After nearly three years of deliberation, regulators have finalized an important rule that impacts housing. The Qualified Residential Mortgage (QRM) rule avoids an onerous and costly down payment requirement for consumers and gives creators of mortgage backed securities one less uncertainty on their road to recovery. The immediate impact may be small, but another piece in the glide path for long-term recovery has been laid.
Private MBS and Home Sales
Traditionally banks purchased mortgages and held them in their portfolios. Banks only have so much capital to lend, though. In an attempt to expand the pool of funds, mortgage backed securities, bundles of mortgages, were created and sold to investors beyond just banks.
At its peak, the private MBS market produced nearly $1.2 trillion in MBS annually. Today it is roughly $20 billion. Why? In the mid-2000s dangerous loans like interest-only, those with balloon payments or large resets, and those with no documentation of income, assets or even employment were pushed into private label MBS. Investors who bought these MBS rarely had the details of the loans in them, but were sated by high quality grades from ratings agencies. Adding to the problem were a hodge-podge of legal contracts and an unclear relationship between the trustee of the MBS and the investors; does the manager of the MBS do what is in the best interest of the investor who bought the MBS or the issuer of the MBS? Eventually the MBS cratered in value as default rates on loans in them spiked.
Why is it important to restore the private MBS market? A healthy private MBS market creates competition to government financing, expanding the total pool of funds for homebuyers and putting less tax payer money at risk. A healthy private market can also foster innovation.
Several things have changed since the mid-2000s. The opaque nature of private MBS deals has improved through new private sources of mortgage data, but also through regulations that require issuers to provide investors with better data on the loans in the MBS they issue. Rating agencies have created new guidelines for their grading systems. However, in an attempt to set a clear standard of safety for investors, Congress set forth a rule in the wake of the crisis that would delineate a zone of low risk and force better behavior outside of this zone, the QRM.
The Dodd-Frank legislation specified two rules that would impact the real estate industry: the qualified mortgage rule (QM) and the qualified residential mortgage rule (QRM). The QM rule was finalized in January and is intended to protect consumers. It does so by restoring and canonizing traditional underwriting like requiring proof that a borrower has the Ability to Repay (ATR) a mortgage and banning certain risky products. The QRM rule, though, is intended to protect investors. It requires all issuers of MBS to hold 5% of what they make unless they meet a standard of quality and low risk. Thus, combined the two rules work to protect the sources of financing funds and the recipient of those funds; homebuyers.
The final rule made the standard of quality for exemption from risk retention the QM rule. Thus, if a loan meets the underwriting of the QM rule, then it meets the QRM rule and the MBS issuer does not have to hold a stake in it. If it doesn’t comply with the QM rule, the issuer must hold 5% of the MBS for 5 years or until a majority of the outstanding balance is paid off. The bulk of defaults usually occur in the three years following origination.
Impact on the Consumer and REALTORS®
What does the final rule mean for consumers and housing? There will be a small initial impact…and that’s a good thing. The FHA is exempted from risk retention as are the GSEs while in conservatorship and combined they account for nearly 85% of purchase mortgages. But the GSEs and FHA produce QM loans. Research has demonstrated that QM-compliant loans originated from 2001 to 2008 performed better than conventional, prime loans through the crisis. Compensating factors like those employed by the GSEs would likely have improved that outcome.
When initially proposed, the QRM rule would have applied risk retention to any loan with less than a 20% down payment as well as a front-end DTI greater than 28% and back-end DTI greater than 36%. Had these requirements not been scrapped 45% to 60% of homebuyers could have been impacted. Risk-retention is costly to the MBS issuer, a 75 basis point or more cost that would have been passed onto the consumer. That is the difference between a 4.25% rate and a 5.0% rate or $90 per month on a $200,000 mortgage financed over 30 years. This cost would have disproportionately impacted first-time buyers and minorities as well as the trade up buyers who rely on them.
The higher costs of risk retention would have forced more lending to the FHA maintaining a large government role in the market. Or, if the FHA were restricted by political pressure, borrowers would have been to save for 20 years or more, or pushed out of the market entirely. The result: fewer home purchases, slower price growth, reduced home construction, less of the expenditures that accompany a home purchase, and a drag on the economy.
Another important aspect of the final bill is that it leaves lenders unaffected as they have been familiar with and adjusting to the QM rule for nearly two years. And with a final rule in place, issuers of private MBS gain more clarity and can focus on the contractual and structural issues that dog their market. The capital needed for risk retention can be difficult to raise, so having risk retention apply to a smaller portion of the mortgage market means that more firms can compete, which is good for consumers.
In the future, mortgages with low documentation and risky products will be limited, less liquid and require higher costs. Non-QM lending was only 2.6% of originations in the 2nd quarter of 2014, and any MBS issuer who wants to incorporate them into an MBS will have to hold 5% of the risk going forward.
The final QRM rule may have little impact on the market in the short term due to the current reliance on government product and tight underwriting. However, measured against the initial proposal, the impact could have been significant. Over time, this rule will prevent abuse while allowing a gradual recovery of private capital.
 The GSE are required to write QM compliant loans with the exception of the back-end debt to income ratio which is 43%. This exemption and the exemption to QRM mean that the GSEs production of high DTI loans, roughly 12-16% of their production, would not be forced into the non-QRM space. It isn’t clear that private issuers would be interested in supporting this entire market.
 Roberto Quercia, Lei Ding, and Carolina Reid (2012). “Balancing Risk and Access: Underwriting Standards for Qualified Residential Mortgages,” UNC Center for Community Capital Research Report, January 2012.