Mortgage Standards, the Economy, and You


Have we been here before?

As of yesterday, Wednesday, October 22, 2014, is reporting that the average rate for a 30-year fixed rate mortgage in the United States, the industry standard is 3.94%. This is down over a quarter of a percent from this time last month, and down nearly as much from this time last year.

HousingWire published a round-up of what the downturn in consumer interest rates has done to mortgage lending and, predictably, it’s a sizable upswing: an 11% increase is mortgage applications, and a stunning 23% increase in home refinancing for the week ending October 11.

There’s a lot to unpack in these numbers, and a lot of potential reasons behind their increase, but one thing is clear: credit is flowing more freely now than it has at any other point in 2014. According to the latest Case-Shiller U.S. national home price index, home prices are essentially where they were in early 2008. The 10-year chart shows the roller coaster on the way up. Or, if you’re feeling more cynical, you could suggest that we’re on the growing side of the next bubble. Consumer confidence took a tumble in September, even as the mortgage and refi application numbers were rising. So what’s going on here?

Filtering out the noise of the indices and the confidence numbers for a moment, let’s take a look at the refi and mortgage increase, because that might tell the tale for our industry in the fourth quarter of 2014, and the first quarter of 2015.

The lending and banking industry, arguably the most hated (fairly or unfairly, depending on where you stood in 2007) player in the financial crisis, has been keenly watching provisions enacted under Dodd-Frank that have been working themselves through the bureaucracy since 2011. Consider the Qualified Mortgage (QM) and Qualified Residential Mortgage (QRM) standards the bellwether for any changes lending institutions would need to make to their lending practices going forward. The numbers of mortgages and loan refinancing increasing in the past few weeks may be an indication of the bank’s certainty that the final versions adopted would be favorable, and so they began to approve more loans. And, naturally, one can draw a more or less straight line from flowing credit to repairs, remodeling, renovation and construction.

Qualified Mortgage Rule
Enacted in January of this year by the Consumer Finance Protection Bureau, the Ability Qualified Mortgage standards, a regulatory add-in in the Truth in Lending Act currently prohibits a creditor from making a higher-priced mortgage loan without regard to the borrower’s ability to repay that loan. Essentially, it seeks to correct some of the most predatory subprime lending activity that was the genesis of the 2007-2008 financial crisis and the severe recession that followed.

The wider economic theory was that with tighter regulation on how much someone could potentially be banged for borrowing, the less likely risky loans would be let loose into the securitization marketplace, where they could be packaged, sold, dissected and securitized, spreading the risk out into the wider market. That isn’t what tipped off the financial crisis of 2008, but it is what pushed the housing collapse onto the rest of the economy.

This is the very thing that the CFPB was created by the Dodd-Frank act to address, and so lenders, investment firms, home builders, realtors and anyone else with skin in the game has been watching with interest to see how the final definition of the Qualified Residential Mortgage standard would read when the dust settled.

It settled this week.

But let’s back up a moment and talk about what QRM actually means. The Dodd-Frank act required what the Federal Reserve calls a “risk retention rule.” Basically that means the old system, selling off the loan (and the inherent risk of a borrower defaulting on that loan) the minute after closing the deal, is over.

On the face of it, that’s better for everybody. Banks have to retain some of the risk, so they’re less likely to make risky loans that could kneecap the still-tenuous housing market recovery. But the level of risk mattered. If banks had to retain too much of the risk, there was incentive for them to keep credit tight. Too loose, or too little oversight and there would be no incentive to change. It settled the question which bankers seemed to have the most active interest in: Which loans would be regulated as Qualified Residential Mortgages, and therefore require the risk retention measures, and which would be exempt?

It was a long road to the rule released on Tuesday. Myriad agencies were involved in generating the regulation including Treasury, Housing and Urban Development, the Federal Deposit Insurance Corporation, Securities and Exchange Commission, Federal Housing Finance Agency, and the Federal Reserve. Over the course of the past three years since Dodd-Frank was passed and the initial QRM proposal laid out, regulators received comments on the proposal from over 10,000 individuals and businesses.

What they released as the rule essentially amounts to an alignment with the Qualified Mortgage rule, surprising exactly no one who was paying attention. That the number of mortgages and refinance deals ticked up in recent weeks could be a sign that lending institutions saw this coming.

The major points here are that Qualified Mortgages must have
• regular periodic payments that are substantially equal
• no negative amortization (think of the early 2000s classics the balloon-payment mortgage or the interest-only mortgage)
• a maximum loan term of 30 years (in 2007, you could get a 40-year-term for, confusingly, a much higher interest rate)
• total point and fees that don’t exceed 3% of the total loan amount, or the applicable amounts specified for small loans up to $100,000
• payments underwritten using the maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment is due*
• consideration and verification of the consumer’s income and assets, including employment status if relied upon, and current debt obligations, mortgage-related obligations, alimony and child support (essentially, predatory No Income No Asset loans will be consigned to our unfortunate past)
• a total debt-to-income ratio not to exceed 43%

*this was part of the original proposal verbatim

Potential Pitfalls
That final point comes with a cost. A QRM may not be able to have a DTI above 43%, but that doesn’t mean banks can’t lend to heavily leveraged borrowers. It just means they must retain a 5 percent slice of those loans when they’re selling them off to packagers. This seems to complicate the transaction. A big problem late in the subprime meltdown was the evidence of fraud by lenders. Seeking to fight back, borrowers (and the judges who would eventually hear their lawsuits against their lenders) had difficulties en masse trying to decode who actually owned their loans, because they had changed hands many times. If this rule does not limit how many owners a potential loan has, and essentially guarantees that not only will loans have many owners, but that by the 5% rule pieces of loans will be owned by multiple parties, will this pave the way for confusion in the marketplace (to say nothing of the confusion in the legal system).

The memorandum seems to lean heavily on the Dodd-Frank provisions as having “fixed” what was wrong with the marketplace: low transparency for investors, and inadequate, if any risk management (unless you consider spreading risk to everyone in the marketplace, whether they realized it or not, a management strategy).

That Wall Street likes the deal is a clue that maybe this isn’t a great boon for the consumer after all, and therefore a great boon to the building and remodeling industry that is directly tied to the ups and downs of consumer lending and consumer confidence. Another part of the adopted rules say that lenders have to keep stakes in mortgages and the highly leveraged corporate bonds they package for sale to investors.

Yet, CDO managers and their underwriters appear, at least on the surface, to bear new responsibility. Collateralized Debt Obligations, which were the products that actually spread the subprime plague worldwide as they were made up of multiple pieces of subprime loans packaged by banks that, despite all logic, received high marks from the ratings agencies, were a natural target for regulators. So complex a financial instrument that bankers alone could not have come up with them, essentially a CDO has multiples pools of mortgages arranged by risk. Each pool is rated according to its creditworthiness by one of the major ratings agencies: Standard & Poor’s, Moody’s, or Fitch. The problem in the first half of the decade was that no matter how these subprime pools were arranged, every loan was still a subprime loan. And yet, when the agencies went to rate the pools, the pools at the top identified as lowest risk (but, remember, lowest risk among subprime borrowers) were rated triple-A. Which allowed institutional investors like pension funds, which are restricted from buying anything less than triple A most of the time, to buy in. It was all a house of cards: it looks more substantial than a single card on its own, but it’s just as fundamentally unsound.

So, now CDO managers and their underwriters, which are typically big Wall Street firms with departments that specialize in just this one kind of financial instrument, must retain 5 percent of the debt they package or sell. But how big a hit would this really be? Because these are dark pools of unknown quantity and size, the estimates are incalculable, and the method of oversight isn’t immediately clear.

There are opposing voices on both sides. Dissenters on the vote that took place at the SEC decry unseen costs to the markets and claim the process was done for speed not accuracy, according to Bloomberg, but that, too, seems incalculable at this point. The Wall Street journal, on the other hand, sees this as a shift in focus entirely. In a story on Wednesday, WSJ reporters Alan Zibel and Joe Light write that “a push to tighten mortgage-lending standards in the wake of the housing bust has given way to making credit more accessible as Washington frets about the strength of the housing recovery,” implying that the final version shifts the original intention of Dodd Frank, and the amendments to the Truth In Lending Act entirely.

It’s also acknowledged by industry insiders and industry-tied media that this a softer version of the original proposals which included, among other things, the requirement that a borrower have a 20% down payment. I have no numbers to back up exactly how much lobbying the banking and investment industry spent to lobby for changes, but the laudatory press releases issued by industry associations, including those with from our own industry, seems to underline that they had an opinion on the matter.

For example, the National Association of Home Builders is a fan of the rule. Chairman of the NAHB, Kevin Kelly, released a statement on Tuesday applauding the regulating agencies, saying it will “encourage sound lending behaviors that support a housing recovery, attract private capital in the mortgage market, help ease tight credit conditions for borrowers and reduce future defaults without punishing responsible borrowers and lenders.”

(For context, I can count the amount of times I have written the phrase “association applauds regulating agencies” on one hand.)

In fact, early in the statement, he all but admits the Association lobbied for the rule. “Since 2011, NAHB has worked independently and with a coalition of housing advocates to urge regulators to establish a QRM rule that removes downpayment requirements and other onerous underwriting criteria to alleviate confusion in the marketplace and keep homeownership affordable for working American families.”

And why shouldn’t they when they have consumer groups lobbying right alongside them for increased accessibility to credit? As long as groups representing consumers have to balance advocating for greater protections against predatory lending with pushing for looser lending standards, the regulating agencies will be hearing and heeding a set of very mixed and complex messages.

Recession Tutorials
The message for the short term is that there’s going to be better access to credit; we’re already seeing that borne out in the numbers. Consumer confidence took a dip in September, but that’s just one month, too small a sample size to draw any conclusions. The short term looks promising, but the real question, as always, is what we are setting ourselves up for not this quarter or next, but Q3 or Q4 2015 and beyond. Are the regulations enough to keep control on an industry that is remembered for its misbehavior, taking a chunk out of building and remodeling in the not-too-distant past?

What lessons we learned during the downturn about managing cost, reducing risks in our own business models, operating smarter and leaner, will, with any luck, bear us out no matter what rules are passed down for the industries that immediately intersect with and influence our own.

Andrea Girolamo is the editor of

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