Ask The Experts: Will New Mortgage Lending Rules Help Prevent Foreclosures?

Experts Will New Mortgage Lending Rules Prevent Foreclosures

The Consumer Financial Protection Bureau (CFPB) has adopted a final rule giving lenders more guidance about making mortgage loans and giving consumers – especially lower income consumers – additional protection against predatory lending.

At least, that’s the objective. The new regulation, which took effect in January, bars lenders from offering those low “teaser” rates that prompted a lot of buyers to purchase homes they couldn’t afford. When the rates on these subprime mortgages reset to double-digit levels in some cases, the monthly payments were unaffordable.

As a result, a wave of foreclosures began to build within the housing market that not only devastated housing but threatened to topple the international banking system. The new rules are designed to prevent a repeat of that catastrophe by requiring lenders to take more steps to make sure their borrowers will be able to repay their loans.

Reforms

The rules restrict upfront fees and set limits on balloon payment and interest-only loans, which were common subprime lending practices. At a minimum, creditors must now consider eight underwriting factors:

  1. Current or reasonably expected income or assets;
  2. Current employment status;
  3. The monthly payment on the covered transaction;
  4. The monthly payment on any simultaneous loan;
  5. The monthly payment for mortgage-related obligations;
  6. Current debt obligations, alimony, and child support;
  7. The monthly debt-to-income ratio or residual income;
  8. Credit history.

Creditors must generally use reasonably reliable third-party records to verify the information they use to evaluate the factors.

Hopeful But Skeptical

Will these new rules make a difference? The experts we talked to are hopeful but somewhat skeptical.

With regard to the definition of qualified mortgages, I am somewhat dubious that new regulations will lead to a renaissance of ‘good credit judgment’ on the part of mortgage lenders and investors, said Sidney Bostian, a professor of finance and real estate at Virginia Commonwealth University.

He does say that, under the new rules, risk will likely be priced more realistically. The net effect, he says, is that some income groups will be priced out of the market. Other experts agree.

Ability to pay puts pressure on the lenders not to make loans where the loans never should have been given in the first place,” said Russell McClain, a professor at the University of Maryland School of Law. “But it also restricts lending – perhaps too much in theory – preventing consumers who may need loans the most from getting them.

More Needed Than a Definition

James Fanto, a professor at Brooklyn Law School, admits to being skeptical that the definition for “Qualified Mortgages” under the new rules will, on its own, promote responsible lending practices.

So long as loans are securitized, there will be a structural issue related to responsible lending: the lenders don’t hold on to the loans, even if, under the new law, they must maintain a certain share of them,” he said. “Instead, they sell them off. Moreover, Fannie Mae and Freddie Mac had lending standards before the financial crisis. This did not prevent them from buying up Alt-A and subprime mortgage-backed securities.

The new rules will, at long last, provide some firm guidelines for the lending industry that has erred on the side of caution over the last four years. While the real estate industry is hopeful the new rules will place the recovering housing market on even firmer footing, our experts are taking a “wait and see” attitude.

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Derek Hyra

Virginia Polytechnic Institute and State UniversityWhat effects will the new Qualified Residential Mortgage rules have on lending practices?

The CFPB is trying to reach a balance between tightening up regulations to more effectively facilitate sustainable lending that does not cut out moderate-income borrowers. We have been through periods of redlining and in the 2000s we had greenlining, with a loosening of credit standards and a proliferation of unsustainable, high-priced mortgages. Now, the federal government is attempting to tighten up the lending standards once again with new ability-to-pay standards and what’s important is that we do this in a way that does not return us to a period of redlining, where qualified borrowers are unable to obtain credit. The recent exception amendment from the ability-to-pay for community banks and small lenders is based on the assumption that these institutions, compared to the large lenders, will be more willing to work with underserved borrowers to understand and meet their credit needs, particularly if these smaller lenders are going to keep these loans on their books.
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Stephanie Moulton

Ohio State UniversityDo you believe that the definition for mortgages “qualified” to be purchased by Fannie Mae or Freddie Mac is sufficient to promote responsible lending and borrowing practices? Will it have any negative / unintended consequences?

There are really two parts to this question. First, is the definition of a qualified mortgage appropriate? Second, will establishing a qualified lending rule be enough to ensure responsible lending practices? In response to the first question, I would say that generally yes, the definition of a qualified mortgage is appropriate. The current definition excludes mortgages from safe harbor that have certain risky features (e.g. balloon payments and high interest rates). Many of these mortgage features have been associated with higher risk of mortgage delinquency and default, even after controlling for risk characteristics of the borrower. Further, the rule requires that borrowers demonstrate the ability to repay their mortgage, based on total financed monthly debt payments including the mortgage payment not exceeding 43% of a given borrower’s gross monthly income.

The second question, ‘are the qualified mortgage standards sufficient to ensure responsible lending,’ is more difficult to answer. Certainly the standards are in the right direction. But the market is innovative and it is often difficult for regulation to keep pace. There is no single silver bullet regulation that can ensure responsible lending. This takes industry responsibility and diffusion of sound practices, and ongoing monitoring and enforcement by regulators.

What is your take on the recent amendments that lowered the requirements for community banks and low-income lenders?

The justification for these exemptions is based on the premise that community banks and other affordable lending programs have historically originated mortgages that have lower rates of delinquency and default. This has been documented in research, including my own. However, it is difficult to predict whether or not the stronger performance associated with these origination channels is likely to continue in the future. The optimist in me says yes, of course.

Sometimes referred to as relationship lenders, these entities may have more rigorous screening practices based on soft information to select qualified borrowers—for example, community lenders (banks and credit unions) may have a relationship with a customer for years prior to originating a mortgage and the customer may have multiple accounts with the lender. Even if the borrower looks riskier on paper, the lender may have information about their ability to repay from other transactions or interactions with the borrower over time. After purchase, these same lenders may be more likely to have continued interactions with their borrowers, providing a monitoring function that also reduces the incidence of delinquency.

I would like to think that these practices will be sufficient in the future to allow for continued strong performance. However, there is some concern that if these origination channels are the only game in town for borrowers falling outside of the qualified mortgage criteria (e.g., with debt ratios greater than 43%), they may be adversely selected by riskier borrowers, thereby reducing the overall performance of mortgages in their portfolios. This could have a profoundly negative impact on the very industry that has been credited for doing things right. It is thus essential that these community lenders re-evaluate their practices and strategies to (1) ensure strong loan performance for borrowers falling outside of qualified guidelines, and (2) continue to attract qualified borrowers.

How do “Qualified Mortgages” set the tone for the rest of the lending industry? How do you see the new regulations playing out?

These standards certainly set the tone for the mortgage lending industry. It is likely that the majority of mortgage loans originated by conventional lenders will fall within the qualified mortgage guidelines. Lenders will want to avoid originating loans that fall outside of the safe harbor provisions; the liability is likely too high. However, over time, it is likely that innovations will develop to reduce the risk to the lender of originating non-QM loans. The cost of this ‘insurance’ to borrowers may be high.
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Sidney Bostian

Virginia Commonwealth UniversityDo you believe that the definition for mortgages “qualified” to be purchased by Fannie Mae or Freddie Mac is sufficient to promote responsible lending and borrowing practices? Will it have any negative / unintended consequences?

With regard to the definition of qualified mortgages, I am somewhat dubious that new regulations will lead to a renaissance of ‘good credit judgment’ on the part of mortgage lenders and investors. However, limiting the ability of Freddie Mac and Fannie Mae to lower credit standards for the mortgages they purchase should help alleviate the failure to price risk prudently which we saw in the run up to the market collapse seen in 2008 and 2009. To the degree that subprime mortgage risk is priced properly, the cost of mortgage credit should rise for less capable borrowers. This has the potential to reduce the demand for home ownership in some income groups.
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David Oedel

Mercer University School of LawDo you believe that the definition for mortgages “qualified” to be purchased by Fannie Mae or Freddie Mac is sufficient to promote responsible lending and borrowing practices? Will it have any negative / unintended consequences?

Having higher down-payment requirements makes classic lending sense, and the new CFPB regs and guidance are appropriate to that extent. At the same time, one has to wonder if the recent relaxation of the proposed standards that will give banks more leeway in securing a safe harbor will mean more easy money flowing, maybe not as fast and freely as prior to 2008, but still faster and freer than one might like in an ideal lending environment. The fact is there are plenty of political reasons to keep that money flowing. When and if that money stops flowing, there could be bad economic implications. The money flowing into mortgages is more of a critical issue at this point than the particular regs promulgated by the CFPB — regs that haven’t even yet taken effect. The national level of existing mortgage debt is already huge, and the regs won’t change that.
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Russell McClain

UMD LawDo you believe that the definition for mortgages “qualified” to be purchased by Fannie Mae or Freddie Mac is sufficient to promote responsible lending and borrowing practices? Will it have any negative / unintended consequences?

In general, I can say that I am in favor of ability to pay standards, but there is a tension. Ability to pay puts pressure on the lenders not to make loans where the loans never should have been given in the first place. But it also restricts lending – perhaps too much in theory – preventing consumers who may need loans the most from getting them. My personal focus in this area has been in the area of bankruptcy. My argument is that the bankruptcy schema should account for ability to pay at the time of lending. If a consumer did not demonstrate the ability to pay at the time the loan was made, then the consumer who otherwise qualifies in bankruptcy should get greater relief from these predatory loans in bankruptcy.
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James Fanto

Brooklyn Law Do you believe that the definition for mortgages “qualified” to be purchased by Fannie Mae or Freddie Mac is sufficient to promote responsible lending and borrowing practices? Will it have any negative / unintended consequences?

I am a little skeptical that any definition can promote responsible lending and borrowing on its own. So long as loans are securitized, there will be a structural issue related to responsible lending. The lenders don’t hold on to the loans, even if, under the new law, they must maintain a certain share of them. Instead, they sell them off. Moreover, Fannie Mae and Freddie Mac had lending standards before the financial crisis. This did not prevent them from buying up Alt-A and subprime mortgage-backed securities. In addition, whenever the lending world stabilizes, there will again be temptation to do business in the non-qualified world, if money is to be made there.

What is your take on the recent amendments that lowered the requirements for community banks and low-income lenders?

Well, I am not opposed to giving a break to community banks and even to low-income lenders. Often these institutions did not engage in securitizing their loans. Insofar as they do old fashioned lending, which means evaluating a borrower, making a loan and then holding onto it, I am more confident in them than I am in the larger financial institutions, which have an interest in getting loans quickly off their books.

How do “Qualified Mortgages” set the tone for the rest of the lending industry? How do you see the new regulations playing out?

Again, we are trying to set a standard by having a qualified mortgage with its criteria. But standards can in time be debased, as we saw with AAA bond ratings. We really won’t know whether this new standard has any meaning until the housing market takes off again and until at that time there is a temptation to interpret the standard broadly or to make non-qualified mortgages. The problem with all financial regulation is to see whether it is meaningful in the boom times. But that is precisely when banks, as well as their friendly regulators, are inclined to loosen the rules.

 
Image: Andy Dean Photography/Shutterstock

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