- - Sunday, March 3, 2013

Despite the claim that it is “protecting consumers from irresponsible mortgage lenders,” the new Qualified Mortgage rule finalized in January by the Consumer Financial Protection Bureau turns out to be simply another and more direct way for the government to keep mortgage underwriting standards low. This sets the country up for a repetition of the mortgage meltdown of 2007 and 2008.

Simply put, government housing policies, implemented by the Department of Housing and Urban Development (HUD), caused the 2008 financial crisis. Before 1992, the vast majority of  mortgages in the United States were prime loans. Yet a 1992 law required the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—then the dominant players in the U.S. mortgage market—to purchase an increasing quota of loans that were made to borrowers at or below the median income in their communities.

Finding prime loans among borrowers who were below the median income was difficult, especially when, by 2000, HUD had raised the quota from 30 percent to 50 percent. To meet this goal, Fannie and Freddie had to reduce their underwriting standards. In 1995, they were acquiring loans with 3 percent downpayments, and five years later they were advertising mortgages with no downpayment at all. The credit scores required of borrowers were also reduced. 

As a result, by 2008, half of all mortgages in the United States—28 million loans—were subprime or otherwise weak. Of these low quality loans, 74 percent were on the books of government agencies or government-regulated entities like the GSEs, showing clearly where the demand for these loans originated. When the housing bubble deflated in 2007, mortgages that should never have been made went into default in unprecedented numbers, further driving down housing prices, weakening financial institutions and causing the panic that we know as the financial crisis. 

Now along comes the QM rule, which is based on a wholly different narrative about the financial crisis. This view—repeated innumerable times in the media—is that the crisis was the result of inadequate regulation, private-sector irresponsibility and predatory lending. Founded on this story, the rule turns the usual lending process on its head, making the lender liable for various penalties—not just the loss on the loan—if it is ultimately determined that the borrower could not afford the mortgage. 

To avoid these penalties, which may include a defense to foreclosure, lenders must observe several rules. The loan must amortize principal in even monthly payments, may not result in a debt-to-income ratio greater than 43 percent, must have adequate income and assets documentation, and may not be priced at more than 1.5 percent above the prime mortgage rate at the time the loan rate is fixed. If all of these tests are met, and the lender concludes that the borrower can afford the loan, the lender gets “safe harbor” protection against the penalties and the right to call the loan a prime mortgage.

By themselves, the rule’s draconian provisions would probably have addressed the problem of low underwriting standards. The penalties associated with making a loan that ultimately defaults would have reinforced the natural desire of lenders to make mortgages that pay off. 

After making the required determination that a borrower has the ability to pay under the rule, lenders would have added the other keys to a sound loan—a substantial downpayment and a good credit history. These are intended to assure that the borrower has skin in the game and is willing to pay.  

That’s where this alleged reform goes off the rails. Substantial downpayments and good credit histories are unpopular with community “activists,” realtors, homebuilders and other members of what we call the Government Mortgage Complex. They want continued lending to as many potential home buyers as possible, even if these borrowers don’t have the incomes, assets and credit histories to meet common sense underwriting requirements. This coalition has been effective in moving Congress in the past—and the Consumer Financial Protection Bureau in its recent rule—to encourage lending to borrowers whose credit positions are shaky. 

So the rule, in effect, takes the underwriting standards out of the hands of the lender and gives them to the government. If the automated underwriting systems of the GSEs or the FHA give the loan their stamp of approval—even if it is not ultimately guaranteed by these agencies—the loan is considered a prime loan, no matter what its quality.

For example, a mortgage with a 3 percent downpayment, a 580 FICO score and a 50 percent debt-to-income ratio—a loan that would have been considered a subprime loan before the financial crisis—will now be marketed as prime if it is declared eligible for purchase by one of the GSEs or for insurance from FHA. Indeed, FHA approves such loans today.   

Because of their government backing, FHA and the GSEs have lower cost structures, which make it much easier for them to stay below the 1.5 percent cap on risky loans. Thus, originators will have competitive incentives to sell their loans to the GSEs and FHA rather than through private channels. Once again, this threatens the taxpayers with potential losses when these weak loans default. 

Thus, neither Dodd-Frank nor the new QM rule has changed anything significant. Political pressure to continue lending to borrowers with weak credit standing has trumped common sense underwriting standards. 

The only things missing are Chris Dodd and Barney Frank.

Peter J. Wallison is a senior fellow and Edward J. Pinto is a resident fellow at the American Enterprise Institute.


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