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The Qualified Residential Mortgage Debate

Adam Rust's picture

Posted November 30, 2010

The Dodd-Frank bill requires lenders to retain a five percent risk-retention in loans sold to the secondary market.  It is an idea driven by the lessons that we learned from the financial crisis. Give banks a moral hazard by making them hold some skin in the game. It is hoped that they would then respond by not making unsustainable loans.

The bill gives regulators some time to decide how to implement that requirement. The Dodd-Frank bill does offer some guidance. The Merkley Amendment sets an expectation that lenders will hold a five percent stake in any "qualified residential mortgage."   A "QRM," as it known, needs risk retention.  An exempted loan does not.

First Thoughts

This is a classic example of a rule that could have unexpected consequences. At first glance, it seems like common

sense. Force the lenders to drink from their own cup, and they will be less likely to produce poison.

If the rule produces that response, then it is a great outcome. On the other hand, if you have a lot of doubt about the ability of banks to gauge risk, then it is a different problem. This just means that more banks will have more bad loans on their books.

Mortgage lenders, small banks and brokers that are thinly capitalized believe that the Merkely Amendment will put them out of competiton with big banks that have the capital for risk retention. 

The immediate conclusion is that banks will want to find a way to avoid holding on to loans. That instinct generated the demand for securitization, after all. Now, with many financial institutions under capital constraints, that aspiration seems likely to be even more intense.

Wells Fargo Gets Involved

That is why the response by Wells Fargo is so interesting. Legal staff at Wells drafted a letter, dated Nov. 16th, to heads of the FDIC, HUD, the OCC, the Federal Reserve, the SEC, and the Federal Housing Finance Agency. The letter fixes onto the current debate. How might this risk retention rules be established? Specifically, what definition should regulators apply for exemption from QRM?

Wells is encouraging regulators to make more loans applicable to the QRM. Huh? 

In the context of current down payment trends, Wells Fargo's fix would effectively mean that approximately 85 percent of mortgage loans require some risk retention.  Why would they do that?

I will hazard my own guess: this an attempt to use their size as a way to create a competitve advantage.  If almost all loans require risk retention, then many banks and thrifts are going to be constrained. The small bankers should be worried. It makes sense that they are crying "foul."

There are other consequences, as well. One issue is that this may means that banks shift more lending to the FHA program. If that is the case, then  private mortgage insurance companies are going to sell fewer products. It is also a problem for many consumers. In particular, the new plan would it much harder for most first-time homebuyers to get a loan. Given the demographics of wealth, it would also put barriers to homeownership on many low-and-moderate income households. Ditto for many minority households.

More broadly, the shift to FHA is worrisome for taxpayers. 

Read between the lines: it means that even more mortgages are going to go to FHA. The conventional market has 95 percent of loans made where borrowers put more than 30 percent down. By contrast, conventional loans only make up 21.5 percent of the market for borrowers that are putting down five percent or less.Last month, 84 percent of home purchase mortgage loans originated in North Carolina had a loan-to-value that was greater than 70 percent. Under the "Wells Standard," five of every six loans would at requires additional risk retention.That spells out the possibility that five of every six new loans would be destined for FHA.

We don't know how many FHA loans are going to go bad, but it is clear that banks have already decided to move more of their lending to this program. The Mortgage Bankers Association reported that 12.62 percent of FHA loans were delinquent in the second quarter of 2012. Taxpayers will be on the hook for the guaranteed portions of those loans if they go bad. FHA premiums and the general malaise of the economy have produced a decline in FHA origination lately, but that could change.

Risk Retention: It's the Way that You Do It

Wells' letter addresses the question of how that exemption will be defined. Restating it, an exemption allows for some loans to be excluded from risk retention rules. Lenders can make exempt loans without worrying about having to keep any share of the mortgages on their books. Wells' idea is to establish a QRM exemption for loans that have an loan-to-value that is below 70 percent.

That is a high standard. Most borrowers are challenged to produce a thirty percent down payment. In North Carolina, for instance, only about one in six borrowers put down more than 30 percent.

Wells logic relies on an expectation that the market will learn to accommodate the "new normal." A more expansive set of loans that are held back means that the market will have to find a new center. Over time, the market would adjust, and then there would be more capacity to turn these loans more efficiently.

But think about it from Wells perspective. Because of their size, when the pool of held-back loans is bigger...they make more money!

The problem is driven by where the line in the sand is drawn. When the exemption is a product of loan-to-value, then a narrow definition risks creating a disparate impact.  Coming out of a recession, loan-to-value barriers price people out of the market. Already, that can be seen in the existing refinance market, where lenders want LTVs that are below seventy percent. If Wells has its way, the QRM rules will apply to any home mortgage that a lender intends to deliver to a GSE.

Nationwide, the median home price is around $200,000. In the Wells standard, the median home would require a borrower to produce a down payment of $60,000l. Homes cost a bit less in North Carolina, so the typical borrower might have to put down a bit less. In other states, the new rules would be much more crippling. In Orange County, California, the median home price settled at $430,000 last month.