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Why Arcane Mortgage Rules Matter for the Middle Class

homeowners

SOURCE: AP/David Zalubowski

A sign promotes the availability of a new home in Aurora, Colorado, on Sunday, August 19, 2007.

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For everyone except hardcore policy wonks and mortgage bankers, it’s natural for eyes to glaze over reading headlines such as “QM rule commentary captures CFPB website.” But numerous arcane incremental policy choices currently being made in Washington to reshape our housing-finance system will determine whether working Americans and their children will be able to move into the middle class, build up assets, and avoid greater dependence on entitlements.

Homeownership is a path to the middle class

Access to homeownership has long been a key component of a family’s ability to build wealth in America. In 2010 the equity in one’s primary home accounted for 29.5 percent of all family assets in the United States. For those families in the middle-income tiers—neither wealthy nor poor, with annual household incomes between roughly $30,000 and $70,000—home equity represented 40 percent to 50 percent of family wealth. And that was at a time when housing values had fallen dramatically after the U.S. housing bubble burst.

While homeownership is not the only path to building assets—and more needs to be done to create widespread equity options for renters—it remains one of the key underpinnings of broadening the base of prosperity.

Historically, homeowners have built wealth in part because each monthly mortgage payment pays down a little more principal on the loan, building equity through a regular “forced savings” program. Moreover, for most of the past 75 years, houses have shown long-term modest price appreciation—a realistic expectation for the future if policymakers continue prudent steps to avoid repeating the housing bubble of the mid-2000s.

The rise of homeownership as a tool to help people enter the middle class was in part a result of post-World War II government policies. Before 1940 the U.S. homeownership rate was just 43.6 percent. But with 4.3 million veterans using zero down payment, low-interest Veterans Administration loans to buy homes between 1944 and 1955, and millions of nonveterans  borrowing with help from the Federal Housing Administration, or FHA, the homeownership rate climbed to nearly 62 percent by 1960. Beyond veterans benefits, the liquidity and stability that the FHA and the government-sponsored enterprises Fannie Mae and Freddie Mac provided to the home-mortgage markets by continuing to attract private investment to fund home loans expanded the average household’s ability to get a long-term, fixed-rate, and safely underwritten loan to purchase a home.

While some conservative commentators still insist that government involvement in the housing market was responsible for the foreclosure crisis, many analysts have debunked this view time and again. It is true, however, that due to the past five years of widespread foreclosures, the federal government has assumed an even larger role in the market by ultimately guaranteeing repayment to private investors buying mortgage securities, maintaining the flow of credit to housing markets to avoid wider economic collapse.

Policy choices will determine who can become a homeowner

There is emerging consensus that the current degree of governmental direct involvement in the housing finance market is neither sustainable nor desirable. Yet it is important to maintain access to affordable credit while reducing the government’s footprint. As banking and consumer protection agencies implement the host of regulations required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, they must be careful to  make choices that protect consumers without limiting safe and stable access to mortgage credit for the middle class.

One key issue, for example, is the size of the down payment required to get a mortgage. One regulation that could significantly impact down payments is the so-called risk retention rule and its qualified residential mortgage, or QRM, exemption that will likely be issued by a group of six federal regulators this spring. In brief, for loans to be “securitized”—packaged in large pools and sold as securities to investors—lenders have to hold back on their books 5 percent of the value of loans that do not meet the soon-to-be-released QRM definition, making it less likely that borrowers will be able to get loans that don’t fit this upcoming QRM definition.

The QRM definition will address whether larger down payments of 10 percent to 20 percent of the home purchase price will be required for mortgages to be eligible for securitization, which  brings hundreds of billions of dollars of private investment into the U.S. mortgage market each year. Loans that cannot be securitized generally carry higher interest rates.

QRM rules might seem to be arcane issues of financial-system risk analysis. But a QRM rule that makes lower down payments of 3 percent or 5 percent costly and unattractive to mortgage lenders could prevent a generation of younger workers, as well as lower-wealth communities, including those of color, from attaining homeownership.

The Center for Responsible Lending estimated that a mandatory 10 percent down payment (plus closing costs) would require nearly 20 years of savings for the average American family to buy a home. These higher down payments disproportionately affect the very communities that were most preyed upon during the subprime predatory mortgage-lending wave of the 2000s. Black and Latino households, which tend to have less wealth than white households on average, could pay a down payment of only 10 percent or less in roughly 45 percent of home purchases in 2009, in part because black and Latino households are less likely to receive gifts or use inheritance or proceeds from the sale of previous homes to finance their home purchases.

What’s more, locking so many households out of the market by requiring higher down payments would not have a significant effect on reducing systemic risk, according to a study by the UNC Center for Community Capital. That is because the ability-to-pay rule and its qualified mortgage exemption—another complicated but targeted new regulation that was recently finalized and that will go into effect in January 2014—will already prohibit most of the more toxic and higher-risk lending practices that led to the crisis. The UNC researchers concluded that there would be little benefit—in terms of additional reduction in mortgage defaults—from adding tough down-payment requirements on top of that. In fact, it is likely that excluding so many households from the market will have a negative effect on home values for the long term by significantly reducing demand.

Regulators should not unnecessarily limit access to mortgage credit

No one is arguing, of course, that every family in America can or should buy a home. But unduly narrowing safe and sound access to homeownership perversely undercuts the widely shared goal of broadening each family’s ability to achieve a degree of self reliance and economic independence while minimizing the likelihood of needing direct government assistance.

First, severely narrowing access to the conventional mortgage market will likely mean even greater government involvement in mortgage finance for millions of families. We have seen this over the past few years, as the Federal Housing Administration’s share of the number of home-purchase mortgage loans grew from just 4.5 percent in 2006 to more than 25 percent of all loans in 2012. A large number of borrowers during this time period were ones who, in normal times, would have been served by the conventional mortgage market but who could not qualify either for the higher down payments or the very high credit scores lenders have required in recent years.

The FHA has handled this influx of demand well, financing some 4 million home-loan purchases and roughly 2.6 million refinancings since 2008, which served a critical countercyclical role in keeping home prices from plunging even further after the housing bubble burst. But the direct government insurance that the agency provides is a much greater and more direct federal government involvement in the home-loan market than is recommended by most proposals for a reformed government catastrophic insurance role in the broader mortgage market.

Second, unduly restricting access to mortgage credit will force even those who have steady incomes and desires to be homeowners to remain renters. Their monthly payments will build equity for their landlord but not for their family. And the wealth gap between homeowners and renters is already vast: From 2001 to 2010 U.S. homeowners had on average a net worth of $211,150, while renters averaged just $5,250.

Third, in many rental markets, paying rent results in a higher risk of needing other public assistance. One-quarter of U.S. renters now spend more than half of their monthly income on housing, and that percentage isn’t expected to go down anytime soon. The National Association of Realtors estimates that average rents will increase nationally by 4.6 percent in 2013 and continue to increase by at least 4 percent per year in 2014 and 2015.

As a result, many workers earning even a decent wage will be unable to build up a personal cushion of savings to call upon in times of economic setback—such as job loss, health issues, death of a loved one, and divorce. This asset drain increases the number of households likely over time to need some form of government assistance in times of economic stress. Research shows, for example, that women without assets are more likely to need welfare assistance following marital disruption than women with assets, who are better able to maintain income and independence.

Finally, overly tightening access to homeownership may constrain entrepreneurship, job creation, and educational advancement. Savings in a home have often been a source of capital for entrepreneurship and education. According to a December 2010 study by the Federal Reserve Board of Cleveland, roughly one in four small-business owners in the United States used home equity as a source to finance their businesses before the financial crisis.

The ability to tap home equity has also proven to be a critical factor in access to college. One recent study by Cornell University researcher Michael F. Lovenheim, after noting that 85 percent of U.S. college attendees come from families that own a home, found that higher amounts of parental home equity increased the likelihood that middle- and lower- class students would enroll in college.

Consequently, both small-business activity and college attendance would likely contract in the future if an unduly large share of American families who are otherwise qualified to be homeowners are locked out of the conventional mortgage market. This will only put greater pressure on governmental sources of financing for small business and higher education.

None of this, as noted earlier, argues for making mortgage loans unduly easy to obtain or overly risky. But the process in Washington that is reshaping the lending rules of the future is moving ahead largely in the language of credit markets, systemic risk analysis, and opaque acronyms such as “QRM”—even though the decisions being made will largely affect Americans outside of Washington and financial circles, vastly reshaping where millions of people will live, what they can save, and whether they can achieve the degree of independence that is central to the American Dream.

David M. Abromowitz is a Senior Fellow at the Center for American Progress.

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