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The Real Threat to Mortgage Lending

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Reporters for this newspaper recently fired the starting gun for another exciting round of regulatory competition, when they showed that miscreant mortgage servicers will pay out far more to "consultants"—for searching mortgage files to find defective foreclosures—than they are slated to pay to supposed victims of such foreclosures.  (How can anyone be a victim, when he got to live for three years in a nicer house, paying little or nothing and very likely getting cash off the top?)

This round of the competition was a sprint, won handily by the Fed with its inspired response of "No Comment."  What that lacks in originality, it more than makes up for in aptness of thought.

The loser was the OCC, which said it didn't care how much the servicers had to pay the consultants.  (We're told this will total many hundreds of millions or maybe a billion dollars.) Their answer shows remarkable lack of common sense and public relations savvy.  Still, give it points for sincerity.

The simple mind might suspect that these "consultants" are paid prodigiously to wink and nod, but numbers prove the contrary. No surviving bank could be stupid enough to pay big fees to avoid arbitrarily small restitution payouts.

No, the most important implication, which should again be spotlighted, is that the typical mortgage application or servicing file is lengthy, complex, non-standard and larded with pot holes and speed bumps that invite skepticism and further inquiry.

Without such density of detail, how could you get any new or modified loan's annual loss expectation down to 0.2%, typical of prime mortgages? The only assurance of quality when mortgages are sold is risk retention by the originator—which is exactly what the industry detests and is most determined to avoid, even at a 5% level.  

We've now seen the worst in bad mortgages. But although mortgage-related fines, settlements and legal costs sound huge, few if any institutions were bankrupted or lost a substantial fraction of their value as punishment for unsound mortgage production or servicing. Our departed brethren, including Countrywide, New Century and GMAC, sank because ultimately they sucked in bad mortgages faster than they could sell them.  Not because a court or a regulator held their feet to the fire for their frauds.    

Nevertheless we are insistently told that originators and securitizers won't give us another golden flood of private securitizations until they receive protection against potential legal liabilities, while avoiding retention of credit risk. At least for mortgages that they can claim attain specified debt-to-income and/or loan-to-value measures. Thus, the New Age QM's and QRM's. 

Presumably, support for this counterintuitive and counter-to-experience proposition is magnetized by the widely shared desire for more mortgage production. But investors will lap up this new paper without needing government guarantees and government-supported purchases.

After all, it was the private market, not the GSEs, that specialized in junk mortgages that could never pass as QM's. It was the supposedly high-quality "conforming" mortgages, similar to those that would in future be QM's and QRM's, that went to or through the GSEs – causing additional massive losses. The private market couldn't compete with subsidized GSEs for these safer but still high-risk mortgages.

So, why deprive consumers or investors of basic protections against hawkers of fraudulent but allegedly high-quality mortgages? Without subsidized GSE competition, such mortgages could obviously be securitized. Legal liability would only be a very minor cost, in part because of the inefficiency and unpredictability of our court system, resulting in long-delayed settlements at 10% of claims value.

Fleeing risk retention, seeking legal immunity for frauds, originators turn their backs on a more substantial threat: the disparate impact doctrine, strongly promoted by Consumer Financial Protection Bureau Director Richard Cordray, among others. This doctrine says that if a lender rejects or proposes less advantageous terms to a higher percentage of some protected group (African-Americans, women, Hispanics) than of unprotected applicants, it's assumed to be guilty of discrimination even if lacking intent to discriminate—as in the recent Luther Burbank case. But, protected minorities have lower income than other people.  More of the lower-income people will inevitably be declined or get worse terms. 

Every mortgage lender will consequently expose itself to disparate impact.  Lenders have seen an opportunity to gain legal and regulatory advantage from widespread support for more mortgage production and homebuilding with less taxpayer exposure to losses.

Maybe instead of foolishly trying to exploit this support to gain impunity for more fraud, they should aim their lobbying effort on attacking the odious and unfair disparate impact doctrine.   

Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.

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Comments (4)
Well thought out and well put!
Posted by frankarauscher | Tuesday, November 20 2012 at 2:57PM ET
So originators should be required to retain risk, as they do with covered bonds. And "disparate impact" is a credit allocation tool that was used in the sub-prime lending crisis. Dodd-Frank was enacted six months prior to the FCIC Report, not that it wouldn't confirn the need for a regulatory morass.
Posted by kvillani | Tuesday, November 20 2012 at 4:12PM ET
I don't think avoiding credit and legal risks are the principal issues relating to QM. The main reason mortgage originators need a clear definition of a QM is to avoid the hold back provisions in the Dodd Frank Act. A QM can be sold in its entirety into the secondary market while the originator of a non QM mortgage has to retain a 5% interest. Most mortgage brokers don't have the capital to retain 5% of the loans they originate and most banks will not take the rate risk or tie up much of their capital with long term fixed rate and historically low rate loans. Since the passage of Dodd Frank lenders will only originate QMs. The contraction in housing finance is worse than it needs to be because the lack of a QM definition has caused most lenders to only make loans they know will qualify as a QM when the definition is finally provided. That, in turn, has unnecessarily prolonged the recovery of the housing markets. Because of the lethal effect of the hold back requirements, the QM definition is critically important because it will largely define the scope of housing finance in the future, and it is critically needed now to unfreeze the housing markets to the extent that is currently possible.
Posted by gsutton | Tuesday, November 20 2012 at 4:37PM ET
I believe it's the Qualified Residential Mortgage (QRM) that deals with risk retention. The Qualified Mortgage rule (no "r") pertains to all home mortgages, regardless of whether sold or held in portfolio by the lender, and concerns a lender's liability for failure to assess the borrower's ability to repay. The drafters of Dodd-Frank showed little imagination in naming these two categories, and their handiwork will be confusing us all for decades to come.
Posted by Marc Hochstein, Executive Editor, American Banker | Tuesday, November 20 2012 at 5:00PM ET
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