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June 22, 2011

When Congress adopted the Dodd-Frank legislation last year, it included a provision to require entities that create asset backed securities of any kind to hold at least a 5 percent interest in the securities.  This so-called “skin in the game” provision was intended to better align the interests of borrowers, loan originators, and investors by assuring that the entities putting together securities backed by mortgages and other assets have a long-term interest in the success of the underlying loans.

The task of actually defining the so-called “Qualified Residential Mortgage” (QRM) exemption was assigned to a gaggle of 6 federal regulators.  Their proposed rule was published back in April, with an initial 60 day comment period later extended until August 1, 2011.  

The QRM exemption is important for a couple of reasons.

  1. Mortgages that don’t meet the QRM requirements will cost more because of the risk retention requirement.  How great a price differential this will involve is the subject of continuing research and disagreement.  The FDIC has said, for instance, that they believe the difference will be only one-tenth of a percent, not a significant price increase.  Moody’s.com economist Mark Zandi, however, just published his own analysis of the proposed rule and estimates that the increased cost could be between  three-quarters of a percent to a full percentage point.
  2. Once the federal regulators—who include all the prudential banking regulators—adopt a standard that denotes the “safest” mortgages, it’s possible that investors and even portfolio lenders will shy away from securities backed by mortgages with lower down payments, further raising the cost and restricting access.
  3. As Congress considers further mortgage finance system reforms, the QRM standard could become an attractive “tent pole” around which to organize lending standards of an overhauled FHA and whatever successor structure is erected for Fannie Mae and Freddie Mac.

What it Does

In order to qualify for the QRM exemption, a security would have to be composed entirely of mortgages that meet the following criteria:

  • At least 20 percent down payment for purchases, 25 percent for rate and term refis, and 30 percent for a cash-out refi
  • No 60 day late payments on any credit obligations for the 2 years preceding origination, and no 30 day lates at the time of origination
  • A mortgage debt-to-income ratio of no more than 28 percent, and a total DTI of no more than 36 percent.

In addition, QRM mortgages cannot include features like teaser rates, balloon payments, interest only payment plans, or so-called Option ARM payment plans, features which played a prominent role in the housing finance bubble and crash.

The proposed regulation has generated a firestorm of protest from all points of the housing policy compass.  Consumer groups, lenders, real estate interests and others involved in the home buying process have all scored the proposal’s requirement for a 20 percent or greater down payment as unnecessarily shifting a large portion of all renters into the non-QRM mortgage space.  

With a median home price nationally of around $170,000, a 20 percent down payment would require a renter to come up with $34,000 plus closing costs.  This is a hurdle few renters without rich parents or other sources of gifts will be able to make.  The Harvard Joint Center for Housing Studies, for instance, has estimated that the median renter household has about $1,000 in cash savings, and the median minority renter household only about $500.  Even at the 75th percentile, these numbers are $5,000 and $2,500, respectively.

These points are laid out in a White Paper published by a broad coalition of groups and released on June 22, 2011.  The following Market Place Radio report gives a very brief explanation of the issues:

The statute exempted loans insured by FHA from the risk retention provisions because of their full faith and credit backing.  The proposed rule would also not apply to Fannie Mae and Freddie Mac, as long as they remain in conservatorship, because of the Treasury’s explicit backing of their obligations.  With these 3 entities responsible for 90 percent of current mortgage finance, the QRM rule is unlikely to have an immediate impact even after the current review and comment period, and the mandatory one-year gap between final rule adoption and implementation.

But as the Administration moves forward on recommendations in its February, 2011 White Paper on mortgage finance reform and tries to shrink the size of the market in which both FHA and Fannie and Freddie can operate, the QRM rules will apply to more and more mortgages.  And there will be great uncertainty about their impact for years to come until Congress resolves what to do about Fannie and Freddie and the mortgage finance system generally.

Will QRM Mitigate Risk?

Whether or not the proposed risk-retention rules will genuinely increase the quality and performance of mortgage backed securities is an underlying question.  Even at the height of the most irresponsible underwriting and loan origination, many securitizers did hold some underlying risk on the securities they created becuase they thought the risks were small and the gains would be great.  They were proved wrong when house prices started falling rather than rising, and poorly underwritten loans started failing in large numbers.  But their retention of risk was hardly an impediment to bad financial decisions and lack of attention to the underlying quality of the loans being packed for sale to investors.

The rule also has some other, more technical aspects that lenders are very concerned about; Zandi’s paper elaborates on these, as well.  And the rule would prohibit any second mortgages before or at the time of origination.  This provision will effectively halt the popular and successful state and local programs that use so-called “soft seconds” to help low wealth borrowers into their first home.  This would deal yet another blow to affordable homeownership efforts for low income and low wealth borrowers.


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