Jay Weiser is an Associate Professor of Law and Real Estate at Baruch College, and author of the upcoming Mercatus Center study "Qualified Mortgage Standards."
Father Edward Flanagan, the legendary founder of Boys Town, said, "There are no bad boys. There is only bad environment, bad training, bad example, bad thinking." Father Flanagan lives on in the Dodd-Frank Act's Qualified Mortgage provisions, which imagine a housing market where there are no bad borrowers, only bad laws and bad lenders who will cease sinning if the catechism (in the form of 804 pages of regulations) is long enough. Perversely, Qualified Mortgage protects lenders from liability for many high-risk loans, encourages riskier loan types, and continues to rely on federal agency guarantees. Dodd-Frank must be simplified to require borrower skin in the game.
The Consumer Financial Protection Bureau's new Qualified Mortgage regulations are meant to assure that residential borrowers only take loans that are suitable for them. But Dodd-Frank's suitability rules are enforced with a sledgehammer, with damages too high for most lenders to risk. Effectively, lenders subject to the regulations will be forced to make only loans under Qualified Mortgage's safe harbor that protect them from liability—or loans that exploit Qualified Mortgage's loopholes.
The safe harbor requirements were only loosely based on empirical evidence of the causes of default. Some requirements, such as bans on negative amortization, interest-only, and no-doc (no borrower income or asset verification) loans, will probably make borrowers less likely to take on risks they don't understand. Limitations on excessive points (fees deducted from the loan amount) will make it more difficult for lenders to disguise high interest rates.
While these features became common at the bubble's peak, they were not core causes of the bust. That came from ignoring lending principles: borrower ability to pay (debt-to-income ratio), borrower willingness to pay (as evidenced by credit score), and the size of the loan relative to the value of the property (loan-to-value ratio). The result was Ponzi finance, in which borrowers took down ever-larger loans in the expectation that rising prices would allow them to refinance out of unaffordable debt. When prices dropped, massive defaults followed. Of these three key criteria, Qualified Mortgage only addresses one: debt-to-income ratio.
Although lenders will find the debt-to-income safe harbor the financial equivalent of Rotterdam's Maeslantkering flood barrier, borrowers may feel like Jersey Shore denizens during Hurricane Sandy. The Qualified Mortgage regulations set the maximum debt-to-income ratio at 43 percent—yet it is unclear that debt-to-income is the relevant measure. As the Consumer Financial Protection Bureau acknowledges, Federal Reserve Board research shows "debt-to-income ratios may not have significant predictive power once the effects of credit history, loan type, and loan-to-value are considered."
The safe harbor itself permits risky loans, but Qualified Mortgage loopholes encourage further risk. Dodd-Frank exempts home equity lines of credit—revolving credit lines, secured by second mortgages—that turned borrowers' homes into ATMs as prices appreciated. The Qualified Mortgage regulations will encourage borrowers to unsustainably leverage up with home equity lines of credit soon after closing, like Bridezillas who go off their crash diets the minute they tie the knot. The home equity lines of credit exemption will also encourage lenders to offer hazardous high-debt-to-income ratio, home equity lines of credit first mortgages. (Timeshare loans and reverse mortgages are also exempt; kudos to their lobbyists.)
The Consumer Financial Protection Bureau offers further Qualified Mortgage exemptions for government-favored financial services entities that have traded in high-risk, low-cost loans for 40 years, using regulatory arbitrage to drive out market-priced competitors. The regulation exempts loans involving Fannie/Freddie (a $187.5 billion bailout so far) and federal agencies such as the Federal Housing Administration. The Federal Housing Association's post-bubble binge, Ed Pinto reports, enticed over 300,000 low-income borrowers into unaffordable loans, likely wrecking their credit while leaving the agency $31 billion underwater with a 10 percent default rate. The Consumer Financial Protection Bureau proposes to extend the exemption to community banks (whose savings and loan predecessors went bust on bad housing loans in the 1970s) and nonprofits (which laundered developer loans to low-income borrowers for sham down payments in "down payment assistance" programs, fueling the bubble). These exemptions are less about protecting unsophisticated borrowers than about protecting the taxpayer-guaranteed business models of favored entities.
Despite all the verbiage, Qualified Mortgage does not require borrowers to have skin in the game in the form of substantial equity. The statute and regulations are silent on the loan-to-value ratio. (Other forthcoming regulations will address this indirectly through complex lender risk retention and reserve requirements.) During the bubble, borrowers leveraged up: By 2006, the median down payment for first-time buyers was 2 percent. With artificially low-interest financing courtesy of the Greenspan/Bernanke put and Fannie/Freddie implied guarantee, borrowers went into a refinancing and house-flipping frenzy. They were indifferent to risks, believing that they were making a one-way taxpayer-funded leveraged bet.
The Qualified Mortgage regulations, by giving the lender sole responsibility for suitability, will continue to discourage borrower prudence. Consumer Financial Protection Bureau Director Richard Cordray tells the sob story of Henry, whose house went into foreclosure after his $50,000 salary was insufficient to pay his $500,000-plus mortgage. In Cordray's funhouse mirror world, Henry never chose to borrow this huge amount—the lender "sold him a mortgage." While there is a place for suitability rules, the United States will float from bubble to bubble until borrowers have real money at risk. Investing substantial cash in a house—20 percent down payments were common before the decision to massively subsidize the American Dream—would give borrowers an incentive to examine whether their housing purchases and mortgages make sense, rather than having taxpayers bear the loss.
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