Practically everyone who is concerned about the future of the housing market is focused on Fannie Mae and Freddie Mac. The Treasury is leaking details of its overdue plan for the hobbled mortgage giants; the House Financial Services Committee held a hearing so Republicans could rant about the evils of government involvement in the housing market; think tanks are holding conferences to devise solutions.
But behind the scenes, there's another huge debate taking place, one that has every bit as much potential—maybe more—to shape the housing market. It involves a provision in last summer's Dodd-Frank financial reform legislation, one that was inserted partly due to Lou Ranieri, the former Salomon Brothers bond trader and executive who helped create the modern mortgage market back in the 1980s. The provision is called the qualifying residential mortgage, or QRM. What is a QRM? Well, that's precisely the cause of the debate. The answer will play a big role in determining who can get a mortgage at what cost.
One of the factors that made the housing bubble so big was that financial institutions that made mortgages were able to sell them off, whether to Wall Street firms or to Fannie and Freddie, thereby ridding themselves of the risk. Over time lenders became increasingly indifferent to the question of whether the borrowers could pay. (Many of them couldn't, as we all know now.) To fix this, Dodd-Frank imposed a requirement that mortgage companies keep 5 percent of the risk on their own books even when they sold off the loans. The idea was to give lending institutions a financial incentive to care about their borrowers' creditworthiness—"skin in the game," as the requirement is colloquially called. Banking regulations also compel lenders to maintain capital against that risk, thereby increasing their cost. Five percent may not sound like a large commitment, but for smaller institutions that operate on a thin margin (community banks, independent mortgage companies) it's huge. Even big banks, which face a slew of new capital requirements, find it a headache.
As Lou Ranieri watched Congress enact this so-called risk-retention requirement, he began to worry that while it was necessary for some types of mortgages, it could also limit, unnecessarily, the availability of all mortgages. "We need to come out of this [crisis] with a functioning housing market," he says. What Ranieri calls "old-fashioned mortgages"—traditional 15- or 30-year loans where the borrower pays off interest and principal every month, and where the loan is fully documented, among other things—held up fine even at the height of the crisis, according to analysis he presented to members of Congress. Was it really necessary for lenders to keep "skin in the game" for such super-safe mortgages? (Ranieri also thinks that just as stockbrokers can be held liable for selling customers unsuitable products, those in the mortgage lending chain should be held liable for selling unsuitable mortgages, whether those mortgages are old-fashioned or not. But that's a slightly different discussion.)
So, with input from Ranieri, a bipartisan group—Democratic Sens. Mary Landrieu of Louisiana and Kay Hagan of North Carolina and Republican Sen. Johnny Isakson of Georgia—inserted a provision into the financial reform legislation stipulating that old-fashioned mortgages (i.e., those that met certain time-tested guidelines) would be exempt from the skin-in-the-game requirement. These were the mortgages labeled "qualifying residential mortgages." Congress left the details of what could and could not be considered a QRM up to a clutch of federal agencies that includes the banking regulators, the Department of Housing and Urban Development, and the Federal Housing Finance Agency, * which oversees Fannie and Freddie. They are supposed to issue a final regulation by April 21.
That rule will likely have a huge impact on what sort of loans lenders offer, and to whom. Smaller, thinly-capitalized mortgage originators can't afford to keep any of the risk, and other lenders simply don't want to keep it, so mortgages that don't qualify will be more expensive and harder for average consumers to get. Or, as the Mortgage Bankers Association predicts, loans made outside the QRM framework "will be costlier and likely to be made only to more affluent customers." J.P. Morgan Chase estimates that the 5-percent risk-retention requirements could increase rates on loans that don't qualify as QRMs by up to 3 percentage points.
Decisions about the QRM will also have a big effect on Fannie and Freddie (assuming Fannie and Freddie are still around when the rule takes effect). Because lenders will have to retain 5 percent of the risk on any nonqualifying loans that they sell, they will probably sell fewer such loans to Fannie and Freddie. In effect, how QRMs are defined will dictate which mortgages end up on the government's books. So if the government is going to maintain any kind of role in the housing market, then taxpayers have skin in the QRM game too. In which case, shouldn't the government tailor regulation of QRMs to minimize that risk?
The difficulty is that neither the regulators themselves, nor the industry, agree on what a qualifying mortgage should be—and whether minimizing risk should be the only criterion. The stricter the definition—for instance, requiring a 30-percent down payment—the fewer homeowners will get QRM mortgages. That's fine if your goal is to make sure that qualifying mortgages never default. But what if your goal is to make sure home mortgages remain affordable and widely available? Using Census Bureau data, the research firm Height Analytics calculated that in 2009, 47 percent of homebuyers who borrowed money to purchase their home made a down payment of less than 10 percent. So even requiring a seemingly modest down payment of 10 percent would disqualify about one-half of all prospective borrowers from obtaining QRMs. "As a result, these borrowers would have to take out a mortgage with a significantly higher interest rate or their efforts to buy a home could be restricted," Height Analytics noted.
Requiring a high down payment also stands to benefit the bigger players. Wells Fargo, which made some less-than-pristine loans during the subprime mania, sounded like a recovering alcoholic in a letter to regulators last fall that said a 30-percent down-payment requirement would provide a "simple and balanced" definition of a QRM. Big banks can afford to keep loans that don't qualify on their balance sheet. Smaller institutions can't. The Community Mortgage Banking Project, a coalition of mostly smaller lenders, argues in a position paper that a restrictive QRM definition would concentrate lending in the "too big to fail" banks. Operating in a less competitive market, the big banks could boost profits by charging higher rates to consumers who didn't qualify.
At the opposite pole is the Mortgage Bankers Association, which represents many non-bank mortgage originators whose business models depend on selling off the loans they make. The MBA wants even very risky loans in which borrowers pay only interest, not principal, to qualify as QRMs. "[U]nnecessarily constraining the mortgage market," the MBA wrote in a letter to regulators last fall, "will not only deny the American dream of homeownership to many qualified persons, it will further depress the housing market and threaten the economic recovery." Of course, that's the same reasoning the MBA applied before the subprime crash.
Then, there are the mortgage insurers, companies such as MGIC and Radian, for whom the QRM represents nothing less than an existential threat. Mortgage insurance exists because Congress requires it on loans with a down payment of less than 20 percent that are bought by Fannie and Freddie. But if a QRM by definition requires a 20-percent down payment, what place will there be for mortgage insurance? So mortgage insurers are arguing that insurance makes mortgages safer for both borrowers and lenders, and are applying their considerable lobbying clout to stay in the game.
As for the regulators, sources say the Federal Reserve and the Federal Deposit Insurance Corporation, which traditionally care more about the safety and soundness of the financial system than they do about homeownership, are pushing for a conservative down-payment requirement—at least 20 percent. But they are meeting some resistance, too. A fixed down-payment requirement "would likely result in a furor on Capitol Hill," notes Height Analytics, because it would block such a large percentage of buyers from qualifying for a less costly loan. Although the housing-focused agencies like HUD and the FHFA haven't made public statements, the general sense in Washington is that they want a less strict standard in order to promote affordability and accessibility.
Sources in Washington say that the regulators will propose a rule requiring a hard down payment of 20 percent. But that would be controversial, and with all these conflicting agendas, the research firm MF Global predicts "very little chance" that we'll see a final QRM rule by the April 21 deadline. A "more realistic deadline," it says, "is mid-summer." A lot will ride on the regulators getting this right.
Correction, Feb. 13, 2011: The article originally misstated the name of the FHFA as the Federal Housing Finance Authority. (Return to the corrected sentence.)