New mortgage rules strike the right balance

A new proposed regulation to curb securitization abuses that helped stoke the housing bubble -- by requiring issuers to retain risk on mortgages backing securities -- has some critics warning that it will  exempt too many mortgages and reignite irresponsible lending.

Everyone should be wary of causing a replay of the mayhem that drove the housing bubble and financial crash. But in this case, the critics are wrong. 

ADVERTISEMENT
Regulators have crafted a smart and sensible compromise that achieves the difficult task of balancing accountability and safety with reasonable access to credit, particularly for those with good credit but low wealth. 

The risk retention rule was first proposed in 2011, and then reissued for comment in 2013 after a storm of negative comments.  The new version eliminates the use of underwriting factors that were in the first proposal, including a 20 percent minimum down payment, to define the so-called Qualified Residential Mortgage (QRM) exemption to its  risk retention requirements.  Instead, it adopts the restrictions contained in the Consumer Financial Protection Bureau's (CFPB) Qualified Mortgage (QM) provision in a different rule that becomes effective January 10.The QM definition is part of the Bureau's rule that requires mortgage lenders to underwrite a loan based on a reasonable expectation that the borrower can repay it. 

The two regulations were designed to realign creditor/ borrower and  securitizer/investor interests to create more accountability and  common interest within the system, and the regulators' new QRM  proposal does just that. 

The proposed rule would keep risk retention for the types of loans --   such as interest only, balloon, teaser-rate ARMs -- behind the underwriting race to the bottom that drove the mortgage crisis.  These product features had the largest differential effect on whether loans failed or not.  In addition, the rule would require that loans exempted from risk retention be fully documented, have limits on points and fees and prepayment penalties, and when added to other debts not exceed 43 percent of the borrower's income.  

The 20 percent requirement in the first draft would have raised mortgage prices for many lower-wealth, creditworthy working families, a high social cost not justified by the difference in loan performance, and would have hit minority home buyers, who traditionally have less wealth, particularly hard. 

The proposed rule's critics have included former FDIC Chair Sheila Bair and former House Financial Services Committee Chair Barney Frank, who have argued that the proposed risk retention rule is too lax. Their warnings carry special weight.  But QM loans are not reckless loans.  They are not subprime loans. Investors - who the risk retention rule aims to protect -- have long experience in understanding   and pricing their risks. Originators have powerful incentives to make sure that QM loans are reasonable for borrowers and therefore likely to perform well. 

Aligning the two definitions also will create a much clearer line of sight from investors to originators.  Investors will know what is in the securities that qualify for QRM treatment, because the definition is clear and originating lenders have powerful economic and reputational interest in toeing the line.  It will reduce regulatory burdens on lenders by giving them one, rather than two possibly different standards to follow.   

Consumers today already face significant barriers to mortgage credit. Fannie Mae and Freddie Mac have raised their minimum down payments and credit scores on their loans are more than 50 points higher than they averaged in the 1990's -- a period of very good loan   performance – potentially shutting out more than 12 million potential borrowers, according to a recent paper from the Urban Institute and Moody's  Analytics.  FHA also has raised its standards while lenders have backed away from its most generous underwriting rules. Adding more unjustified costs is not good public policy. 

The financial prudential regulators' decision to propose a risk retention exemption that mirrors the Bureau's rule provides plenty of incentive for securitizers and ample protection for investors.  It strikes the right balance between access and reasonable standards. The regulators should adopt it as a final rule.

Zigas is director of Housing Policy at Consumer Federation of America.