All of the major regulatory agencies worked together over the past few months to devise a set of rules governing what risks financial institutions may take on as they work in and around the securities markets.
The 376-page document can make for rough reading, but the section which pertains to residential mortgage risks is certainly clear enough. One of the concepts open for public comment is the definition of a qualified residential mortgage (QRM) (see bottom of page 105 of the document). A QRM is intended to be a loan so secure that a lender who packages mortgage-backed securities (MBS) from them doesn't need to hold any money back against them in case the loans which make up the security should go sour. All loans not classified as QRMs would see the security-issuing entity required to hold back 5 percent of the value of the security on their books.
About the QRM
In the working document, the outline for a QRM calls for a minimum of 20 percent down for a purchase, and a 25 percent remaining equity stake for a standard refinance (30 percent stake for a cash-out refinance). These requirements could pertain to fixed rate or certain adjustable rate mortgages, with borrowers subject to full income verification and documentation and traditionally-conservative qualification ratios of 28 percent for housing debt and 36 percent for all debts (a.k.a. "front-end" and "back-end" ratios). There is no standard for a minimum-qualifying credit score, since the agencies believe that would leave open too many questions about the private models (e.g. FICO, VantageScore) which are used by lenders. Instead they’re choosing to use specific borrower information as it pertains to late payments as a qualifying standard. Presumably, though, and in light of the other restrictions, this standard would call for QRMs to be available only to borrowers with very good to excellent credit.
Along with other criteria, the proposed definition of the QRM is so narrowly written that there are legitimate concerns that few borrowers will be able to overcome the hurdles to get access to what is expected to be the cheapest and most-widely available mortgage in the market.
But is this a good thing or a bad thing? These super-prime borrowers (those who would qualify for a QRM) would pose the least risk to themselves, lenders and the financial system, which is a good thing, to be sure. At the same time, however, how much additional risk might there be with only a 10 percent down payment with private mortgage insurance (PMI) coverage, or even slightly wider qualification ratios? The Fed did conclude that the incidence of loan failure didn’t improve with the use of MI in conjunction with a smaller-than-20-percent down payment. If the financial losses from those risks are covered, though, does this pose an undue risk to the system?
For and against such a narrow definition
Among the arguments heard during the document's drafting was that a narrow definition would leave a sizable non-QRM private market -- large enough so that lenders wouldn't ignore it and would be willing to lend to it at fairly competitive prices.
On the other hand, opponents argue that with such a narrow definition, lenders may simply focus on these super-prime borrowers and may not want to (or not always want to) go after the non-QRM audience, what with the holdback requirements and any number of risks in the market at a given time.
A lack of non-QRM competition might leave too many good-quality borrowers without access to the home financing market, or faced with considerably higher interest rates and fees when financing is available. Lenders or security issuers might also run into capacity issues, since each MBS which is created will likely require millions (perhaps billions) of dollars to be held in reserves.
It also brings up geographic issues, since there may be markets where only a very slim minority can attain the financial levels needed to get a QRM-level loan. Furthermore, if real estate markets should crater in a given market, will lenders even be interested in making any loans outside the QRM? What will become of the housing markets in these areas?
Authors still unsure of definition
We may again return to the days of wide disparities in loan availability and pricing from lender to lender and market to market, as banks and others turn from broad lending supermarkets to specialty retailers serving only small profitable niches of the market. Products may appear and disappear from the mortgage menu, or may only appear in one locale and not another.
The QRM is a thorny issue, to be sure. Even the authors of the document are unsure since they left open for comment their concerns that perhaps the definition might better be wider than narrower. In Section E (page 153) the authors ponder whether 90 percent loan-to-value (LTV) loans, or loans with higher qualification ratios (and other factors too) might be better, or whether stricter guidelines should be considered than those proposed.
While public comments will be gathered between now and June 10, 2011, final proposals may not come for a while after that, and any implementation into the market will probably have a future date of six months or more after that. It seems to us that at least some of this might not be resolved until we know the structure of whatever secondary markets will exist at that time, be they Fannie, Freddie or a new entity or set of entities. If nothing else, someone needs to make a market for the new QRM-backed securities to foster at least initial liquidity, as at the moment it's a reasonable bet that Wall Street entities may wait on the sidelines before they dip any toes in the water, so to speak.
So, is the definition too wide or too narrow? Will the private market be incented to flourish or will it run for the protection of the government definition of a risk-free mortgage? Even if they should jump in, do lenders have sufficient capacity and desire to serve all comers, and at what price will that service come? Will a lack of reasonably-easy financing continue to keep the housing market from staging any semblance of a normal recovery for years yet? Is there a risk of turning the housing market into one of have and have-nots?
In addition to these, there are many more (and will continue to be many more) unanswered questions as reform of financial markets continues. As we disturb well-established markets, we of course run the risk of unintended consequences. Should reform be a matter of "first, do no harm" or perhaps a single, overarching question: "Is collateral damage preventable?"
We'll be following closely in the coming months... and here's hoping you will be, too.
Keith T. Gumbinger, Vice President of HSH Associates, is a 25-year expert observer of the mortgage and consumer debt industries. Keith has been cited in tens of thousands of articles covering a wide range of consumer finance topics. These have appeared in publications and outlets including The Wall Street Journal, USA Today, Money Magazine, the New York Times, Kiplinger publications, U.S. News and World Report, BusinessWeek, Forbes, Bottom Line Publications, and dozens of local newspapers. He has been a featured guest on NPR Radio and Oprah Winfrey's XM Radio program with Jean Chatzky, and has been occasionally seen on CNBC, CNN and the national news broadcasts for ABC, CBS and NBC television networks. Keith has authored or co-authored a number of consumer guides, including those for first mortgages, refinancing, home equity, mortgage prepayment and more, and is the primary researcher and writer for HSH.com's MarketTrends newsletter.