Thursday, August 29, 2013

Lawler: Regulators “Caving” on QRM

by Calculated Risk on 8/29/2013 04:09:00 PM

From housing economist Tom Lawler:

Six federal agencies on Wednesday issued a notice revising a proposed rule requiring sponsors of securitization transactions to retain risk in those transactions. The new proposal revises a proposed rule the agencies issued in 2011 to implement the risk retention requirement in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) .

After intense lobbying and political pressure, the agencies have reluctantly agreed “to define QRMs to have the same meaning as the term qualified mortgages as defined by the Consumer Financial Protection Bureau.” The agencies also changed its original proposal that risk-retention requirements would be based on the par value of securities issued and included a “premium recapture provision; the new proposal has risk retention based on “fair value measurements without a premium capture provision.”

The agencies requested comments on whether an alternative definition of QRM should include “certain underwriting standards in addition to the qualified mortgage criteria.” With the exception of the DTI and verification requirements, the QM doesn’t really have underwriting “standards related to risk.

The “Dodd-Frank Act” had, among other things, two “definitions” of mortgages: “qualified mortgages,” to be defined by the CFPB and focusing on a borrower’s “ability to pay;” and “qualified residential mortgages,” to be defined by six regulatory agencies, focusing on mortgages with underwriting and product features related to the probability of default. A “qualified mortgage” would give lenders something of a “safe harbor” against future litigation, while a “qualified residential mortgage” would be exempt from risk-retention requirements associated with issuing mortgage-backed securities.

In setting the “qualified mortgage” definition, the CFPB focused on (1) product features); (2) up-front fees charged; (3) verification of relevant borrower information; and (4) a maximum backend debt-to-income ratio (and implicitly a maximum front-end ratio) of 43% (with some exceptions). While the CFPB gave a list of factors creditors must consider in determining a borrower’s ability to pay, it did not dictate that creditors follow any particular underwriting model. In defining a “QM” the CFPB did not take into account many extremely important variables/factors that impact the probability that a mortgagor will default.

The original intent of the Dodd-Frank “risk retention” rule was to make sure that issuers/originators had “skin in the game,” which it was hoped would better align the interests of issuers/originators and investors. Mortgage and real-estate industry lobbyists argued that “low-risk” mortgages should be exempt from the risk-retention requirement. While this exemption didn’t make any sense – after all, the proposed legislation required a 5% retention of “risk,” meaning that issuers/originators of “low-risk” mortgages backing a private-label MBS would have to retain 5% of a “low” amount of risk -- legislators succumbed to the lobbying and introduced the “QRM” concept into the final Dodd-Frank bill – relegating the definition to regulatory agencies, but requiring that QRMs be mortgages with “underwriting and product features that historical loan performance data indicate result in a lower risk of default.”

In their preliminary proposed definition of a “QRM,” regulators tried to define a QRM as a mortgage with so little risk that risk-retention to ensure mortgage players would have “skin in the game” was “unimportant.” Not surprisingly, the original proposed definition of a QRM included a hefty (20% down) down payment, a DTI no greater than 36%, had restrictions on a borrower’s credit, and excluded most of the loan features excluded from a QM.

The real estate and mortgage industry lobbyists who had argued for a QRM exemption were stunned, even though the regulators’ “framework” of (1) assuming that risk-retention was a “good thing” (and should be applied to the bulk of mortgages backing private-label RMBS), and (2) only “extremely” low risk mortgages should be exempted from this requirement made perfect sense.

Real estate and mortgage industry folks started lobbying hard against this QRM proposal, and (1) massively inflated the “costs” to issuers/originators of the risk-retention requirement – which would be based on to consumers; (2) argued that many potential borrowers would be excluded from getting mortgage credit; and (3) argued that having a QM definition that differed from a QRM definition would add to the growing regulatory burden being placed on mortgage lenders, and lobbied extremely hard to make the two definitions the same – even though the legislation explicitly differentiated between the two. This latter argument was mildly humorous, in that the only reason the legislation HAD both a QM and a QRM was because of real estate and mortgage industry lobbyists!

An alternative and more logical approach would have been for regulators to decide that there simply WAS no mortgage that was so inherently low risk that it made sense to exempt such a mortgage from the risk-retention requirement, which would effectively have eliminated the concept of a QRM. If they had done so, then the “burden” on the industry of having both a QM and a QRM would have been lifted.

Making the QM and the QRM essentially the same pretty much violates the intent of the Dodd-Frank law, in that the QM definition has very little to do with risk, while the QRM was explicitly supposed to be related to risk. E.g., a 30-year fully amortizing loan with no down payment to a borrower with a FICO score of 580, no current debt outstanding but also hardly any assets, and a front-end debt-to-income ratio of 43% would be deemed a qualified mortgage, even though by any standard such a mortgage would be viewed as extremely risky! An interest-only loan to an extremely wealthy borrower with an 800 credit score who made a 40% down payment would not be a QM.

If the current proposal is finalized as is, then the risk-retention requirement for private-label RMBS, which was very explicitly designed to better align the interests of issuers/originators and investors, will effectively be gone.

That may not be bad, in that it was not clear if a 5% risk-retention requirement would really alter behavior. However, risk retention was a clear INTENT of legislators in Dodd-Frank, and real-estate and mortgage lobbyists have effectively eliminated it for the vast bulk of mortgages that will be originated.