It will be a surprise if there is much left of the mortgage market now that new rules on the so-called Qualified Mortgage (QM) were put into effect today by the Consumer Financial Protection Bureau (CFPB). Both the CFPB and the QM are artifacts of the Dodd-Frank Act, adopted in July 2010. The unique thing about the QM is that it purports to punish the lender if the borrower can’t afford the mortgage. This is quite unique in concept, but is a product of the behavioral economics school, which holds that consumers are easily deceived about financial products. Hence, if it turns out that the borrower cannot afford a loan, the presumption is that the lender was either not careful enough in explaining it or was reckless in providing it in the first place.
Following this logic, the punishments for the lender can be severe, and include a defense to foreclosure, which of course provides an incentive for borrowers to be less than fully candid with lenders. We will be seeing many more rules like this as the CFPB moves along in the future, because its economic policy staff is dominated by behavioral economists.
The new proposed rules are complicated, of course, but basically they say that if a QM is a “prime loan”—a mortgage that does not involve any special compensation to the originator and is approved by the automatic underwriting systems of Fannie Mae, Freddie Mac, and the FHA—the lender has a “safe harbor” exemption from the penalties the act and the regulation contemplate. That sounds pretty good until you look at what the lender has to be sure about before the safe harbor kicks in. The regulation outlines eight key factors the lender has to address in order to gain the safe harbor. Most of them are numbers that can be knowable, like monthly payments that the borrower must make on this and other loans. However, at least three of them are subject to considerable ambiguity, making the mortgage a risky bet for the lender.
The lender must determine, for example, the borrower’s “current employment status” and “reasonably expected income or assets.” These are not objective facts. Is the lender supposed to know if the financial condition of the borrower’s employer is shaky? Should the lender be aware of news articles about the employer’s sales and future prospects? Or should the lender be charged with knowledge about whether the borrower is a well-regarded employee whose long-term employment prospects are good? In local communities, lenders can actually know these things and might be charged with the knowledge if the borrower actually loses his or her job and cannot meet the mortgage obligations. Another requirement for the lender is to know the borrower’s “credit history,” but the FICO credit score is not mentioned as an objective test.
Thus, for mortgage lenders in the future making a mortgage for anyone but a bullet-proof credit will be a crap-shoot, a risk that many will not be willing to take. Moreover, the defense to foreclosure creates a risk for investors in mortgage-backed securities. They may find their returns significantly affected if the originators of the loan lose their safe harbor exemption and the borrower establishes the defense to foreclosure.
Dodd-Frank set about to prevent the deceptive lending practices that its sponsors believed, without much evidence, were one of the principal causes of the 2008 financial crisis. It now appears that they have thrown the baby away with the bathwater.