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.