the penalties and legal costs associated with originating a loan outside the "safe harbor" provided by QM, they won't write any loans other than those that meet the QM standards.

The CFPB was dealt a difficult hand. It had to attempt to limit the damage to credit availability for a staggering housing market and at the same time eliminate much of the bad behavior of lenders during the boom in qualifying borrowers for homes that in many cases were unaffordable. Still, as in all regulation, there are winners and losers.

Pivotal to the determination of who wins and loses out of QM is the bright-line 43% debt-to-income standard.  While regulatory simplicity has its virtues, in this case heavy reliance on a 43% DTI ratio has a number of flaws and with it implications for the industry and borrowers. 

One problem is the rule only allows consideration of other compensating factors such as loan-to-value ratio and credit information in determining QM-eligibility by the government-sponsored enterprises and the Federal Housing Administration.  By imposing the 43% DTI limit, a 780 FICO score borrower with a 37% LTV and 44% DTI would be QM-ineligible if otherwise outside the GSE and FHA standards.  What makes this problematic is DTI is effectively the weakest link among the three C's of underwriting (credit, capacity and collateral).

Debt-to-income has for many years been one of the more notoriously difficult risk attributes to use in estimating borrower default. At best, DTI shows little correlation to default rates (compared to risk factors like FICO score or LTV) until the ratio reaches 45%. And the delineation of the 43% cutoff is curious as it doesn't exactly conform to GSE guidelines which are at 45%. 

One of the losers from this simplistic approach will be borrowers above that DTI cutoff who happen to live in relatively high-cost areas such as Oakland, Calif.  Simply because their loan requirement may be above the GSE loan limit (making it a jumbo loan), even if it otherwise meets the GSE underwriting guidelines, the borrower may not get the loan. 

If so, this could have negative repercussions on house prices and borrowers in a number of these markets.  Another group of potential losers are first-time homebuyers who have historically accounted for as much as 40% of the mortgage market but more recently have made up about 35%. 

With student loan debt reaching near-crisis levels, this increasing nonmortgage debt burden may shut out many new entrants to the mortgage market if it pushes their DTI over 43%.  For example, in the last few years, student loan debt as a percentage of household income for borrowers with incomes between $36,000 and $59,000 has hovered around 12%, according to the Pew Research Center.

Fannie Mae, Freddie Mac, the FHA and the Department of Veterans Affairs are big winners in QM, in the narrow sense that they are sure to retain their dominant market share. That's because there's a "temporary" second category of QM loans that allows slightly more flexible underwriting guidelines, provided the mortgages are eligible for sale to these agencies. I use air quotes around "temporary" because the period will last either seven years or until the GSE conservatorship ends, whichever comes first.

This concession to maintaining housing market stability by CFPB simply adds to the policy inertia surrounding the GSE issue and thereby postpones any real re-entry of private capital to the market. 

Finally, QM stifles financial innovation. Now, many will argue that financial innovation is exactly what got us into this mess in the first place. However, the fact that the QM rule is the mortgage underwriting equivalent of a Cyclops, looking only at product and capacity attributes, and ignoring other credit and collateral compensating factors, will maintain a chilling effect for any lender interested in developing flexible solutions for borrowers. 

The QM might not be the Mayan Apocalypse the industry feared, but it is unlikely to spark any enthusiastic response by originators.  If anything it winds up being an example of where poor industry practices lead to well-intended but suboptimal regulatory outcomes.  Overdependence on a seemingly arbitrary DTI ratio in determining what loans merit a safe harbor exacerbates our dependence on the GSEs and FHA while potentially harming a large swath of potential borrowers and severely handicapping the market's ability to effectively serve their customers with products and services tailored to their needs.

Next: Winding down the GSEs and alternative solutions.

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. 

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Comments (6)
Does anyone have a clue? Does anyone really think these new rules, regulations or whatever you want to call them are really going to fix anything? S@#t flows downhill folks and that is exactly what is happening here. I would guess most people at the CFPB can barely spell mortgage let alone understand all the nuances of the multitude of mortgage products available in the market. And we are going to rely on them to decide what's right for me? They don't even know me, but they know what's best for me financially. Right. I'm a big boy, I've educated myself to the world of mortgages and I don't need your assistance.

Do really want to help consumers? EDUCATE THEM!!!

Think about this; an 80 year old has to sit through an education process before getting a Reverse Mortgage, but Lunchbox Larry can walk into any bank and be served by a 20 year old "Banker" who has never even read a set of mortgage documents. Really? And you wonder why we have a problem. Its called idiocracy folks. We are becoming dumber and dumber by the generation.

Fix it from the bottom up people. Make the consumer smarter and you produce better results. Have the consumer rely on some idiot who is ONLY motivated by a paycheck and you, well you've seen the result.

This is simple stuff people.
Posted by Bill Westrom | Friday, January 11 2013 at 11:39AM ET
The new rules have taken away any chance of a responsible lender making loans for low priced "starter" homes. What lender would assume the risk now for a $25,000 home loan? (very common price in Kansas) The very people who need help on the low end of the economic scale have been completely pushed out of the market. It is really sad. The people we used loan money to in this group now must pay rent. The rent payments are twice what home ownership payments would have been. As far as "protecting" this group from vultures, they still can easily be taken advantaged at any auto dealership without receiving any good faith estimate or independent appraisal. The young, the old, and the poor are getting the regulatory shaft. Some deniers say these people could use government programs. That is not true as most low priced properties would not pass the government inspection and repairs could equal the purchase price.
Is this just sour grapes from a lender? Not in the least, we simply changed business models and now only make those loans to landlords.
Posted by bwyckoff | Friday, January 11 2013 at 11:55AM ET
I'm shocked, shocked I tell you, to hear the QM rules favor government GSEs. Dodd Frank's mis-diagnosis of the financial crisis could only lead farther down the path of a government run system, hardly by accident.
Posted by kvillani | Friday, January 11 2013 at 1:27PM ET
Remember, I believe that only 3 Republicans voted in favor of Dodd-Frank, Scott Brown, Olympia Snowe and Susan Collins. The QM rule is 800 pages and that is just one of these rules to "protect consumers" [maybe we should say "allocate credit"]. Why did they wait to release this rule until after the election and the fiscal cliff negotiations? Maybe because they knew that the implementation of Democrat policy by the CFPB would harm many of the very people who were so eager to vote in November.
Posted by jpodvin | Friday, January 11 2013 at 3:26PM ET
Remember, I believe that only 3 Republicans voted in favor of Dodd-Frank, Scott Brown, Olympia Snowe and Susan Collins. The QM rule is 800 pages and that is just one of these rules to "protect consumers" [maybe we should say "allocate credit"]. Why did they wait to release this rule until after the election and the fiscal cliff negotiations? Maybe because they knew that the implementation of Democrat policy by the CFPB would harm many of the very people who were so eager to vote in November.
Posted by jpodvin | Friday, January 11 2013 at 3:27PM ET
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