The Federal Government in the Restoring American Financial Stability Act of 2010 reversed its long-standing policy of favoring disadvantaged borrowers. Under the new rules, borrowers who can qualify only for mortgages with relatively liberal repayment provisions, which are already priced higher because they are riskier to lenders, will be subject to an indirect cost that will affect only them.

Implications of the Act For Mortgage Borrowers

This unintended effect arises from new restrictions on mortgage lenders, combined with a safe harbor where lenders are not subject to the restrictions. Lenders are in the safe harbor when they make qualified mortgages, which are those with low risk characteristics, such as fully-amortizing payments, terms no longer than 30-years, qualification based on the highest possible rate in the first 5 years, and so on. Disadvantaged borrowers who need lower payments in the earlier years will require non-qualified mortgages.

The new burdens imposed on lenders are non-trivial. One holds lenders responsible for loans being “affordable”, and spells out in excruciating detail all the bases lenders much touch in meeting this responsibility. A second burden is that lenders must retain at least 5% of the credit risk on new loans. But if a mortgage is qualified, the law presumes that it is affordable, and the lender is not obliged to retain any of the risk of loss.

Qualified Versus Unqualified Mortgages

Very shortly,  the market will split between qualified and non-qualified mortgages. At best, the price difference between them will increase to reflect the new costs associated with non-qualified mortgages.

As an example, on July 19, the rates on 40-year fixed-rate mortgages were almost 1% higher than the rates on comparable 30-year mortgages. Since under the Act 40-year loans cannot be qualified, the price difference will widen as soon as lenders making 40-year loans are forced to assume the new burdens imposed by the aCT. The borrower who needs a 40-year loan to qualify will be further disadvantaged.

At worst, the market for non-qualified mortgages will disappear altogether, or (almost as bad) will shift entirely to a small number of mega-lenders.

It would be one thing if crippling an important segment of the market – one that caters primarily to the disadvantaged – was a necessary price to pay for making the system safe and stable. It is quite another when the restrictions are not only unnecessary for achieving that objective, but will make the current excessive stringency in the home loan market, even worse.

The Loan Affordability Requirement 

The rule that lenders should be responsible for all mortgage loans being affordable to the borrower is a knee-jerk reaction to the excesses of the bubble period, when many adjustable rate loans to sub-prime borrowers were not affordable past the initial rate period -- usually 2 years. The underlying presumption was that the lender would be protected by rising home values.

The fallacy of that presumption became so glaringly evident after the crisis that underwriting requirements – the rules defining who can and who cannot be approved - swung 180 degrees, from lady bountiful to Mr. Scrooge. Fannie Mae and Freddie Mac, whose excessive liberality during the bubble sowed the seeds of their subsequent insolvency, have been spearheading the swing to excessively restrictive rules. These are currently preventing millions of borrowers with perfect mortgage payment records from being able to refinance at the currently low interest rates. The current rules are as restrictive regarding affordability as those in the Act, but they are not yet frozen into law.

A rigid affordability rule terminates an industry trend toward increasing flexibility in underwriting requirements. Over several decades ending in 2007, the industry (including Fannie and Freddie) learned that it was both safe, fair and market-enlarging to balance one underwriting rule against another. Conventional ratios of housing expense to income became a part of the decision process but were no longer rigid barriers to approval.

As an example, before the crisis a borrower with a credit score of 800 and equity of 40% would be approved, even though he could not document much or any income. The sensible presumption was that such a borrower knew more about what he could afford than the underwriter, and in the unlikely case where the presumption was wrong, the lender was protected by the equity. Today, such borrowers are being rejected out of hand. The Act  would freeze this into law, since it explicitly bars lenders from basing a loan decision on the borrower’s equity.

This is absurd, not only because such loans are safe to the lender, but also because some unaffordable loans are clearly in the interest of borrowers. My web site article on “Mortgage Affordability: Should Government Require It?” cites many different situations where a loan is both safe to the lender and useful to a borrower who can’t meet affordability tests. Some of these involve using home equity to offset a temporary loss of income, much as in the case of reverse mortgages. The difference is that reverse mortgages are exempt from the affordability rules in the Act while other mortgages that employ the same principle of using equity to supplement income, are not.

The "Skin in the Game" Requirement 

The second burden imposed on lenders by the Act, which they can escape only by writing qualified mortgages, is the 5% “skin in the game” requirement. It is an excellent rule to impose on issuers of mortgage-backed securities – if it had been in force during the bubble period, the panic would have been avoided. Lenders made unaffordable loans during that period only because they could sell them to security issuers, who were able to shift the risk to investors. If security issuers had been on the hook for losses, none of it would have happened.

To protect the system, we need security issuers to have skin in the game. But imposing the rule on lenders accomplishes nothing except raising the cost of mortgages to disadvantaged borrowers.