At some point in the next two weeks, seven federal agencies will jointly issue a proposed rule required under section 941 of the Dodd-Frank Act to define a “qualified residential mortgage.” This apparently obscure rule could have a profound impact on the U.S. residential mortgage market and the availability of sustainable homeownership options for creditworthy Americans of all incomes and communities.
Why? Because as a practical matter, the new rule may well define a “good” mortgage for purposes of most nonfederally insured mortgages. Done badly, the rule could essentially lock first-time homebuyers in particular out of all but the government-insured mortgage market. This would further increase wealth inequality in general, and especially across racial lines. Poorly thought-through rules could also impede new and existing home sales, thereby slowing the current economic recovery. Indeed, if the structure of the rule pushes all low-down-payment mortgages into the 100 percent federally guaranteed market—instead of encouraging the private sector to share the risk of some of those mortgages—the rule could also increase taxpayer risk in the event of another housing market downturn.
Done right, however, the new rule could be an important step in returning our country to a housing finance system dominated by quality mortgages, backed primarily by private capital, that are well-underwritten and available to all with an ability and willingness to pay. This would enable a broad diversity of prospective first-time homebuyers to continue to enter the housing market, enabling them to accumulate the savings and wealth associated with sustainable homeownership.
What are qualified residential mortgages and why is their definition so important?
The Wall Street Reform and Consumer Protection Act of 2010, known more commonly as the Dodd-Frank Act because of its two chief sponsors, Sen. Christopher Dodd (D-CT) and Rep. Barney Frank (D-MA), seeks to prevent a repetition of the housing market collapse of 2008. The new law forces financial institutions that bundle home mortgages together into mortgage-backed securities to retain at least 5 percent of the “credit risk of any asset.” This risk-retention requirement is designed to ensure that the “securitizers” have some “skin in the game,” thus aligning their interests with investors as well as mortgage lenders and borrowers—resulting in both mortgages and securities that are paid according to their terms.
The Dodd-Frank Act, however, exempts from the risk-retention requirement securities backed exclusively by “qualified residential mortgages,” or QRMs—mortgages with “underwriting and product features that historical loan performance data indicate result in a lower risk of default.” By exempting QRMs from the risk-retention requirement, the cost of securitizing these mortgages is reduced, thus providing a market incentive for the wide origination of responsible loans.
The seven regulatory agencies—the four bank regulators, the Securities and Exchange Commission, the Federal Housing Finance Agency, and the Department of Housing and Urban Development—must define the QRM by regulation. Final regulations were due to be in place by mid-April (and effective a year later) but the travails of reaching agreement among seven agencies on this complex, controversial, and important subject have delayed the rule. It is possible that the proposed rule will be unveiled at a meeting of the Federal Deposit Insurance Corporation on March 15.
The statute provides an initial list of “underwriting and product features that historical loan performance data indicate result in a lower risk of default,” giving the regulators some guidance. The list includes:
- Full documentation of the borrower’s financial resources
- Standards with respect to income available to pay the mortgage, including the impact of the mortgage and other debts
- Product features that mitigate payment shock, such as limits on the amount monthly payments can increase when the interest rate on an adjustable rate mortgage increases
- Mortgage insurance and other types of credit enhancement
- Prohibitions of negative amortization (monthly mortgage payments that increase a loan balance over time) and balloon payments (low monthly payments for a period of time followed by the full payment of the entire mortgage)
To complicate matters further, the QRM cannot include mortgages that do not meet the presumption of ability to pay ascribed to a “qualified mortgage,” or QM, in section 1412 of Dodd-Frank (to be defined in a different set of new regulations). Neither the QRM nor the QM statutory lists of factors to be considered include the size of the down payment or its inverse, the loan-to-value ratio (the size of the mortgage compared to the appraised value of the property). The loan-to-value ratio is a well-known underwriting parameter in the mortgage financing industry, so we can assume its exclusion was deliberate. This makes sense because for well-underwritten, responsibly structured mortgages, low down payments are not a significant driver of default.
The importance of the forthcoming QRM rule
What are the major implications of the QRM definition? Most directly, the definition will affect the size of the market for so-called private-label mortgage-backed securities—those securities issued without any government involvement, whether from Ginnie Mae (backed by loans guaranteed or insured by the Federal Housing Administration, the Veterans Administration, or the Department of Agriculture), Fannie Mae, or Freddie Mac.
Issues beyond the QRM definition, such as the type and duration of risk retention that will be required for securities backed by non-QRM mortgages, will also have an important impact on that question. But assuming the risk-retention requirement is meaningful, a QRM definition that exempts a large number of sound mortgages from risk retention would likely result in a larger private-label market. Conversely, a rule that has a narrow definition of products that are exempt will likely result in a smaller private-label market. In either case, effective implementation, including enforcement, of the consumer and investor protection provisions of the rest of Dodd-Frank is essential to making certain that a resurgent private-label mortgage-backed securities market does not lead to another financial and economic disaster.
The rule will also have an impact on how the secondary market in mortgages will be structured. What will be the role of Fannie and Freddie? Both financial institutions are now under federal conservatorship, with reform plans now under debate in Congress and within the Obama administration that envision years of unwinding their reliance on federal support. In the context of the ongoing debate about the future of Fannie and Freddie, what are the implications of the QRM definition under each of the options the Obama administration described in the report, “Reforming America’s Housing Finance Market”? Under the administration’s first two options (privatization or extremely limited government backing for mortgages without a 100 percent government guarantee), virtually the entire securitized market would be affected by QRM. What would be the case under option 3, which envisions a larger government role to protect the private market from catastrophic risk?
Other questions that may be dealt with directly in the rule, but that certainly will be impacted by the rule, whether or not faced head on, include:
- How will the QRM definition affect how much of the market will be concentrated in the big banks, whose capital position may give them an advantage in securitizing non-QRM mortgages (assuming such loans will in fact be made)?
- What will be the role of nonbank aggregators and conduits, who played such a large role in the pre-crash issuance of private-label mortgage-backed securities?
- Will credit enhancement providers such as mortgage and bond insurers, who would bring countercyclical capital and additional underwriting strength to the table, have a role either in the definition of QRM or in meeting the risk-retention requirement?
Of more direct interest to those concerned about housing policy, the QRM definition may also influence the availability, price, and terms of mortgages that do not carry a direct federal guarantee. For instance, it is likely that non-QRM mortgages—those requiring risk retention—will be more expensive for borrowers than those within the QRM definition. Non-QRM mortgages also may be less generally available, and may carry more risky product structures, although they conversely may well be subject to less-restrictive underwriting standards.
More subtly, the QRM definition may also have an impact on the willingness of any originator—especially a bank subject to regular examinations—to make any mortgage that doesn’t meet the QRM definition—even if the bank initially intends to hold that mortgage in its portfolio. Will bank examiners explicitly or implicitly look upon non-QRM loans as “unsafe” even if the lender is keeping 100 percent of the risk on its books? In particular, if the regulators—contrary to the apparent intent of the statute—define QRM to require a 10 percent or 20 percent down payment, will anyone be willing to originate an affordable low-down-payment loan not insured or guaranteed by the FHA, VA, or USDA?
With renters having (in 2007) a median net worth of $5,100, compared to a current national median house price of approximately $170,000, a 10 percent or 20 percent down-payment requirement could lock out millions of creditworthy working families from homeownership, including the vast bulk of families of color. The problem would be even more acute in high-cost areas of our nation that are home to working families, such as Oakland, California, and Staten Island, New York, where the average listing price for a single-family home is $415,516 (as of 2010) and $484,476 (as of 2011), respectively.
What to look for in the proposed QRM rule
It is likely the proposed QRM rule will ask a lengthy set of far-ranging questions to guide the regulators as they write the final rule. It may even include alternative forms of the rule itself. Here are some of the things those interested in broad and diverse American homeownership should be especially on the lookout for:
- What are the underwriting parameters of a QRM; in particular, do those parameters include features not in the statute, such as the size of the down payment or the loan-to-value ratio?
- How closely do the QRM definitions track the QM definitions? Significant inconsistencies would create compliance challenges for lenders and securitizers.
- What, if any, is the role of mortgage insurance, a risk mitigant that is listed in the statute? Can it count as risk mitigation in the definition of the QRM? For example, if there is a down-payment requirement, can it be met in part or whole by mortgage insurance?
- How are securitizations by Fannie Mae and Freddie Mac treated? Is risk retention required for any securities they issue, whether the underlying loans meet QRM standards or not? Does the rule say anything about how potential successors to Fannie and Freddie would be treated?
- Do the rules set standards for the servicing of securitized loans? If so, would such standards apply to all such loans, or only to loans meeting the QRM definition?
For many reasons, discerning the exact implications of the many choices the regulators will have to make will be difficult. Prime among the unknowns are the future of Fannie and Freddie—and the market they now serve—and the extent to which the consumer and investor protections of Dodd-Frank will in fact be effectively implemented. But it will be important to try to understand not just what the rule means, but what its impact will be on our entire housing market. The rule’s unintended consequences may well be its most important.
Ellen Seidman, former director of the Office of Thrift Supervision, is a member of the Mortgage Finance Working Group sponsored by the Center for American Progress.