During the height of the housing boom, in 2006 and 2007, one of the fundamental tenets of home mortgage lending flew out the window: the borrower’s ability to repay the loan. A broad swath of lenders simply took it out of the equation, figuring that since home prices were rising so fast, borrowers could simply sell their way out of any trouble.
It didn’t happen that way. Home prices crashed, borrowers had no escape from the faulty loan products they’d been sold, and an epic foreclosure crisis ensued.
As a result, Congress created the Consumer Financial Protection Bureau and directed the bureau to implement the ability-to-repay rule. It requires lenders to look at a consumer’s financial information, document income and assets; review current debt obligations; and assess the borrower’s credit history.
The rule also prohibits some of the riskier loan products, like low- and no-doc loans, and says that affordability will be determined based on the interest rate that would prevail in the absence of any teaser rates.
“In these key respects, borrowers no longer will be sold mortgages that are predestined to fail,” CPFB Director Richard Cordray said earlier this year. “Lenders have to check on the numbers and make sure that the numbers check out.”
The CFPB also created the so-called qualified mortgage (QM), a category of loans where borrowers would be the most protected. These are the only loans Fannie Mae and Freddie Mac will buy. This mortgage goes further than the ability-to-repay rule: It cannot be an interest-only loan or carry excessive fees, and the borrower’s monthly debts, including mortgage payment and related housing expenses, cannot add up to more than 43 percent of the borrower’s monthly gross income.
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In return, the lender gets certain legal protections if the borrower defaults. The QM rule does not go into effect until January of 2014, but most lenders are already complying with it, and critics are crying foul.
“One of the big problems is if you get a certain kind of loan that meets certain terms you have no recourse against the bank and that should never be the case,” said Alyse Cohen of the National Consumer Law Center. “Homeowners will always have some problems paying their bills, that’s just a natural part of our economy; the question is really more are banks still in a position where they can take advantage of people and then not have to face the consequences in the end?”
With these safeguards firmly in place, though, and more regulations to protect investors still coming, some lenders say the nation would never see another crisis like the one the economy just survived.
“I think we’ve gone full circle, back to having a customer at the center of ability to repay, making sure they can have sustainable home ownership rather than necessarily having products that investors will buy that may not make sense for the customer which is, where we were in 2006, 2007 as an industry,” said Franklin Codel, head of mortgage production at Wells Fargo.
Codel pointed to innovations at his own shop, the nation’s largest home mortgage lender by volume. Wells Fargo borrowers click through a website that caters to each individual loan type and client. It explains fees, payments, rates and terms in clear language and pictures.
“We did not have this five years ago,” said Judy Cantor, senior vice president of e-business at Wells Fargo.
While the big banks—most watched by federal regulators since the housing crisis—are simplifying the mortgage application process, others in the industry are still catching up to the new rules.
“I think it’s a terrific start,” said Raj Date, former deputy director at the CFPB and one of the architects of the new regulations. “I think that the Congress and the regulatory agencies have tried to do the best that they can, but when push comes to shove, making sure that we have avoided a big problem going forward is up to the industry. It’s up to loan originators. It’s up to the capital markets, and it’s up to the rating agencies.”
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In fact, the final rules are not as strict as originally proposed. With the housing recovery still in its infancy and facing rising interest rates, regulators were concerned about tightening an already tight lending environment. So could we have another epic crash?
“In the short run, over the next half decade to decade, it’s going to be extremely unlikely, virtually impossible for that to happen because all the programs that created the bubble are outlawed now,” said David Stevens, CEO of the Mortgage Bankers Association. “What really concerns me is how are people going to behave outside the QM protection.”
Lenders can still operate outside the QM rules but don’t get the same legal protections in cases of default, and they cannot sell the loans to Fannie and Freddie. They need to hold on to the risk. Still, the non-QM market is growing even before the QM rules take effect in January.
The leader of this movement is Date himself. He formed a firm, Fenway Summer, to launch the new mortgage products.
“I think the best credit models, the ones that really pay for themselves in terms of risk-adjusted returns over time, are the ones where you make great credit decisions and then you actually bear the risk of those decisions working out well or working out poorly,” said Date, adding that he is optimistic about this new market.
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Loans outside QM will be more costly but will offer investors greater returns. They will still have to comply with ability-to-repay but not the QM standards. Therefore, borrowers who may have very large assets but little to no income could qualify. Interest-only, adjustable-rate mortgages would also fall into this category.
“I am quite confident that a senior funding market will develop for non-QM loans—I have no doubt about that at all,” Date said. “It is simply too big of a market.”
Wells Fargo will also operate outside QM for some loans.
“When you look at the entire profile of the borrower, we can be comfortable they have the ability to repay even though their income by itself may not fall into the standard dictated by the qualified mortgage,” said Codel, who added that non-QM loans may be an even safer product because lenders will hold more risk and be subject to legal action in the case of a loan failure.
Still, the non-QM market does open the doors for lenders seeking higher returns through higher risk, which is how much of the recent trouble began, at least in the mortgage-backed securities trading space. Regulations for investors in loans are still being finalized, but recent proposals follow the QM standards.
“That is where I think drawing the boundaries around the rules can be a good thing but it can also set up bad behaviors outside those boundaries, and we’re going to see those kinds of institutions being created, I’m confident of it,” said Stevens.