Seven years after U.S. home prices started tanking, America’s housing market overhaul seems on track to produce a wall of new rules that might still leave the door open to excessive risk.
Before delving into the crux of the matter, though, a brief history is in order. The core of the reform effort is the gargantuan Dodd-Frank bill of 2010, with which Congress set the guidelines for shaking up the entire financial system. On the housing sector, Dodd-Frank established two main principles. First, mortgage lenders should be held accountable for verifying borrowers’ ability to repay. Second, sponsors of mortgage-backed securities (MBS) should be required to “keep some skin in the game,” by holding on to at least 5% of the risk connected to the underlying assets, except in the case of mortgages deemed extremely safe.
Congress charged the newly created Consumer Financial Protection Bureau (CFPB) with setting the standards lenders should follow to establish prospective homeowners’ ability to repay. The task of defining which mortgages should be exempt from the 5% risk retention rule, on the other hand, went to a committee of six regulatory agencies including the Treasury Department, the Federal Reserve and the Securities and Exchange Commission (SEC).
The CFPB draft rules were ready in 2013 and are on track to become effective in January of next year. Unsurprisingly, the agency’s standards exclude the kooky practices that became popular in the bubble era, such as teaser rates, balloon payments and no-docs mortgages, which allowed borrowers not disclose income and any assets already owned. CFPB also recommends capping a prospective homeowner’s debt-to-income ratio at 43% of gross income—with “debt” meaning all of a person’s outstanding loans, not just the mortgage. Lenders can opt to disregard the CFPB guidelines, but face greater legal liability doing so, as borrowers can sue them for damages if they default.
On risk retention, the first stab at the new rules came in March 2011. The Fed, SEC et al. proposed, among other things, that only MBS backed by mortgages with a downpayment of 20% or more be exempt from the 5% rule. The draft, though, provoked an uproar from the housing industry and housing advocates, who argued the standards were so high they would choke financing for anyone but the wealthiest and most credit-worthy borrowers. Reacting to the backlash, the agencies have re-issued different proposed rules last week: The new standards for mortgages deemed safe enough to be excluded from the 5% rule are now the same as CFPB’s.
That’s a very low bar. The exception is so broad it would have covered 98% of the mortgages issued last year, according to the Wall Street Journal. According to the SEC, which opposed the new draft rules: “Of the loans originated from 2005 to 2008 that would have qualified [under the re-proposed rules], a staggering 23 percent experienced a 90-day or greater delinquency or a foreclosure by the end of 2012.”
If the draft rules are approved as they are, in other words, the end result of a multi-year overhaul effort will amount to little more than discouraging the most gimmicky mortgage practices.
It might be too early to declare that the new regulations are too lax. Perhaps they truly are what’s needed to inoculate the U.S. housing market against systemic risk while preserving high levels of liquidity and ensuring even low-income Americans can buy a house.
But even if you’re fan of minimal regulation, you won’t be happy with the outcome that’s in store here. The end result will be very different than if regulators had decided right away that the solution was to deter the creation of new junky mortgages. Had that been the case, today we’d probably have a couple of commonsensical, simple rules. Instead, the never-ending regulatory rumination that started after the financial crisis has produced a jungle of new provisions that try to micromanage lenders’ behaviour.
As the SEC noted in its dissenting opinion, the new mortgage standards effectively remove “all incentive to perform meaningful borrower-level reviews to determine, on a case-by-case basis, whether a loan is likely to be repaid and, therefore, should be made. Instead, [they focus] almost exclusively on the product features of the loan.”
But the new rules don’t just excuse lenders and securitizers from exercising their own judgement. They could also create perverse incentives. As one prominent housing market commentator noted, “a 30-year fully amortizing loan with no down payment to a borrower with a FICO [credit] score of 580, no current debt outstanding but also hardly any assets, and a … debt-to-income ratio of 43% would [meet the proposed standards], even though by any standard such a mortgage would be viewed as extremely risky.” By contrast, an interest-only mortgage (whereby you only need to pay the interest, not the principle) made out to a very wealthy borrower with an impeccable credit score who made a 40% down payment wouldn’t qualify because interest-only mortgages fall outside CFPB standards.
More red tape and little risk reduction would be the worst of both worlds.
Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy.