Tuesday, May 17, 2011

Questioning Quirky QRM

Can an already fragile housing market handle a further tightening of available capital? That is one of the issues that Congress and the Obama Administration have to grapple with as they attempt to create an environment where the mortgage market is less reliant on the government. This was also the topic of a presentation and panel discussion in which I particpated with several industry leaders including Amy Swaney of Citywide Home Loans, Bill Rogers of Homeowners Financial, and John Foltz. We also were fortunate to have Congressman David Schweikert, Vice-Chairman of the House Capital Markets Sub-Committee.

You may have heard the term, QRM. The initials stand for Qualified Residential Mortgage. It is the title for loans that are exempt from credit risk retention rules that came about from the 2000-plus page Dodd-Frank Wall Street Reform Act. It essentially requires mortgage lenders to retain at least a 5% slice of the loans they securitize and sell to other investors. The purpose, according to policymakers, is so that mortgage lenders keep some "skin in the game" when they sell loans in the form of mortgage backed securities.

On the surface that sounds logical. 5% doesn't sound like much, but it's enough to make sure that lenders make quality loans. And durring the real estate boom, plenty of poorly underwritten loans were sold to investors without the lender having to keep any portion of loan themselves.

The problem is that the 5% retention rule ties up the lender's capital. If a lender securitizes a pool of mortgage loans totalling $100 million, they have to keep $5 million in an escrow account until maturity or payoff of those loans. That could be a long time on a 30 year fixed mortgage. That $5 million just sits in that account waiting for there to be losses on those loans. It can't be lent out or invested any other way.

Now there are some exemptions to the Risk Retention requirements, and that's where QRM comes into play. First of all FHA & VA loans are exempt. FHA loans are about a third of the market right now, but that will soon change as maximum loan amounts are set to go down later this year. Also, Fannie Mae and Freddie Mac loans are exempt but only while the entities are in the conservatorship of the Federal government. It is expected by everyone that Fannie and Freddie will be wound down, and if they exist in the future it will be as private entities.

The only other exemption from the Retention Rule is for Qualified Residential Mortgages (QRM). QRM loans must meet the following guidelines:

  • 80% Loan-to-Value (LTV) for Purchase transactions (20% down payment)

  • 75% LTV for refinances

  • Housing Expense to Income Ratio of no more than 28%

  • Total Debt to Income Ratio of no more than 36%

  • No current late payments on credit

  • No late payments of more than 60 days in past 24 months

  • No collections or judgements in past 36 months

  • No pre-payment penalties, limits on balloons and ARMs

Most of these items are just common sense underwriting standards, but a few restrictions stand out as onerous. The 20% down payment requirement is the most notable. There is an alternative proposal to allow QRM loans up to 90% LTV with mortgage insurance.

Also the housing and total debt ratio limits of 28% and 36% will create complications. Calculating a borrower's income can sometimes be complicated, especially for those that are self employed or have inconsistent sources of income (commission, bonus, overtime, etc). This is a very important part of the underwriting process because the lender must verify the borrower can repay the loan. The method by which an underwriter calculates the income means much more going forward because now it can mean whether or not there is a legal violation. Look for underwriting to tighten up even further as a reaction.

By winding down Fannie and Freddie and pulling back on FHA loan limits, the government is reducing the tax payer's exposure to mortgage loan losses. They are also opening the door for the private market to return the market of purchasing home loans, probably at higher rates than the government programs. In the long run that is going to be healthy for the mortgage and real estate markets. But the housing market is still in an incredibly fragile position, and is in the second dip of a double dip.

Being sensitive to this, I think it would be wise to throw out the credit retention requirements altogether. Lenders already retain risk on loans they sell in the form of "Re-purchase Risk." If the loan they sell doesn't meet the underwriting guidelines agreed to by the investor, then the lender has to buy the loan back for the sold price.

Knowing that Congress and the Administration will not back-track on credit risk retention, I would recommend an alternative definition of QRM that allows for up to 95% LTV with mortgage insurance and throw out the housing expense and debt to income ratio portion of the definition. We are continuing to close the door on the American Dream. And yes, homeownership is still a noble dream for many Americans. We can help people achieve it responsibly.

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