The Federal Reserve proposed some new mortgage rules today that might not seem particularly radical: it wants lenders to be sure that borrowers can actually afford the loan they're given. Imagine that! While this might sound like common sense to most of us, this basic concept was pushed aside by many banks and mortgage companies during the housing bubble. As a result, loans were given to borrowers who could not repay, and ultimately defaulted. The Fed intends to force lenders to ensure that borrowers can afford loans in a few ways.
Fed Wants Mortgages Only Given to Those Who Can Afford Them
On some level, these rules are actually kind of hilarious, because they amount to a course in Basic Loan Underwriting 101. Take, for example, the Fed's "General Ability-to-Repay Standard." Lenders must determine that a borrower can afford a loan by:
- Considering and verifying the following eight underwriting factors:
- Income or assets relied upon in making the ability-to-repay determination;
- Current employment status;
- The monthly payment on the mortgage;
- The monthly payment on any simultaneous mortgage;
- The monthly payment for mortgage-related obligations;
- Current debt obligations;
- The monthly debt-to-income ratio, or residual income; and
- Credit history; and
- Underwriting the payment for an adjustable-rate mortgage based on the fully indexed rate.
In other words, they must actually do some underwriting. None of these concepts are revolutionary. For example, the lender must verify the "monthly payment on the mortgage." Yes, that's a pretty good idea. In fact, anyone who has worked in mortgage underwriting prior to the housing bubble should have ample experience analyzing these borrower characteristics. A potential borrower exhibiting a pulse alone will no longer be enough.
But notice: the Fed does not provide minimums for any of these standards. For example, the lender must verify the borrower's monthly debt-to-income ratio, but the rule does not say it must be, say, below 100%. In essence, the Fed is saying here that lenders must do some underwriting, but that underwriting must qualitatively be "reasonable" and "in good faith." The exception, however, is that last bullet point. Using the fully indexed rate (which is calculated by adding the margin to the index) is potentially a more conservative assumption if the loan starts at a rate below the fully indexed rate. So this could somewhat shrink the adjustable-rate mortgage market.*
How to Create a Qualified Mortgage
Next, the Fed introduces the concept of a "qualified mortgage." These are mortgages products that conform to certain rules, so they get "special protection from liability." Obviously, this distinction will be important to some banks, who want to avoid lawsuits related to their mortgage products. But banks who wish to create non-standard mortgage products can still do so, they will just face legal liability.
The Fed offers two alternate definitions for qualified mortgages. One alternative requires that the loan not contain:
- Negative amortization,
- Interest-only payments,
- A balloon payment, or
- A loan term exceeding 30 years;
- The total points and fees do not exceed 3 percent of the total loan amount;
- The income or assets relied upon in making the ability-to-repay determination are considered and verified; and
- The underwriting of the mortgage (1) is based on the maximum interest rate that may apply in the first five years, (2) uses a payment scheduled that fully amortizes the loan over the loan term, and (3) takes into account any mortgage-related obligations.
Obviously, this would eliminate lots of the wacky, dangerous loan products that became popular during the bubble. The second alternative would include all of these criteria, plus the some of the "ability to pay" rules explained above. It would consequently receive an even stronger liability shield.
Don't Confuse "Qualified Mortgage" With "Qualified Residential Mortgage"
Unfortunately, regulators aren't that creative. As a result, there's ample room for confusion with the terminology used here. You may have heard the term "qualified residential mortgage." That is a loan that adheres to certain requirements which allow banks to escape risk retention requirements. One criterion of the proposed rule is a 20% down payment. This is different from the "qualified mortgage" explained above. Essentially, qualified residential mortgages would be a subset of qualified mortgages that met additional criteria.
Some Super Subprime Mortgages Are Okay
In order to ensure credit availability in "rural or underserved areas," the Fed wants to allow lenders some leeway in writing very risky loans. So in some circumstances, lenders can write mortgages with a balloon payment. In other words, the mortgage would have a monthly payment too low to pay off the loan at the end of its term, and some chunk of principal must be paid by the borrower at the loan's maturity. Presumably, the bank would refinance the loan at that time to prevent default.
Ignore Income When Refinancing Wacky Mortgage Products
There's another way that banks can avoid some of the rules above. If they refinance a "non-standard" mortgage, like a negative amortization or option adjustable-rate mortgage, to become a standard mortgage with a lower monthly payment, then they can ignore income verification. The idea here is likely that borrowers are so much better off with standard mortgage products and lower monthly payments that there's little reason to worry about their income.
Although these rules don't take many drastic steps in changing the way most banks write mortgages, they sure would have been helpful about seven years ago. The Fed wants to avoid bad mortgage products and borrowers who cannot afford their mortgage. Doing so should help to create a more stable housing market in years to come.
* Initially, I wrote that the fully indexed rate would be the maximum rate that the loan could hit. This has been corrected, as the actual requirement is less drastic.
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