QM Rule Puts Too Much Trust in Fannie, Freddie

Lenders be nimble, lenders be quick, lenders watch out for that regulatory stick.

For months mortgage lenders and banks of all sizes were watching and waiting for the Consumer Financial Protection Bureau to issue its qualified mortgage rule, one of the anticipated regulations that will shape the mortgage market for years to come.

Lenders had become anxious that the CFPB, an unusually independent and powerful agency, would further restrict credit in its zeal to protect consumers from mortgages they can't afford. Adding to this uncertainty were policy analysts in Washington who commented that lenders must be prepared for more ad hoc interventions in the mortgage market by regulators rather than a more predictable rules-based response to the housing crisis.

Yet, the unveiled qualified mortgage rule was anything but unpredictable as it left mortgage lending much like it is today: highly leveraged, tightly underwritten and dependent on Fannie Mae, Freddie Mac and the Federal Housing Administration's underwriting systems for sanctioning what is to be a qualified mortgage. Fannie Mae, Freddie Mac and FHA were not exactly pillars of low-risk underwriting during the years leading up to the bursting of the real estate bubble.

Be prepared for a new twist in regulatory risk, including underwriting and credit risk, encompassed in the CFPB rule. Note that a qualified mortgage sanctioned by the GSEs is not automatically a mortgage with low ability-to-repay risks.

The Dodd-Frank Act, which led to the creation of the CFPB, is intended to promote stability in the financial and mortgage markets through better accountability and transparency in order to protect consumers from abusive lending practices. The qualified mortgage rule results from provisions in Dodd-Frank for establishing minimum mortgage standards, or essentially what ingredients constitute a prime loan.

Edward Pinto, former Fannie Mae chief credit officer, points out that the qualified mortgage "is being touted as making sure ‘prime loans' will be made responsibly." He adds, "Yet true to the government's long history of promoting excessive leverage, it sets no minimum down payment, no minimum standard for credit worthiness and no maximum debt-to-income ratio."

Under the rule's definition of a qualified prime loan, Pinto argues, "a borrower can have no down payment, a credit score of 580 and a debt ratio over 50% as long as long as approved by a government-sanctioned underwriting system." 

As Yogi Berra would say, could this be "déjà vu all over again?"

Credit remains extremely tight today, especially for borrowers desperately wanting to buy an affordable home with a couple of dings on their credit.  What would happen should Congress decide to lean on the GSEs to loosen underwriting standards in a few years? Under the new rule, if a mortgage makes it through their automated underwriting systems, it's qualified.

Now more than ever competent risk management is requisite. In fact, banks and lenders could run the risk of becoming complacent, thinking that qualified mortgages will reduce their credit and underwriting risks. However, the CFPB rule uses the interest rate charged to determine whether a loan is prime or subprime and not the associated underwriting, credit and repayment risk of the loan.

For example, the qualified mortgage rule adopts the FHA's approach in not pricing a loan for risk. A qualified mortgage can have an interest rate, which qualifies under the rule, but also contain excessive leverage based on a high loan-to-value ratio. The rule does not address such risk. Remember, excessive leverage fueled the housing bubble.