Housing finance experts from the American Enterprise Institute are warning that a proposed change in the Qualified Mortgage (QM) rule would exacerbate existing risk management difficulties and ensure continuation of “unsustainable” pricing of entry-level homes.
The proposal of the Consumer Financial Protection Bureau is critiqued in a recent paper by Tobias Peter and Edward Pinto, director of research and director, respectively, of the AEI Housing Center. CFPB is advocating use of an average prime offer rate (APOR) that the authors contend is “dangerous” and “a major policy mistake even worse than the original QM and the GSE Patch.”
The QM rule is designed to assure loan affordability based on borrowers' ability to repay. The GSE Patch is an exemption applying to loans backed by government-sponsored enterprises Fannie Mae and Freddie Mac, and CFPB favors that it be allowed to expire in January 2021.
The CFPB revealed its intentions in a July 2019 advance notice of proposed rulemaking, eyeing “a more transparent, level playing field that ultimately benefits consumers,” CFPB director Kathleen Kraninger said. She has indicated that a QM rule could be issued by May, also allowing for a brief extension of the patch.
“Looser Lending Standards”
Peter and Pinto write that replacing the QM debt-to-income (DTI) measure with an APOR-based margin rule “is but the latest example of advocating for looser lending standards in order to 'make housing more affordable,'” as that is defined by the so-called housing lobby. Contrary to those interests' claims, they say, “the APOR margin rule would make housing less, not more, affordable, and it would create a less stable housing finance system.”
The paper describes how survey data determines the APOR, noting: “The APOR rate spread rule is based on the difference between the annual percentage rate (APR) and the APOR. A conventional loan at or below the APOR threshold of 150 bps [basis points] bestows safe harbor status on the lender against a consumer challenge.
“While advocates of the APOR approach have argued that 'mortgage rates reflect credit risk more holistically than DTI ratios,' the APOR rate spread rule is actually more dangerous than the original QM rule. The APOR does not accurately capture risk, could be subject to gross manipulation, and would not provide any friction to slow a housing boom already in its 9th year,” the paper concludes.
Cyclicality and Affordability
The QM patch, meanwhile, provides a safe harbor from consumer challenges for certain mortgages eligible for purchase or guarantee by Fannie Mae or Freddie Mac - an exemption from the requirement that a debt-to-income ratio be at or below 43%. The GSE loans can go up to 50%, with stiffer requirements for borrowers between 45% and 50% than those at or below 43%.
Another danger cited by Peter and Pinto: “The APOR rule will act pro-cyclically to boost demand by providing more leverage during a seller's market, which will get capitalized into higher home prices. The results will be worsening affordability and even greater exposure to mortgage risk, especially for low- and moderate-income borrowers. This outcome would be worse than maintaining the QM patch.”
A further boom in housing “would potentially intensify the next bust,” they assert. “In short, gains would be privatized for the industry, and losses would be socialized for the public.”
Mortgage Default Rate
With APOR deemed “a very weak proxy for risk,” a superior solution would be to replace the 43% DTI limit on QM loans “with a stressed Mortgage Default Rate (MDR) limit, which captures risk holistically while ensuring responsible, affordable mortgage credit availability.”
Peter and Pinto explain, “The MDR takes risk layering into account by assessing risk based on the interaction of three major risk factors (credit score, DTI, and combined loan-to-value ratio). This test is based on the default experience of over 3 million purchase loans that originated just before the financial crisis. It is a stress test comparable to a hurricane rating for buildings.”
They say DTIs “are not perfect but they are still a useful tool in assessing credit risk.”
They suggest: “If the CFPB has an overarching desire to avoid the use of DTI in the QM regulation, it should work towards testing if months of reserves were found to be predictive in determining ability to repay. If they were, substituting months of reserves for DTI may present the best possible solution for the CFPB and homebuyers.”