Regulators Reverse One of Dodd-Frank's Few Quality Attributes

There are many reasons to be critical of the Dodd-Frank Act, but in at least one respect its drafters had the germ of a good idea. They recognized that in order to create a stable housing finance system it was necessary to have a high quality mortgage that would result in few defaults. The answer was the Qualified Residential Mortgage, or QRM, a prime loan that would-if widely adopted-return mortgage financing to the stable system that prevailed before the adoption of the affordable housing requirements in 1992. To encourage the use of the QRM, the Act required the securitizers of lower quality loans to retain 5% of the value of any pool they sponsor. The risk retention idea was not workable-a simpler and better system would have relied on higher interest rates to compensate for additional risks-but at least it reflected a recognition of the inherent risks in nonprime mortgages.

In late August, however, the six government agencies charged by Dodd-Frank with the task of designing the QRM essentially reversed the underlying purpose of the Act. Their QRM proposal seems to rest on the notion that the goal of housing policy is not a stable system but the widest possible availability of mortgage credit. It's as if the mortgage meltdown and the 2008 financial crisis never happened.

In addition to the QRM, Dodd-Frank also required a minimum standard for mortgages-the so-called Qualified Mortgage (QM). Among other things, the QM prohibited negative amortization or interest only loans, and mortgages inadequately documented or with interest costs more than 3% over a prime mortgage rate. Most important, the QM also required that the originator determine that the borrower has the ability to repay the loan, and that after the loan was closed the borrower will not have a debt-to-income ratio that exceeds 43%. The penalties for violating the QM standards were severe, and could include a borrower's defense to foreclosure.

To be sure, there were flaws in the Dodd-Frank structure. Fannie Mae, Freddie Mac and the Federal Housing Administration were to be exempted from the 5% risk retention requirement, which would have funneled all non-QRM mortgages through these government agencies and impaired the revival of a private securitization system. The 5% retention requirement also favored the largest banks, which alone had balance sheets big enough to hold these assets indefinitely. Finally, the severe penalties for violating the QM rules-including the threat of endless litigation implicit in a defense to foreclosure-will probably drive many lenders out of the mortgage business, at least until the scope of this threat is defined by the courts.

Nevertheless, if it will be necessary in the future to live with the provisions of Dodd-Frank, the possibility that a group of regulators would devise a prime loan standard was a hopeful element. It would at least create a government-sanctioned baseline for mortgage lending, avoiding the kind of deterioration in mortgage underwriting standards that occurred when Fannie Mae and Freddie, functioning under the requirements of affordable housing goals, were the standard-setters for the mortgage market.

That, however, is not how it has worked out. In 2011, the six agencies (the Federal Reserve, the Comptroller of the Currency, the FDIC, the SEC, the Federal Housing Finance Agency, and the Department of Housing and Urban Development) published an earlier version of the QRM. This drew sharp opposition from the mortgage industry, primarily because it included a 20 percent downpayment. Many of the opponents complained that this would make it difficult or impossible for low-income, minority or first-time homebuyers to buy homes.

Faced with this opposition, and probably pressed by the Obama administration to meet the objections of community activists and others who oppose meaningful mortgage underwriting standards, the agencies seem to have thrown in the towel, deciding that there would be no underwriting standards at all. Their new proposal simply conformed the QRM-which was supposed to be the gold standard-to the minimum standards of the QM. Accordingly, any mortgage that meets the limited requirements of the QM would also meet the standards of the QRM and thus would not have to comply with the 5% risk retention provisions of Dodd-Frank. It is rare that an implementing regulation completely vitiates a major provision of a law, but here is one for the books.

There is little doubt that the roots of this proposal were a politically motivated reversal of a statutory policy. This was made clear when the agencies justified their decision by noting that they are "concerned about the prospect of imposing further constraints on mortgage credit availability at this time, especially as such constraints might disproportionately affect groups that have historically been disadvantaged in the mortgage market, such as lower-income, minority, or first-time home buyers." In other words, the goal of housing market stability-the underlying goal of Dodd-Frank's QRM-is to be sacrificed to the idea that mortgage credit should be made as widely available as possible.

If these are the standards that ultimately prevail in the mortgage market, we will be led back to the time in 2008 when half the mortgages in the financial system-28 million loans-were subprime or otherwise weak. This is because the QM standards are wholly insufficient to protect against widespread defaults and foreclosures. The six agencies admitted as much, pointing out in their joint release that of mortgages made between 2005 and 2008 that complied with the QM standards, 23 percent had experienced serious delinquency or default rate by 2012. That is what awaits us if the identical QM-QRM standards the agencies have now proposed become the basis for our housing finance system in the future.

Even Barney Frank, one of the key drafters of the Dodd-Frank Act and a long-time supporter of the affordable housing goals, eventually recognized that a policy of reducing mortgage underwriting standards was self-defeating; it did not help its intended beneficiaries. , "It was a great mistake," he said in August 2010, "to push lower-income people into housing they couldn't afford and couldn't really handle once they had it."

Ironically, however, it was possible for the agencies to have devised a prime mortgage, without a 20 percent downpayment, that complied with Dodd-Frank's concept of a QRM . In March of this year, Freddie Mac released a dataset consisting of 15 million fixed rate fully documented 30 year mortgages that the firm had acquired between 1999 and 2011. The following table, based on the performance of the 1999 cohort through 2012, demonstrates that a prime mortgage-a mortgage with an incidence of default less than 1%--need not entail either a 20 percent downpayment or a high FICO score.

Prime vs. Nonprime Default Rates on Freddie Mac Loans Acquired in 1999

Loan type A in the table shows that, for mortgages acquired in 1999, a loan with a 10 percent downpayment, a FICO score above 660, and a debt-to-income ratio of 38% had a delinquency rate of only .55% through 2011. This would be well within the standards expected of a QRM and a prime loan, and would certainly satisfy the standards that Congress had in mind when it enacted Dodd-Frank.

Given this data, the agencies should withdraw their August proposal and-using the Freddie dataset-re- propose a QRM that meets the congressional mandate for a high quality mortgage. If the Dodd-Frank Act is what will govern the housing market in the future, only a prime quality QRM will protect the stability of our financial system.