When Governor Romney brought up the seemingly obscure issue of "qualified mortgages" during the first presidential debate, it underscored the importance of this forthcoming regulatory definition.
The Dodd-Frank Act's provisions for QMs and Qualified Residential Mortgages attempt to force a nice, neat public policy solution on the market to address a multitude of sins committed during the housing boom. But as we approach the Jan. 21 deadline for a definition of QM, pinning down a set of attributes increasingly looks harder than perhaps the drafters of Dodd-Frank envisioned.
The CFPB is in the awkward position of having to make a tradeoff between protecting consumers from contemptible lending practices and limiting their availability to mortgage credit. In the end, with regulators' hands tied by legislation, whatever the CFPB decides to do is likely to be a suboptimal solution for the mortgage industry.
The QM provisions attempt to ensure that borrowers are not put into homes they cannot afford by offering some measure of legal protection to lenders that properly assess the ability to repay. The mortgage industry has been squarely behind establishing a rule providing a high degree of legal protection in the form of a safe harbor from being sued if a loan meets the QM standards. But if those standards are set too narrowly, the fear is that mortgage credit will be artificially restricted.
This critical public policy dilemma hinges on defining what is meant by a borrower's ability to repay the mortgage obligation. According to some press reports, a bright-line maximum debt-to-income ratio of 43% seems to be favored as one of several criteria prescribed by Dodd-Frank in setting the ability-to-repay standard. According to Federal Housing Finance Agency data, about 85% of borrowers in 2010 and 2011 would meet this standard, thus providing a broad definition to the market. But applying a few rules such as a maximum DTI to define QM would oversimplify the underwriting assessment of borrower capacity to repay the obligation and in may be policy overkill.
Among other considerations, to meet the definition of QM, lenders must document a borrower's income. In fully documenting a loan, if a lender has strong processes and controls in its underwriting department to verify income, employment and assets, a determination of a borrower's ability to repay should not be a problem. After all, lenders had been doing just that for decades leading up to the boom, using industry standard debt-to-income ratios of 28% for housing debt alone and 36% for all debts, among several underwriting tests.
Without a safe harbor, the argument goes, lending may be restricted if the contingent legal liability isn't substantially reduced. Yet the industry didn't need a safe harbor before for there to be an adequate, or in the case of the boom years, excessive amount of credit to be available. Low and no-doc loan programs defaulted at multiples above fully documented loans, controlling for other risk factors, and have been a major focus for repurchase litigation activities due to the lack of attention to proper underwriting of the loan. In other words, requiring a lender to fully document a borrower's income reduces the industry's repurchase risk.
In the two years since the enactment of Dodd-Frank, the very existence of a QM rule has introduced unnecessary uncertainty into mortgage markets when a return to prudent underwriting standards by the industry significantly addresses the ability-to-repay issues that surfaced during the housing bust. In fact, through regulatory edict, fear or other motivations, mortgage lending standards have returned to plain-vanilla underwriting.
Reviewing a borrower's tax returns and other income documentation in conjunction with prudent underwriting standards is the best assurance for a quality mortgage. Further, if lenders perceive there could be legal challenges on the basis of a borrower's ability to repay, then that very perception establishes a reasonable check on the use of high DTI ratios. If we were to cull through litigation over borrower ability to repay in the years before the crisis, it would be surprising to see many cases lost by lenders where fully documented loans were underwritten at a 36% total DTI.
Unfortunately, we are stuck with the QM rule, so how best to proceed? Determining a borrower's capacity to repay (one of the three C's of underwriting, in addition to creditworthiness and collateral) involves a number of assessments including factors such as the number of months' reserves of liquid assets, and the income left over after debts and other expenses have been paid.
Such factors need to be weighed against one another, as well as against others reflecting credit and collateral. It is the entire borrower's risk profile that ultimately determines whether a loan will default or not, not simply the ability to repay.
The CFPB ought to look at the automated underwriting scorecards used by Fannie Mae, Freddie Mac and the Federal Housing Administration as a basis for developing an industry QM scorecard that weighs all relevant borrower risk factors in place of a few simple rules such as maximum DTI. The CFPB could instruct lenders to manually override the model in cases where one risk factor was simply too great (a debt-to-income ratio of 55% would be worrisome no matter how high the same applicant's down payment or credit score, for example). Importantly, the spreadsheet of scenarios would be transparent to the entire market, so there would be no doubt as to whether any loan fit the QM criteria.
While such an approach would not reduce the problem of the QM definition restricting credit availability, it would provide greater underwriting flexibility than a handful of capacity-to-repay factors and at least create a rule more in line with prudent practices that had been in place for years before the boom.
Regardless of the outcome, Dodd-Frank did the industry and borrowers no favors in prescribing how mortgages should be underwritten.
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.