The Consumer Financial Protection Bureau issued rules last week to beef up mortgage-lending standards. One of them, the ability-to-repay rule, was mandated by the Dodd-Frank financial-reform law. The new rule is “designed to ensure that lenders are offering mortgages that consumers can actually afford to pay back,” Richard Cordray, the bureau’s director, said in prepared remarks at a Jan. 10 field hearing.
And here I thought it was the borrower’s job to determine if he has the means to repay a loan.
It used to be. Homebuyers would look at their income, assets, monthly cash flow, job security, debt outstanding and things like that to determine if the family could afford to own a home. The lender’s job was to perform adequate due diligence and protect against loss by requiring a down payment.
That was before the housing bubble burst, before toxic mortgage loans rippled through the entire economy, before the government decided that allowing big banks to fail wasn’t an option. Those events convinced lawmakers that more rules were in order, ones that shifted the onus to the lender.
What does it say when we have to codify what should be common sense and best lending practices?
I think it says that incentives became misaligned. Lenders cared more about the quality of the collateral than the quality of the borrower, says JPMorgan Chase senior economist James Glassman. It makes perfect sense when home prices are rising at 15 percent a year.
What it doesn’t say is that new rules will fix the problem. They may even make it worse, by creating the illusion of safety.
In the old days, a wannabe homeowner went into his local bank to get a mortgage loan. The banker knew the applicant, probably knew his father and grandfather, even handled the finances for the family business. The banker knew his customer, in the proper sense of the word.
Mortgage securitization helped change that relationship, made it impersonal. The ultimate lender became the buyer of the mortgage-backed security, which made the market more liquid and enabled financial institutions to make more loans.
“Affordable housing” became a national priority. If a borrower didn’t qualify for a mortgage under the existing rules, by all means, lower the standards.
Without re-litigating the cause of the housing bubble (greedy bankers or government housing policy) suffice it to say that more rules are no substitute for improved market mechanisms, increased protection (more capital, less leverage) and old-fashioned law enforcement.
People seem to forget that mortgage fraud — providing “any materially false, fictitious or fraudulent statement or representation” on a loan application — was, and is, a felony. That applies to both borrower and lender. Even the slimiest predatory lender didn’t hold a gun to the borrower’s head to make him sign on the dotted line. Only a handful went to jail.
New regulations will never prevent the next crisis. They can’t. The rule writers, as instructed by Congress, didn’t even try this time, according to Edward Pinto, a resident scholar at the American Enterprise Institute: They ignored two of the three C’s of underwriting.
A borrower’s credit reputation (credit score and history), capacity (things like debt ratios and cash reserves) and collateral (total equity or down payment) must all be acceptable for the mortgage to qualify for sale to Freddie Mac, according to the government-sponsored enterprise.
Yet the new rule, as prescribed by Dodd-Frank, “focuses on debt ratios at the expense of everything else,” Pinto said. “There’s no standard for credit quality. Lenders have to verify the source of the down payment, but a down payment isn’t required.”
That’s because Congress viewed it as discriminating against the poor, Pinto said.
The ability-to-repay rule requires lenders to verify a potential borrower’s financial records, including income, assets, employment status and overall debt obligations. Affordability will be determined on the basis of the interest rate over the life of the loan, not a teaser rate. “Credit history” is one of the eight criteria — but, as Pinto said, verifying credit history isn’t the same as setting minimum standards.
What do lenders get for all their verification efforts? Protection against liability suits on so-called qualified mortgages.
A potential borrower’s total debt payments can’t exceed 43 percent of pretax income, according to the new rule. Unless, of course, you qualify for a loan under the existing automated underwriting systems of Fannie Mae, Freddie Mac and the Federal Housing Administration, which were grandfathered for up to seven years. And you wonder where the risks lie?
Rescuing Fannie and Freddie has cost the taxpayer about $140 billion since they were taken over by the federal government in 2008. The Obama administration has yet to offer an alternative to the government’s long-standing role in housing finance.
Then there’s the FHA, which insures lenders against losses — and suffered losses of its own last year. The $16.3 billion deficit in its insurance fund in fiscal 2012 opens the door to a taxpayer bailout for the first time in its 79-year history.
Together, the FHA, Fannie and Freddie back about 90 percent of the home loans in the United States. Fixing them must be a priority.
Relying on rules, rather than market forces, to allocate credit will turn out to be a mistake. And as for potential homeowners, a short course in individual responsibility will serve them better in the long run than turning the mortgage lender into a nanny.
Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. © 2013, Bloomberg News