Will CFPB's QM proposal create new housing bubble?

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The Consumer Financial Protection Bureau's proposed overhaul of its mortgage underwriting rule is alarming critics who say it will lead to another housing bubble. One commentator even claims the plan will violate fair-lending laws.

The agency in June proposed using a pricing threshold, instead of the current debt-to-income limit, to determine which loans are Qualified Mortgages and therefore safe from liability. Lenders have argued the current 43% DTI limit is too restrictive. The new plan would award QM status to loans capped at 150 basis points above the prime rate.

But free-market advocates and others worry the new QM standard will flood the market with unaffordable loans and boost defaults in a repeat of 2008.

“The use of the [average prime offer rate] margin may destabilize mortgage markets and lead to episodes of increased delinquency similar to the financial crisis,” said Susan Wachter, a professor of finance and real estate at the University of Pennsylvania’s Wharton School.

Ed Pinto, a resident fellow and director of the American Enterprise Institute’s Housing Center, who has long advocated for conservative housing policies, has gone a step further. He has urged the CFPB to refer its proposal to the Department of Housing and Urban Development, which can investigate potential violations of the Fair Housing Act.

In a recent complaint letter to CFPB Director Kathy Kraninger, Pinto said the proposed APOR pricing threshold is consistent with higher delinquencies for Black and Hispanic borrowers compared to white borrowers.

“Once you take away the DTI requirement even more minorities will end up with even higher delinquencies compared to nonminorities and therefore, the proposed rule has a discriminatory effect,” Pinto, a former chief credit officer at Fannie Mae, said in an interview.

It can be hard to determine if someone is going to default or go delinquent until a stress event triggers a job loss or other financial problems. The coronavirus pandemic provided the stress that Pinto needed to analyze whether delinquency rates would disproportionately harm minority borrowers.

Using Home Mortgage Disclosure Act data, Pinto found that as of July 2020, delinquency rates for loans originated in 2018 and 2019 to Black and Hispanic borrowers were 14.2% at 100 basis points above APOR and 16.7% at 150 basis points. By comparison, the delinquency rates for white borrowers were 9.4% and 11.4%, respectively.

"The facts relating to the CFPB's rule-making practices indicate a pattern or practice of discrimination in violation of the Fair Housing Act," Pinto wrote in the letter.

But it is not clear whether the CFPB will forward Pinto's complaint to HUD, and some observers question the linkage between the APOR threshold and fair-lending rules.

A recent paper by the Urban Institute acknowledges that higher loan pricing leads to more delinquencies, but that is regardless of a borrower's demographic characteristics.

"Our analysis found all measures of default to be highly correlated with rate spreads," Laurie Goodman, a vice president co-director of the Urban Institute’s Housing Finance Policy, wrote in the paper.

Dave Stevens, the CEO of Mountain Lake Consulting and a former commissioner of the Federal Housing Administration, was more explicit.

"I don’t think [Pinto's] view holds water," Stevens said. "Ed is on a mission to knee-cap [Fannie Mae and Freddie Mac] and he’s been using this distorted view that government programs harm minorities."

When Congress passed the Dodd-Frank Act after the financial crisis, it created a category of ultrasafe QM loans that gave legal protection to lenders. Dodd-Frank requires that lenders verify a borrower's ability to repay a mortgage and also eliminated most risky loan features such as teaser rates and balloon payments.

Kraninger released a QM proposal in June to replace the hard 43% DTI ratio — the core underwriting requirement when the rule was issued in 2013 by then-CFPB Director Richard Cordray, an Obama appointee — with the pricing metric that mortgage industry and consumer advocates both support.

Under the proposal, lenders that originate loans with rate spreads no higher than 150 basis points above APOR for a comparable transaction would receive a so-called safe harbor against claims that a lender failed to comply with the ability-to-repay standard. The APOR rate spread is the difference between a loan's annual percentage rate and the average prime offer rate, as reported by federal regulators.

But Pinto, who has long been an opponent of easing credit through low-down-payment mortgages and higher debt-to-income ratios, thinks allowing borrowers to pile on more debt when the housing market has so little inventory has the effect of driving up home prices.

"This will hurt protected-class borrowers because it allows riskier loans to be made," Pinto said. "If you have a shortage of housing and you increase leverage, which is what APOR + 150 will do, that means you are going to make riskier loans. But if you haven’t done anything to expand the housing supply, all you end up doing is having everybody outbid each other using leverage, which will raise housing prices even more."

Still, many others think the CFPB's proposed QM rule is a step in the right direction because it aims to reduce the government's outsized role in the housing market.

"What the CFPB proposed, while not perfect, is really the only workable solution to make sure we have a system that doesn’t unnecessarily handicap banks and credit unions," said Stevens.

The bureau is facing significant pressure to replace the current 43% debt-to-income limit with a different method for determining QM.

The original CFPB rule provided a temporary exemption to the government-sponsored enterprises, known as the GSE patch, that allowed Fannie and Freddie to purchase loans with DTI ratios above 43%.

Banks and mortgage lenders have lobbied heavily to eliminate any DTI requirement, claiming the 43% cutoff would capsize the housing market. In a rare alignment of interests, consumer advocates agreed with lenders because many minorities with high debt loads would be shut out of the market if nothing is done when the GSE patch expires.

In the six years since the QM rule was finalized, the GSEs have come to dominate the mortgage market. Banks and lenders sold Fannie and Freddie roughly 957,000 loans with DTI ratios above 43%. If the patch expires without anything to replace it, lenders claim anywhere from 15% to 20% of borrowers would be prevented from getting a loan.

The CFPB also has proposed higher price thresholds for smaller loans that the bureau said are particularly important for manufactured housing and minority consumers.

But some experts agree with Pinto that the CFPB’s proposal to base the rule on a pricing cap would harm some minority borrowers, particularly during a financial downturn.

“It is likely to heighten the probability of a bubble and bust and we know from experience that bubbles and busts tend to affect marginal homebuyers more,” Wachter said.

The GSE patch is supposed to end in January 2021 or when Fannie and Freddie exit conservatorship, whichever comes first. (Other government-backed loans such as those insured by the Federal Housing Administration have a similar exemption.)

Kraninger has promised a smooth transition for the mortgage market by having the GSE patch expire on the date that a final QM rule goes into effect.

Pinto filed the complaint under a 1994 executive order designed to ensure that government programs and activities related to housing and urban development are administered in a manner that affirmatively furthers the goal of fair housing as required by the Fair Housing Act.

He said Kraninger is required to send the complaint to HUD, which could refer it to the Justice Department.

The CFPB declined to comment.

The mortgage market is on a tear this year and few lenders expect the CFPB's proposal to upend that direction. Low interest rates have sparked a huge refinance boom, while the coronavirus pandemic has prompted many homebuyers to move to less crowded communities and homes with more space.

While Pinto may be one of the few voices against the QM proposal, he sees further trouble ahead.

"If you want to know why minorities and low-income families are unable to build wealth, it's because they tend to be the last ones to get in the market, then house prices peak and collapse, and they get pushed out, and it takes years for them to come back and they start the roller-coaster cycle all over again," he said.

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CFPB Fair Housing Act Qualified mortgage rules Qualified Mortgages Underwriting Racial Bias Delinquencies Interest rates