By Andrew Davidson
The scheduled expiration of the so-called QM patch has produced a flurry of dialogue around who should be the standard-setters for residential mortgage origination.
For conventional loans — that is, loans that are not part of FHA, VA and other government programs — the CFPB rules for the qualified mortgage (QM) created a trifurcated system. Conventional loans could:
- Qualify for QM safe-harbor status by demonstrating that the DTI (debt to income ratio) was less than 43% using the relatively narrow guidelines of Appendix Q (12 CFR Appendix Q to Part 1026).
- Be approved for purchase by the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, under whatever underwriting standards the GSEs deemed appropriate.
- Be originated to meet a more general Ability to Repay (ATR) standard outside of the QM safe harbor. These loans could be originated to any standard that the originator felt would withstand legal challenge under the CFPB ATR rules.
At the same time, as QM has been reshaping the conventional loan market, there has been growing divergence in the amount of post-closing review and representation requirements for loans intended for sale into the secondary market. Because the GSE has implemented automated validation systems that evaluate the quality of newly purchased loans, many loans sold to the GSEs are eligible for “day-one certainty” which substantially lowers repurchase risk. In contrast, the non-GSE market, whether for loan sales or for securitization, has moved toward more loan-level diligence and enhanced representations and warranties. The cost and amount of the diligence has increased, due to the variety of underwriting and documentation approaches used to achieve ATR status.
The diverging trends represent a fundamental conflict between standardization and innovation in mortgage underwriting. Standardization can reduce cost and limit unsafe lending practices, while innovation is necessary to extend sustainable home ownership to more eligible households. Standardization via strict QM rules and reliance on the GSEs can lower the cost of home ownership, while innovation can extend financing to self-employed borrowers and those whose income comes, at least in part, from the gig economy. On the other hand, unconstrained innovation is a particularly fraught problem in the mortgage market. The experience of the mortgage meltdown in 2007 as a result of poor underwriting practices is an example of the potential fallout.
Mortgage markets are especially vulnerable to a “race to the bottom” due to the structure of the housing finance system and the nature of mortgage risk. Due to the size and scope of the mortgage market there is often separation of the origination and investment functions in the market. The people and entities that originate a loan and interact directly with the borrower are not the same as people and entities that bear the risk if that borrower defaults. In addition, there may be a substantial period of time between loan origination and the emergence of evidence (such as delinquencies) that the borrower is unable to meet their obligations.
Imagine a comparison to buying groceries. On one hand you can go to a farmers’ market and buy fruit directly from the farmer. Generally, you can examine the fruit for freshness and learn something about where the fruit was grown. A farmer with poor quality will not get much return business. Moreover, bad fruit seldom leads to serious health issues.
On the other hand, if you are purchasing meat from a grocery store, you have little knowledge of where the animals were raised or the path from the farm to the store. The risk of severe illness from improperly, raised, processed and transported meat is very high. Moreover, it may be difficult to tell by looking at meat at the store whether or not it is safe to eat. It is not surprising, then, that the government has established regulations, protocols and inspections to ensure the quality of meat.
The conventional secondary market generally operates under three different systems for loan validation.
- In the GSE sector, Fannie Mae and Freddie Mac set underwriting standards, validate loan information and enforce representations and warranties, thus operating a complete system of standards and enforcement.
- In the private loan market, sellers and buyers individually negotiate underwriting, monitoring and enforcement standards.
- In the private-label securities market, there are no universal standards or enforcement mechanisms. Instead, underwriting standards are set by originators and a relatively weak representation and warranty framework provides enforcement. The primary mechanism for ensuring performance is through disclosure requirements and enforcement. Investors have the ability to avoid or pay less for securities that they believe have worse performance. Disclosure provides a far weaker — and in some ways, more expensive — approach to ensuring the quality of the loan manufacturing process.
With the introduction of ATR requirements, borrowers also have claims against the originator and investor if the loans were not in accord with the ATR rules. This creates additional risk to investors who do not have full transparency into the underwriting process.
One way to offset the risks associated with the separation in time and of originators and investors in the private-label securities market would be to adopt some aspects of the standard setting and perhaps enforcement mechanisms present in the GSE market. It may make sense to establish an industry self-governance entity to develop data driven standards for loan origination. These standards could be expressed as best practices that allow voluntary compliance, they could be part of a certification program that identifies lenders that follow the best practices, or could even form the basis for a self-regulatory organization (SRO) that derives enforcement powers from the government.
The goal of such an organization would be to promote greater standardization in loan underwriting consistent with the ATR rules, while facilitating the experimentation needed to extend credit to currently underserved communities on a responsible basis. Such an organization could:
- Provide a centralized database for evaluating underwriting and validation practices
- Establish standards for evaluating underwriting and validation practices
- Promote effective underwriting practices
- Identify ineffective underwriting practices
- Facilitate diligence and rating agency review of loan files
- Provide clarity for meeting QM and/or ATR rules
- Help originators defend against claim that loans were not QM or ATR
- Help investors get comfortable with assignee liability risk
- Provide stability to lending/investing practices even as regulatory requirements change.
Whether an industry standards group could reduce legal liability would largely depend on the degree to which regulators endorse or empower the industry group. A group that establishes “best practices” independent of the regulators would add a lot of value to the market as a mechanism for discussing trends, issues, and challenges in underwriting and selling loans. That said, the more informal the nature of the group, the less credibility it could have in a legal proceeding. If legal certainty is a goal, a self-regulatory organization (SRO) operating under rules established by the regulators could be a solution.
Regardless of the ultimate resolution for the QM patch, there are many benefits to the development of a process to provide a data-driven analysis of the underwriting approaches being utilized throughout the housing finance system. As we have seen, if the industry can’t self-govern, governance will be imposed upon us, and we may not be happy with the outcome.