August 30, 2013

Regulators Made Questionable Call on QRM Rule

Hester Peirce

Former Senior Research Fellow
Summary

Hester Peirce at American Banker.

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In 2011, financial regulators issued a proposed rule on "qualified residential mortgages" — as required by the Dodd-Frank Act — but the plan generated enough criticism to send them back to the drawing board. At issue were what parameters the government should set for defining mortgages that require risk retention by the mortgage securitizer and mortgages that don't. With a recently issued revised proposal, federal regulators have effectively admitted defeat and, in adopting "qualified mortgage" parameters, ceded the job to the Consumer Financial Protection Bureau.

The intent of risk retention, or "skin-in-the-game" as it was called ad nauseam during Dodd-Frank's drafting, is to ensure that securitizers of residential mortgages (and other asset classes) don't package junky loans into securities and sell them to unsuspecting buyers. To prevent this, securitizers would be required to hold 5% of the credit risk of the loans backing the securities they sell. The 5% figure was an arbitrary number plucked out of the air in congressional hearing rooms. "Skin-in-the-game" proved to be a good slogan for those hyping Dodd-Frank.

Even as the risk-retention provision was being drafted, people tripped over themselves to create exemptions from it. The most important exemption was left to regulators to design: "qualified residential mortgages," a type of mortgage so solid that no risk retention is necessary; the sort of mortgage with no historical track record of defaulting.

Defining the QRM was ill-fated from the get-go. Asking the government — which is always torn between its desire to facilitate homeownership and its fear that banks will fail — to set underwriting standards is a bad idea. For government officials, boosting homeownership invariably trumps all.

Making matters worse, QRM design is a multi-regulator effort involving the banking agencies, the Federal Housing Finance Agency, the Department of Housing and Urban Development, and the Securities and Exchange Commission, some of which have undermined underwriting standards in the past.

These regulators' first proposal, issued in the spring of 2011, was met with hearty disapproval. It required QRM loans to have a 20% down payment and borrowers to meet a 36% debt-to-income cap. A flood of comments came in with a common message: the proposal was too stringent.

On this recent attempt, regulators tried something different. They deferred to the CFPB, an agency that Congress, presumably by design, left off of the QRM rule-writing team, and adopted its qualified mortgage definition as the definition for QRM. What could be easier than simply pulling a ready-made definition off another regulator's shelf?

Unfortunately, the CFPB did not design the Qualified Mortgage with safety and soundness in mind. Instead, its definition enshrines a "one-size-fits-all" mortgage that ignores the nuanced needs of American consumers and avoids terms, such as balloon payments, that the bureau finds distasteful. Qualified Mortgage standards don't include down-payment requirements and set a debt-to-income cap of 43%. The QM definition does not serve the same purpose as QRM was supposed to and thus is inapt.

Nevertheless, QRM regulators have embraced that definition and any future amendments to it. As a result, in the words of SEC Commissioner Daniel Gallagher in his dissenting statement, "The QM designation, so to speak, is the new NRSRO [credit rating agency] triple-A rating."

The regulator now in charge of this new triple-A rating is a one-man-show, unaccountable to Congress, the President or the American people, which is especially troubling. By effectively handing their job over to the CFPB, regulators are giving that regulator even more power than Congress already unwisely has.

The Federal Deposit Insurance Corp. staff explained its decision to the FDIC in a memorandum recommending that the FDIC adopt the rule: "Aligning the definition of QRM with the definition of QM achieves an appropriate balance between limiting credit risk for the protection of investors ... and preserving credit access." Actually, this new proposal appears to be an admission that the risk-retention provision of Dodd-Frank is more trouble than it is worth.

Government-mandated risk retention is not an answer to the problem of bad loans being bundled up and sold to unsuspecting buyers. A better approach is to make sure that purchasers of mortgage-backed securities have access to good loan-level data about the loans backing the securities they are buying.

New SEC Commissioner Michael Piwowar recommended enhanced disclosure, including loan-level disclosure, as an alternative worthy of consideration in his start-of-his-tenure dissent from the new rulemaking. With better disclosure, buyers would no longer be blindsided, and the government could stay out of mortgage underwriting. A nice side benefit would be that we would not be wasting regulatory resources on an ineffectual rule.