In case you have not heard, a clutch of regulators is holding court awaiting feedback from the public on the merits of their proposed rule that would reshape a major facet of mortgage finance. The QRM rule, commonly referred to as the 20% downpayment requirement, will have a dramatic impact on the future of housing finance. If done right, it will enhance the safety and stability of the system to the benefit of all, but it could also create a system of high hurdles to credit that skews access to credit away from a large segment of homebuyers especially lower income or first-time buyers, places excess credit costs on worthy borrowers, and creates another headwind for the housing market.
The rule in question goes much further than a 20% downpayment. It would create a definition of what a qualified residential mortgage (QRM) would look like pursuant to the Dodd-Frank financial reform legislation. A loan that qualifies for QRM would represent a safe asset for sale in the secondary market. Since banks can only hold so many mortgages in their portfolio, selling mortgage backed securities (MBS) to non-bank investors in the secondary market plays an important role in providing credit to homebuyers. Under the new rules, those mortgages that don’t meet this standard, 70% to 80% of all mortgages, would carry higher mortgage rates.
The impetus behind the rule is to make the housing finance system safer by forcing parties who sell all but the safest mortgages into the secondary market to retain 5% of any issuance they make. Thus, the issuer would have an incentive to ensure that the mortgages which back the mortgage backed security (MBS) that they issue are of sufficient quality that they are less likely to end up in delinquency. The rule stipulates that to qualify as a QRM, a newly originated loan must have 1) a downpayment of 20% or more, 2) a front end debt-to-income ratio of no more than 28% and a back end ration of no greater than 36%, 3) that the loan be fully amortizing (e.g. no interest-only loans), and 4) that the rate on the mortgage not increase more than 2% in any one year or 6% over the life of the loan (if an ARM). In addition, the rule requires that borrowers meet a number of credit requirements. Loans that don’t meet this standard will face higher mortgage rates since securitizers will need to retain 5% of their value in order to sell them as mortgage backed securities.
Since banks must hold back 5% of each non-QRM MBS issuance, they will not be able to re-use that capital for further MBS issuance or other more productive ventures. The sideline capital will need to be managed, incurring costs. Furthermore, since each issuance will begin to lock-up the capital of an issuing entity for an extended period of time, only those with large portfolios will be able to compete in this space. Loans that qualify as QRM will likely be perceived as less risky than non-QRM loans. Finally, with fewer regulations, the larger variety of mortgages in the non-QRM space might make it more difficult for securitizers to create standardized securities. These costs will be passed on to the consumer.
- Discussions with economists and analysts familiar with the securitization process put the impact on mortgage rates of 5% retention at an increase of 40 to 100 basis points. At this time there are several unknowns regarding the mechanics of the QRM rule. Issuers do not like to hold loans with long terms, like the 30-year fixed, because rising rates can eat away profits. Consequently they are asking for a sunset provision that would allow them to sell off their retention after the loans have successfully performed for a number of years. In addition, the law creates a “premium capture” facet, which makes it difficult for issuers to reap profits in the short-term, reducing their incentive to issue MBS, or to offer loan features like interest rate locks. This estimate of basis points could rise or fall as these uncertainties are resolved.
- The banking industry experienced consolidation since the housing boom that has placed upward pressure on the rate spread between the primary and secondary mortgage markets. Similarly, only a few entities have portfolios large enough to securitize mortgages with a 5% retention requirement. Consequently, securitizers of non-QRM loans are likely to exercise their market power in light of limited competition, driving rates upward. Likewise, it remains unclear whether the private securitizers will have the ability to handle the volume of securitization under the current system. During periods of financial distress, both investors and securitizers will likely choose to pull back. Together these facets will add an additional 30 to 60 basis points to the full impact of a system under QRM, or more.
- MBS investors underpriced the risk of borrowers with non-QRM characteristics in the past and are likely to command a higher risk premium going forward. Furthermore, portions of the non-QRM market will become idiosyncratic and have troubles pooling into sellable MBS. The void in lending that would result suggests an additional spread of 10 basis points and possibly more due to liquidity issues.
A simple forecast of long-term mortgage rates was created and displayed below using the Congressional Budget Office’s January forecast of the 10-year Treasury and the historical spread between the 30-year fixed rate mortgage published by Freddie Mac and the 10-year Treasury. For simplification, the rate for QRM loans assumes the forecast baseline, while spreads are added to reflect the low and high estimates of the non-QRM rates. The impact of the spread on the non-QRM market is significant and heightened by the rising baseline mortgage rates.
Beyond the increase in costs to borrowers, the new QRM regulation will introduce volatility into the system, particularly as the government’s role in the securitization market declines.
- The impact of duration risk and a sunset provision are uncertain as of yet. Furthermore, flaws in the rule are likely to emergence that will cause securitization to ebb and flow in the years to come. This process will impact the flow of funds to the origination market.
- During periods of economic instability or falling/flat home prices, securitizers will reduce the volume of loans that are securitized. This mechanism tends to over correct as evidenced by the sharp reduction in loans made by banks over the past 3 years despite the large increase in deposits and improved credit quality of loans made since 2009.
Loose lending standards and poor oversight by securitizers played an important role in creating the instability in the finance and banking system that transferred local housing market problems into an international recession. Reform is important for the future health of the housing market and economy, but it is important to understand the costs that will be borne by future borrowers. The regulators have an important task in creating a safe financial system, but there is also substantial risk in a system that is unnecessarily costly for credit worthy home buyer and could reduce economic growth.