In the wake of the mortgage meltdown, risk-retention provisions in the Dodd-Frank Act established a smart new framework for mortgage lending. After much debate, the framework was devised to match loan-quality standards against the need for lenders to keep some skin in the game.
To encourage responsible lending, the law includes a provision that exempts safe, stable mortgages to borrowers whose income and assets are fully documented. Policymakers thus rewarded responsible borrowers and lenders — seemingly good policy, right?
The devil is in the details, however.
Federal banking regulators, the Department of Housing and Urban Development, the Securities and Exchange Commission and the Federal Housing Finance Agency are now writing regulations to enforce the "qualified residential mortgage" exemption. A draft is expected early this year.
But one of the nation's largest lenders has come to believe that what is good for the responsible consumer — strong competition that leads to lower-cost mortgages — might not be good for its business. In comments to the agencies writing the risk-retention rule, Wells Fargo & Co. proposed different standards for the QRM exemption. Rather than focusing on a cohesive set of strong underwriting practices, including documentation, debt-to-income ratios, and other traditional loan metrics, Wells suggests a single threshold for the exemption — a maximum loan-to-value ratio of 70%.
Under this framework, thousands of responsible, low-risk borrowers would instantly lose the option of getting a loan with lower costs. After so many homeowners have seen the value of their properties fall in recent years, many simply cannot come up with a 30% down payment. Prospective new homeowners who otherwise present little risk, but lack a 30% down payment, would face mortgage rates that one expert estimated could be up to three percentage points higher. The incentive for sound underwriting and stable, affordable loan features would disappear.
The definition of a QRM is meaningful. According to an analysis of 35 million mortgages originated from 2002 to 2008, loans that satisfied eight basic product and underwriting criteria — the same ones specified in the statutory framework — performed almost three times better than non-QRMs. In other words, mortgages that did not meet those standards defaulted at almost three times the rate of QRMs.
Why would one bank want to gut the statutory QRM framework, a standard that clearly results in fewer defaults, and deny responsible borrowers the opportunity to be rewarded for their good credit and smart product choices? The answer is that gutting the QRM loan profile would drive up costs for many otherwise low-risk borrowers, thus creating the opportunity for significantly bigger profit margins at the biggest lenders.
As Congress debated Dodd-Frank, early drafts included risk-retention provisions that treated all mortgages alike. When Sens. Mary Landrieu, D-La.; Kay Hagan, D-N.C.; and Johnny Isakson, R-Ga., proposed the final risk-retention language, their goal was to encourage responsible lending. They recognized that not all mortgages are the same and that risk-retention requirements should be tailored to match the risk. In the end, their correction became law.
Midsize and smaller lenders offer consumers choices in the marketplace. But under the Wells Fargo model, without the access to cheap capital enjoyed by the megalenders, independent lenders would not be able to satisfy the risk-retention requirement on a significantly bigger pool of loans. Rather than encouraging responsible lending, the Wells Fargo model would force most independent lenders out of business, reducing competition for the "too big to fail" megalenders and driving mortgage costs higher.
Coincidentally, assuming the Wells proposal would produce bigger profit margins at the megabanks, this would come just as the megalenders would have to raise additional capital under Basel III.
In keeping with the letter and spirit of the law as enacted, regulators must base the QRM standard on those loan features and underwriting standards that have been proven, through loan performance data, to reduce default risk. They must reject this transparent attempt by the megalenders to use rulemaking to enhance profit margins at the expense of consumers and independent mortgage lenders.
Responsible lending — not higher profits for "too big to fail" banks — is a key element of the housing recovery and national economic growth.
