Traditionally, mortgage lenders in the United States (banks, savings & loans, mortgage bankers and credit unions) generally made a loan to a borrower under guidelines provided by investors, including government sponsored entities (GSEs) such as Fannie Mae or Freddie Mac, or made a loan according to their own institution's guidelines. In either case, the lender certified that the loan met the applicable guidelines. Many of these loans were sold and the lender used the money to make more loans. This system was called the "originate-to-distribute" lending model.
When Congress investigated the causes of the financial crisis, the originate-to-distribute model was seen as a contributing factor to imprudent lending. Many members of Congress, academics and policymakers believed that if lenders had "skin in the game" (i.e., kept a percentage of these loans on their books as "risk retention" in the event of default), these lenders would have had the incentive to make better, more responsible loans, because they, and not just the investors who purchased the loans, would also suffer any losses.
The Dodd-Frank Act attempts to address the perceived problems with the originate-to-distribute model by requiring securitizers of loans to retain "an economic interest in a portion of the credit risk" of the loans being securitized. Residential mortgage loans that had characteristics that indicated a "lower risk of default", called Qualified Residential Mortgages (QRM loans), would be exempt from this "skin in the game" requirement.
The law gives regulators a broad outline of what types of risk mortgage loan originators should retain. Translating this concept into concrete rules for a mortgage market that is still struggling to recover has been challenging.
Earlier this year, six federal regulators issued proposed regulations to implement the risk retention rules. The proposal defines QRM loans as those that are "plain vanilla," meeting historically conservative underwriting guidelines such as:
Loans exempted from the QRM loan requirements under the proposed rules include loans originated and insured by The Federal Housing Association (FHA), Veterans Administration (VA) loans and loans securitized by either of the GSEs. The proposed rule has proven to be contentious.
Many argue that by defining QRM loans too narrowly, regulators may overly restrict access to credit for many lower income borrowers, those who lack the requisite down payment, and/or those who may have less-than-pristine credit profiles as a result of the financial crisis.
The QRM loan rules, when finalized, will help shape market dynamics - originators will need to determine whether or not they want to make non-QRM loans, and what they would need to charge in order to make up for the retained risk. This will ultimately affect how easy it is for consumers to get a mortgage and what the price of that loan will be. In order for the housing market and economy to recover, there needs to be sufficient credit available for creditworthy people to obtain mortgages to buy homes. However, as we learned in the last decade, credit underwriting criteria that are too lenient can have unintended consequences.
What do you think? Has the right balance been struck between the need for mortgage credit and the risk of default? Share your thoughts below.
Other Reading Material:
There are a number of studies and analyses by various parties on the web that discuss the proposed rules. Here are several that might be of interest: