6 questions on the CFPB plan to end Fannie and Freddie’s ‘patch’

WASHINGTON — The Consumer Financial Protection Bureau caught many in the mortgage industry off guard Thursday when the agency said it will retire a policy that gives Fannie Mae and Freddie Mac a competitive advantage in complying with underwriting rules.

The CFPB's ability-to-repay rule includes a class of loans known as "qualified mortgages" that automatically meet underwriting criteria in light of certain features, such as a 43% debt-to-income limit. But the government-sponsored enterprises have been exempt from that stipulation since 2014; all Fannie- and Freddie-backed loans are QM.

But changes are on the horizon. The CFPB asked for public comment Thursday on possible changes to the QM rule. They include whether the agency will adjust the DTI limit. Any such proposal would have to be subject to more public comment before a new rule is finalized.

Yet one thing is for sure. Even though the GSEs' exemption — now slated for January 2021 — may get temporary extensions, the CFPB is set on eventually letting it expire.

Because of the exemption, known as the GSE QM "patch," nearly one-third of GSE-backed loans exceed 43% DTI but are still compliant. Letting the patch expire therefore raises questions about the future of a large chunk of the GSEs' business, just as the Trump administration prepares to unveil a plan on how to release the two companies from conservatorship.

Here are six key questions about the future of qualified mortgages and the GSE patch.

Fannie Mae's headquarters

What impact will ending the patch have on the GSE-backed market?

There is no doubt that the CFPB's announcement could have a huge impact on Fannie and Freddie's current domination of the market. Yet the agency's intention to eliminate the GSE patch is only one half of the story.

On the face of it, ending the patch means the GSE-backed loans with DTI ratios above 43% are suddenly noncompliant with QM, and lenders originating Fannie and Freddie loans suddenly have to overhaul underwriting.

But the CFPB also asked for public comment on whether, in the QM rule, the DTI limit should be adjusted for the entire mortgage market. If the limit is raised, it could potentially preserve the GSEs' compliance while still removing their competitive advantage.

“The goal here is to get a version of the patch [so that] QM covers a significant percentage of the borrowers that are currently served, but applies to the market entirely,” said Pete Mills, the senior vice president of residential policy at the Mortgage Bankers Association.

The agency also floated the idea of moving away from DTI or considering other factors to assess a borrower’s ability to repay, such as residual income, which could support some of the loans that now rely on the patch.

Others have argued for a lower DTI limit across the board.

With interest rates falling, homebuyers may not need as much leverage because monthly mortgage payments are going down, said Ed Pinto, a resident fellow at the American Enterprise Institute’s Center on Housing Markets and Finance.

“If I were writing the rule from scratch, I’m not sure I’d use 43%, I might use a lower number,” Pinto said. “But if you’re going to have a DTI requirement, you’d leave it at that, at 43%.”

To really address rising share of loans with higher DTI ratios, the government needs to do more to address the lack of affordable housing that have priced lower-income families out of the housing market, said Michael Bright, the CEO of the Structured Finance Association.

“The patch is acting as a Band-Aid over a much deeper issue that we have in this country, which is that incomes are going up much more slowly than home prices,” he said.

Yet the CFPB also signaled willingness to implement short extensions of the patch beyond the January 2021 deadline while the agency works on the QM rule.

“We are amenable to what a transition would look like,” CFPB Director Kathy Kraninger said Thursday.

Data shows that lenders have started to pull back on originating high DTI loans, perhaps in anticipation of the patch expiring in roughly 17 months, Pinto said.

Loans with debt-to-income ratios above 43% that were sold to Fannie peaked in December at 31.5%, but dipped to 27.1% in April, Pinto said. For FHA purchase loans, 61% had DTIs above 43%, which also peaked in December, but dropped to 57% in April, he said.

"The industry is going to have to take this for what it is — the patch is going to expire and we don’t know if anything will take its place, or the 43% DTI becomes the rule," Pinto said.
FHFA Director Mark Calabria
Mark Calabria, director of financial regulation studies with the Cato Institute, speaks during a Senate Banking Committee hearing with Richard Smith, chief executive officer of Realogy Corp., left, in Washington, D.C., U.S., on Wednesday, Sept. 14, 2011. The committee discussed new ideas for refinancing and restructuring mortgage loans. Photographer: Andrew Harrer/Bloomberg *** Local Caption *** Richard Smith; Mark Calabria

How much of the market consists of mortgages covered by the GSE patch?

Although an estimated one-third of GSE-backed loans exceed the 43% limit and take advantage of the exemption, Federal Housing Finance Agency Director Mark Calabria pushed back on those numbers Thursday, calling them “static estimates” and “unrealistic worst-case scenarios.”

Resolving the debate over how many high-DTI loans exist in the GSE-backed market is important in light of the administration’s work on a plan to reform the GSEs, which would likely include efforts to recapitalize them, Jaret Seiberg, an analyst with Cowen Washington Research Group, said in a note.

“In our view, the market will want to better understand the ramifications of ending the QM patch on Fannie and Freddie before they commit upwards of a $100 billion to recapitalizing them,” he said.
FHFA headquarters in Washington, D.C.
The seal of the Federal Housing Finance Agency (FHFA) is displayed outside the organization's headquarters in Washington, D.C., U.S., on Wednesday, March 20, 2019. President Donald Trump's pick to lead Fannie Mae and Freddie Macs regulator pledged to work with Congress on overhauling the companies, while downplaying controversial positions he's previously laid out on everything from the 30-year-mortgage to affordable housing initiatives. Photographer: Andrew Harrer/Bloomberg

What role will this play in GSE reform?

Calabria called the CFPB’s move away from the QM patch a “critical component of moving toward a competitive mortgage finance system” that would ensure the GSEs lose special privileges as the government embarks on housing finance reform.

A key of any reform plan likely involves strengthening Fannie and Freddie's capital position should they be privatized. Yet some analysts point out that removing the QM patch equates to lower revenue and profit at the two mortgage companies.

Calabria has reiterated that one of his primary goals is to build healthy levels of capital at the GSEs, which could include allowing Fannie and Freddie to retain earnings.

“We believe the plan to let the QM patch expire is a complication for the recap and release of Fannie and Freddie as the patch encourages lenders to sell more loans to the enterprises,” Seiberg, the Cowen analyst, wrote. “This may make it more difficult to predict GSE revenue in a post-patch environment.”

Ed Mills, a policy analyst at Raymond James, agreed: While clarity on the future of the patch is necessary for a recap and release plan to work, this path forward could make the end goal less attainable, Mills said in a note.

“The shrink of GSE market share, while potentially reducing some of the credit risk of the GSEs, could also reduce profitability,” he said.
Brian Montgomery
Federal Housing Commissioner and Assistant Secretary, U.S. Department of Housing and Urban Development Brian Montgomery, speaks during a hearing of the Senate Banking, Housing, and Urban Affairs Committee examining regulatory response to the current economic crisis, on Capitol Hill in Washington DC, Thursday, October 23, 2008. Photographer: Chris Kleponis/ Bloomberg News

Will FHA take over some of the GSEs' market share?

In its notice, the CFPB posited that eliminating the GSE patch could result in the Federal Housing Administration backing more loans with high debt-to-income ratios. Currently, the FHA guarantees mortgages with DTIs of up to 57%.

“The number of loans that move to FHA would depend in the first instance on FHA’s willingness and ability to guarantee such loans, whether FHA continues to treat all loans that it guarantees as QMs under its own QM rule, and on how many High-DTI GSE loans exceed FHA’s loan-amount limit,” the consumer bureau said.

But the FHA has increasingly sounded the alarm about the growth of higher-risk loans on its balance sheet.

In March, the government mortgage insurer implemented a policy that requires mortgages that exceed a DTI of 43% and have a credit score under 620 to be manually underwritten.

In the 2018 fiscal year, almost a quarter of the FHA’s purchase business consisted of mortgages where a borrower had a DTI ratio of above 50%, which is the highest level since 2000, according to FHA Commissioner Brian Montgomery.

It remains to be seen if FHA would be eager to assume more loans with high DTIs, just as they are expressing concern about their share of those loans trending upward.

“The CFPB expects most of the lower-FICO, high-LTV loans currently covered under the Patch would likely move to the FHA,” analysts from Keefe, Bruyette & Woods said in a note. “This is another reason [analysts] think a full elimination of the GSE Patch is unlikely.”

With a number of factors driving the volume at FHA, adding more loans with higher DTIs would be concerning, Bright of the Structured Finance Association said.

“I don't think FHA as the safety net solution is what I would advocate for,” he said.
CFPB headquarters
Signage is displayed inside the Consumer Financial Protection Bureau (CFPB) headquarters in Washington, D.C., U.S., on Monday, March 4, 2019. House Financial Services Committee Chair Maxine Waters will hold a hearing this week on the semi-annual review of the CFPB. Photographer: Andrew Harrer/Bloomberg

Will the CFPB reform income documentation standards?

Beyond changing the DTI limit for QM loans, the CFPB also asked for comment on how lenders document a borrower's finances.

Under the QM rule, lenders must document a borrower’s income, assets, savings and debt using eight criteria known as Appendix Q. The standards in Appendix Q, adapted from the FHA, are used to determine if a consumer’s DTI.

Technically, the QM rule itself has been muted because of the seven-year exemption for loans backed by Fannie and Freddie.

Since the QM rule went into effect in 2014, mortgage lenders have lobbied the CFPB to change — if not eliminate entirely — Appendix Q, which could have a huge impact on credit availability. They claim the criteria are too restrictive, resulting in some self-employed borrowers, small business owners, and borrowers with assets but no income being unable to qualify for a QM loan.

“Appendix Q has been very difficult to use in certain situations, including for consumers that have changed jobs and self-employed borrowers who are harder to qualify if they have rental income or seasonal employment,” said Richard Horn, managing member at the law firm Garris Horn and a former senior counsel and special adviser at the CFPB.

The CFPB’s proposal could potentially increase access to credit if Appendix Q is modified.

Where is the private market?

Lost in the discussion is that regulators always intended for some segment of the market to operate outside of QM.

But non-QM loans have only recently gained traction and remain a very small piece of the roughly $1.2 trillion mortgage market. Before 2008, loans with certain features have essentially been banned, including ballooning teaser rates and no-documentation or stated-income loans.

Calabria has stated that a core reason for eliminating the patch is to transition or jump-start the private market to originate standard QM or non-QM loans without government backing.

“If you look at the big picture of trying to reform the GSEs and foster private securitizations that means trying to reduce the market share of the GSEs,” Horn said. “Having that safe harbor for them in the QM rule is a hurdle to that objective.”

When the CFPB issued the original rule in 2013, it created the patch with the understanding that “the market would shift toward general QM loans and non-QM loans above a 43% DTI ratio,” and that “the continued prevalence of temporary GSE QM loan originations is contrary to the bureau’s expectation."

Kraninger said the bureau does not intend to make the patch permanent because doing so would be inconsistent with the ability-to-repay provisions under the Truth in Lending Act, which is the basis for the QM rule.