Origins and background

• On Jan. 10, 2014, the Consumer Financial Protection Bureau’s (CFPB) Qualified Mortgage (QM) rule went into effect, almost four years after it was first enacted as part of the Wall Street Reform and Consumer Protection Act (commonly known as the “Dodd-Frank” legislation).[1]
• The primary objective of the rule is to prevent the types of mortgage lending that many observers blame for the housing bubble and bust. In particular, the QM rule forces mortgage lenders to focus squarely on a borrower’s current ability to repay their loan.
• Prior to the rule, lenders were free to make assumptions about the trajectory of home values and write off any repayment risk with the assumption that, in a worst case scenario, the loan could be liquidated without loss because of rising home values.
• As the rule was drafted and finalized, it received substantial opposition and (eventually) input from the financial services and real estate industries concerned that the rule proposed overly restrictive lending standards.
• The National Association of Realtors and the Mortgage Bankers Association do now support the final rule, albeit with reservations. The rule continues to receive criticism, particularly from industry insiders.

What does it do?

The most prominent clauses of the QM rule:

• Prohibits some of the most questionable types of mortgage loans that emerged pre-crisis.[2]
• Specifies criteria that lenders must use to determine whether the borrower has the means to pay back the loan.
• Sets a maximum debt-to-income ratio of 43 percent.[3]
• Caps points and fees at 3 percent.[4]
• Prohibits use of teaser rates in affordability calculations.
• Requires that adjustable-rate mortgages (ARMs) be underwritten to the maximum interest rate that can be charged during the first five years of the loan term.

Like any good legal document, there is fine print. And exceptions. Most prominently, FHA- and GSE-sponsored loans are exempt—for seven years in the case of FHA, and in the case of the GSEs, for seven years or when they exit conservatorship (whichever comes first).

Five common concerns

1) QM will tighten lending standards too much

Most concerns about QM revolve around the argument that it will tighten lending standards too much, making it too difficult for new home buyers and those with smaller down payments or lower credit scores to obtain mortgages.

The “Goldilocks” question—is credit too tight, too loose or just right?—is a bit of a red herring. There is no such thing as “too tight” or “too loose.” Instead, there are decisions regarding the risks lenders are willing (and allowed) to assume and the prices (in the form of interest rates) they charge borrowers to assume that risk. QM puts some limits on the risks lenders are allowed to assume—in part, because the rule was written in response the recent experience of lenders profiting when their risky loans turned out well but passing off the cost to taxpayers when their risky loans turned out poorly[5]—and indirectly limits the prices (interest rates) lenders are able to charge. But, many would argue, this is a reasonable response to recent history when lenders generated, but never bore, credit risk.

So blanket criticism such as “QM makes credit too tight” likely reflects frustration about perceived government interference in what are ostensibly private business decisions. That is debatable, at least when one takes into account the public externalities of private actions.

The same critics who bemoan the too-tight availability of credit also tend to bring up the recent example of former Federal Reserve Chairman Ben Bernanke being unable to refinance because of an inability to document future income potential, even as he stands to make millions on the speaking circuit. As journalists delved further into the assertion, they were able to identify refinance options for Bernanke.

2) QM will prohibit a large majority of loans

Some have expressed concern that QM will force banks to stop lending. Rep. Paul Ryan, R-Wisc., famously said in October 2013 that the rule would prohibit “up to 75 percent” of the mortgage loans in his district.[6] This is wrong, at least in the near term. Given the safe-harbor provisions for loans that meet FHA or GSE standards, the vast majority of mortgage loans already comply with the QM rule.

3) ARM requirements

Another common target of criticism is the requirement that adjustable rate mortgages be underwritten to the maximum interest rate that can be charged during the first five years of the loan term.

For the vast majority of borrowers, this too is a red herring. Most ARM loans are not pure ARMs, but rather hybrid 5/1 or 7/1 ARMs where the introductory fixed rate period equals or exceeds five years.

4) DTI cap is too low

It is common to hear that the 43 percent debt-to-income (DTI) cap in QM will exclude large populations of new home buyers, low-income adults and foreclosure survivors from homeownership. This is particularly concerning given the rise in student debt burdens among young adults in recent years.

• New home buyers with high debt. The most relevant concern here focuses on young adults with high debt levels (particularly student debt) and low current incomes, but high potential lifetime incomes (think: medical residents and some academics). It is reasonable to assume that this population might be able to shoulder higher DTI ratios and, although there might be workaround with a combination of an FHA loan and an eventual refinance, they could be adversely affected.
• New home buyers in high cost areas where home values are growing rapidly. Concerns might also arise with respect to new home buyers in high cost areas where home values are growing rapidly (think: Silicon Valley). High debt levels might be necessary to afford even entry-level homes, and it might be a safe bet if it will be possible to liquidate the asset at a profit if the borrower is suddenly unable to carry the loan. This is the same kind of bet that was widespread pre-crisis.
• Individuals with high debt levels. Finally, what about individuals with high levels of other debts—be they medical, consumer or something else? These borrowers very clearly have, rightly or wrongly, had their mortgage borrowing options reduced.

Finally, to say that the rule will not exclude young adults with high student debt levels from homeownership is distinct from saying that it will likely raise the costs of homeownership for this population. FHA loans with low down payments are typically more costly than conventional loans.

5) QM creates more paperwork and less choices

Probably true. The additional paperwork likely will increase origination costs somewhat because of the need for more lawyers and more time spent verifying paperwork (as evidenced in Fannie Mae’s Mortgage Lender Sentiment Survey, see below). But it also reduces lenders’ repurchase risk, so it’s disingenuous to claim that lenders must bear this cost alone.

Larger lenders are best positioned to pursue more costly, but potentially more rewarding, non-QM loans. They have lawyers, contact with regulators, etc. This is nothing new—that’s where the innovation has always happened and that’s where the risk tolerance is as well.

And on the choice question: Choice is a chimera if it only ensnares you at a later date. Many of the choices that borrowers had pre-crisis—such as interest-only and prepayment penalty loans—have always been small corners of the market and were doubtlessly abused.

Impact

Only 10 months after its enactment, it may be premature to draw sweeping conclusions about the impact of the QM rule on the industry and on housing markets. However, despite the alarmism of some commentary, two recent surveys of mortgage lenders—the Federal Reserve Board’s July 2014 Senior Loan Officers Opinion Survey (SLOOS) and Fannie Mae’s August 2014 Mortgage Lender Sentiment Survey (MLSS)—suggest that the QM rule has had a relatively modest impact thus far.

Since both surveys ask lenders about their perceptions, responses may be colored by preconceptions. However, more definitive evidence likely won’t be available until September 2015, when 2014 Home Mortgage Disclosure Act (HMDA) data are released. Even then, developing sensible baselines and counterfactuals will be particularly difficult.

Senior Loan Officers Opinion Survey

The July 2014 Senior Loan Officers Opinion Survey (SLOOS) included supplemental questions on the effect of the ability-to-repay (ATR) and Qualified Mortgage (QM) standards on approval rates for purchase mortgage loans.

• Most lenders say that QM rules will have no effect on approval rates for most loans. The majority of respondents (63 percent) said the ATR/QM rules had no effect on the approval rates of prime conforming loans, largely because those loans are exempted from the rules since they meet GSE underwriting criteria.
  • About one-third (36 percent) said the prime residential mortgage approval rate was “slightly lower” or “much lower” than it would be otherwise as a result of the ATR/QM rules.
  • Small- and mid-sized banks were much more likely to say that the rules had an adverse effect on prime residential lending: Half of small- and mid-sized banks said that the approval rate had declined, compared to 22 percent of large banks.

• Approval rates have declined for certain specialty loan types. However, about half of respondents said that the ATR/QM rules reduced approval rates on applications for prime jumbo purchase loans (52 percent), and for nontraditional loans (53 percent).[7]
  • Responses were similar for prime jumbo loans regardless of bank size.
  • For nontraditional loans, small- and mid-sized banks were much more likely to cite an adverse effect (67 percent versus 39 percent for large banks).
• Documentation requirements and the DTI cap are perceived to have had the largest effect on lending. The main provisions of the ATR/QM rules cited as contributing most to lower approval rates for prime jumbo and nontraditional loans were:
  • The ATR provisions requiring originators to evaluate income and to assess total assets and debts.
  • The QM provisions that cap borrowers’ debt-to-income ratio at 43 percent.

These results suggest that, six months after their enactment, the QM rules were having little- to no-effect on “normal” borrowers—those with average debt levels and average incomes seeking to buy average homes with average lending terms. At the margins, some borrowers who had difficulty documenting their income and assets, those with very high debt and those seeking nonstandard loan products were certainly experiencing fewer options. Understanding more about these frustrated borrowers—particularly, why they are unable to document income and assets and why their debts are so high—is necessary to fully understand the impact of the QM rules.

Mortgage Lender Sentiment Survey[8]

The August 2014 Fannie Mae Mortgage Lender Sentiment Survey (MLSS) included targeted questions asking Fannie Mae lenders about their responses to QM rule.

• For most lenders surveyed, a large majority of loans already complied with QM rules. Among lenders surveyed, 84 percent said they expect that at least 90 percent or more of their single family mortgage origination dollar volume will still be classified as QM-compliant under the new rules. This is true for all lender sizes.
• Most lenders are taking a ‘wait and see’ approach to non-QM lending. Almost half of lenders surveyed (46 percent) are taking a ‘wait-and-see’ approach to non-QM lending for the time being. About one-third (34 percent) do not plan to pursue non-QM lending, and the remaining fifth (19 percent) plan to actively pursue non-QM loans.
  • Large lenders are more likely to have plans to pursue non-QM lending: More than one quarter (28 percent) of large lenders said they plan to pursue non-QM lending, and another 51 percent are taking a ‘wait-and-see’ approach.
  • By contrast, only 12 percent and 17 percent of mid-sized and small-lenders, respectively, said they plan to pursue non-QM loans. Among mid-sized lenders, 48 percent have explicitly ruled it out, compared to 36 percent of small lenders.
• A majority of firms said they expect QM will have no effect on credit standards. Among lenders surveyed, 58 percent said they expect the QM rule will have no effect on credit standards. About one-third (36 percent) said they expect it will tighten lending standards, with a slightly greater share of mid-sized and small lenders expecting the rule to tighten credit standards.
• Lenders are evenly split in their opinion as to the effect of QM on origination volumes. Equal shares said they think the rule will increase, have no effect on and decrease origination volumes.
• Most lenders think that QM will increase operational costs… A large majority of lenders of all sizes said they think the QM rule will increase operational costs: 74 percent among all lenders.
• …But a large majority of lenders also said they think the rule will reduce repurchase risk. About the same share of firms who said they think QM will increase costs also said they think the rule will reduce repurchase risk.

Similar to the SLOOS findings, the MLSS results suggest that most “normal” borrowers have not been affected by the enactment of the QM rule. Moreover, while the SLOOS suggests that many lenders are reducing the options available to borrowers seeking loans that do not meet QM criteria, the MLSS suggests that this may be a temporary response. Many lenders, particularly large lenders, are sitting on the fence and could begin to offer products to non-QM borrowers. Understanding the concerns of these lenders who are considering entering the non-QM market is a critical step for any future policymaking.

Conclusion

The reality is that many of the activities and products prohibited by QM were artificial affordability extenders pre-crisis—they were financial products designed to give the illusion of home affordability and allowed home buyers to buy substantially more expensive homes that their underlying income, assets and creditworthiness should have permitted. They compensated for weak income growth and rapidly rising home values by allowing home buyers (especially new home buyers) to finance the gap which, in turn, fueled faster home value appreciation. Going forward, this will no longer be the case (or, at least, it will be much harder to get away with).

Some (though not all) of the chicanery involved in financing home purchases in the pre-recession years can’t happen anymore. Borrowers have to meet affordability requirements (squeeze into the archetypal “credit box”) the old-fashioned way—by saving more and longer for a down payment, and/or by adjusting their expectations or budget.

There are upsides and downsides to this new reality. The upside is that the cyclical risks to consumers and the overall economy will be diminished. Transactions and values are not going to increase forever, as many expected in the mid-2000s. Many people will be forced to rent longer than they otherwise would have. But there should also be more transparency in the home financing process, and more responsiveness to local demand.

[1] Although the CFPB is the lead agency responsible for drafting and enforcing the QM rule, five other (six total) government agencies were also involved: the Federal Reserve Board, the Office of the Comptroller of Currency, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Securities and Exchange Commission and the Department of Housing and Urban Development.

[2] For example: negative amortization mortgages, interest-only mortgages, mortgages with terms exceeding 30 years, mortgages requiring a balloon payment and no-doc loans where neither income nor assets are verified.

[3] Prior to the rule there were no hard limits on DTI. Individual lenders were free to select whatever DTI they were comfortable with, although most lenders informally capped DTI between 40 percent and 50 percent. Some special types of loans—such as those insured by the Federal Housing Administration (FHA)—had harder limits.

[4] Prior to the rule there were no caps on points or fees.

[5] There is substantial debate over whether today’s mortgage lenders should “be punished” for the mistakes of their predecessors a decade ago. The focus on punitive action is, perhaps, misplaced. Absent the rule, there is no guarantee that today’s generation of lenders would not repeat the same mistakes of their predecessors.

[6] HousingWire, “Paul Ryan: We will try to get QM delayed,” October 29, 2013.

[7] Nontraditional loans include adjustable-rate mortgages with multiple payment options, interest-only mortgage, Alt-A products and investor mortgages.

[8] Fannie Mae, Mortgage Lender Sentiment Survey, Impact of Qualified Mortgage Rules and Quality Control Review, August 14, 2014.