Dodd-Frank rules on mortgage lending were intended to eliminate abusive practices by lenders, but the legislation may need to be simplified to prevent another housing bubble.
The CFPB’s new rules on qualified mortgages are designed to ensure that mortgage borrowers are taking out loans that are suitable for them because lenders are required to verify and assess the potential borrower’s ability to repay on financial obligations. The rules, however, encourage riskier loans while protecting lenders from litigation under the safe harbor loophole, U.S. News & World Report reports.
The safe harbor provisions were loosely designed around empirical evidence on the most common causes of default. Certain requirements, including interest-only and no-doc loans, as well as a ban on negative amortization, could discourage borrowers from taking a risk on loan products they don’t understand, while limitations on loan fees would make it more difficult for lenders to hide high interest rates.
Though the features were commonly seen at the peak of the housing bubble, the bust was a result of lenders’ decisions to ignore basic lending principles, including a borrower’s ability to repay, a borrower’s willingness to pay and the size of the loan compared to the property’s value. Borrowers took out large loans with the expectation that rising home prices would allow them to refinance unaffordable debt, but falling prices forced many borrowers into default.
The QM rule, however, only addresses the debt-to-income ratio, or the borrower’s ability to repay, and establishes the maximum debt-to-income ratio at 43 percent. The CFPB said that the debt-to-income ratio may not be the most relevant factor, pointing to Federal Reserve data that revealed “debit-to-income ratios may not have significant predictive power once the effects of credit history, loan type and loan-to-value are considered,” according to U.S. News & World Report.
The safe harbor allows for risky loans, but loopholes in the QM rules encourage lenders to take on even more risk. Dodd-Frank exempts home equity lines of credit — or revolving credit lines under second mortgages, which may encourage borrowers to take out equity lines of credit after closing and also encourage lenders to offer first mortgages with high-debt-to-income ratio home equity lines of credit.
More exemptions are available on reverse mortgages, timeshare loans and government-favored financial firms that have offered high-risk, low-cost loans for decades. The QM rules exempt loans secured by Fannie Mae, Freddie Mac and federal agencies like the Federal Housing Administration. The CFPB also plans to extend the exemption to community banks and nonprofit organizations, both of which have contributed to housing crises in the past, U.S. News & World Report reports.
Additionally, the QM rule does not require the borrower to take a stake in the form of substantial equity because the rules make no mention of the loan-to-value ratio. During the housing bubble, the median down payment for first-time home buyers was two percent, and low-interest financing led borrowers to take risks they would not have taken under normal circumstances.
The CFPB’s QM rules, which put the burden of responsibility on lenders, will likely discourage borrowers from being proactive and assessing the risks of certain loan products. Requiring borrowers to examine whether a house purchase is affordable could prevent taxpayers from taking a loss in a future housing crisis, according to U.S. News & World Report.