Sometime in June, the long-awaited final qualified mortgage rule will be released. Considerable speculation and debate over variations of the rule have taken place since it appeared in the Dodd-Frank Act. Its ultimate form has implications for access to mortgage credit, its cost, and contingent legal liability, among others.
The original language describing a qualified mortgage was written more from the perspective of a policymaker attempting to draft rules addressing certain market deficiencies rather than as an effective set of underwriting guidance for establishing a borrower's ability-to-pay their mortgage.
Stepping back from the visceral reaction over poor underwriting practices, it is instructive to look more deeply at what aspects in underwriting the borrower matter as a way of thinking about structuring an effective qualified mortgage rule.
The provision attempts to address a number of underwriting practices and product types employed during the housing bubble that contributed to borrower payment difficulties later. These included complex mortgage products with such features as negative or nonstandard amortization, low or no documentation of income, assets or employment, silent second lien mortgages, teaser rate qualification and large fees.
The qualified mortgage provisions establish a general set of ability-to-pay criteria focusing primarily on the borrower’s debt burden relative to their income as well as their employment status. It does not prevent the lender from originating loans with unusual features as described above.
The provisions do allow for the possibility of a safe harbor or rebuttable presumption of compliance that has generated much controversy in part due to the lack of clarity in the original language of Dodd-Frank. Under this section, a creditor could find some protection against future liability by following a set of criteria that, in addition to considering the borrower’s debt burden and income, also restricts the use of mortgage products with nonstandard features.
But the real hitch in all of this is whether Congress meant full protection as implied by a safe harbor, or whether the door is left ajar under the rebuttable presumption view that affords less legal and regulatory protection to creditors. The Fed has weighed in on this with two options for the rule; one a safe harbor approach, the other allowing for a rebuttable presumption.
The safe harbor option is preferred by industry as it provides greater legal protection against future legal risk in the event of foreclosure. The rebuttable presumption option would provide borrowers with the ability to challenge the creditor under certain conditions with respect to the way the loan was originally underwritten should the loan go to foreclosure
Whichever version or variation of these options is realized will no doubt reverberate across the mortgage industry. Creating a final rule that is restrictive in terms of what constitutes a qualified mortgage has the potential of limiting the scope of available mortgage products, and thus potentially constraining access to mortgage credit and potentially raising borrowing costs. Further, allowing a safe harbor provision could limit a borrower’s recourse to legal claims should there be problems with the underwriting process that ultimately leads to foreclosure. The stakes are thus very high for the regulatory community, industry and borrowers.
In sorting this all out, the final standards should be judged against several important criteria. First, the rule should provide clarity as to what constitutes a satisfactory mortgage. At its foundation, this must mean that the borrower's income, assets and employment are verified. As less than full documentation programs exploded during the boom, historically robust relationships of debt-to-income and default broke down largely due to data integrity issues surrounding stated income. This allowed such measures to be further relaxed over time as their impact on default appeared to wane. Given this, a qualified mortgage must be fully documented.
Further, one of the lessons learned from the mortgage crisis was excessive borrower leverage compounded in part by the proliferation of low-doc programs and relaxed guidelines on loan-to-value ratios. Consequently, establishing some common guidance on this is sensible. After all, lenders in selling loans to Fannie Mae and Freddie Mac are well aware of the agencies' debt-to-income guidelines.
Moreover, due to potential rate shock, a qualified mortgage should keep borrowers at the fully indexed rate over a period of time.
One of the trickier issues for the rule is whether to include nonstandard products and features or not. For decades, products such as negatively amortizing mortgages served financially savvy borrowers or those with variable income flows well during good and bad economic times. The industry strayed from this approach by effectively mass marketing such complex loans. Products with inherently complex features are not necessarily bad products so long as they are marketed to the right borrower segment. Therefore, these products should be included in the final rule conditioned on clear communication of such product's features as well as additional collateral and credit compensating factors.
Last, the final provisions should feature a rebuttable presumption clause. The booming litigation business following the robo-signing fiasco presents a modern day boogeyman to the industry and thus a rationale for a safe harbor. However, such an approach limits a lender's attention to ensuring the loan manufacturing process is robust. As the crisis fades in impact over time, litigation should wane making the prospect of huge contingent legal liability for creditors much lower as we get back to equilibrium.
Unfortunately the excesses in underwriting during the boom years have now come back to haunt the industry in the form of regulated underwriting guidance. We need to remember that not that many years ago we enjoyed a vibrant mortgage industry that featured fairly standard product sets and where borrowers were qualified based on full documentation, strong credit histories and collateral requirements. Getting back to those standards will be healthy in the long-run for borrowers, the industry and taxpayers.
Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae