Defining a Safe Mortgage: Has It Gone Too Far?

A little-known regulation sparked by the 2008 housing meltdown has the potential to fundamentally change the landscape of the housing and mortgage markets, further tightening the stranglehold on credit availability and deepening the housing market downturn.

Known as the qualified residential mortgage (QRM), this draft rule currently being debated by regulators could require prospective homebuyers to have at least a 20 percent down payment and face more stringent debt-to-income ratio standards to qualify for mortgages with the best interest rates. Opponents call the draft rule too narrow and say the tough requirements could severely restrict credit access to a broad swath of prospective homebuyers, effectively shrinking the pool of potential buyers needed to soak up the excess supply of homes in the struggling U.S. housing market.

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"Real estate is 20 percent of the GDP, and you would do tremendous harm to real estate in this country," says Jim Gillespie, CEO of Coldwell Banker Real Estate. "To me, the percent down isn't nearly as important as [the borrower's] job, what their income is, what their assets are, and what their liabilities are. [Regulators] need to be a lot more realistic because you're going to harm middle-income Americans, and you're going to really harm first-time homebuyers."

The QRM rules and other regulations outlined in the controversial Dodd-Frank financial reform legislation are designed to better align the cost and risk for loan originators and compel higher lending standards by requiring lenders to keep at least 5 percent of the risk of loans issued on their books—"skin in the game," as it's called—even if they repackage and sell the loan. That requirement is waived, however, for loans meeting QRM standards.

Contributing to the real-estate meltdown were financial institutions that made mortgage loans and promptly sold them to Wall Street investment banks or government-sponsored enterprises such as Fannie Mae and Freddie Mac, effectively shirking any credit or default risk. Because of high demand in the market for "safe" securities yielding more than U.S. treasuries and also lax regulation, lenders had little incentive to ensure the creditworthiness of borrowers. (As we now know, many borrowers couldn't pay their mortgages, which set off a chain reaction that brought the global financial system to its knees.)

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But as lawmakers and regulators sort through the wreckage of the housing bubble and attempt to come up with preventative measures against a repeat event, some experts say they're going too far in trying to define a safe mortgage. "The definition of a qualified residential mortgage (QRM) is likely to make borrowing both more difficult and more expensive for consumers," said Cameron Findlay, LendingTree Chief Economist, in a statement. "The proposed rule would mandate a 20 percent down payment; a standard that is sure to be a barrier. All in all it adds up to a more challenging environment for borrowers in the coming year."

Only 20 percent of the loans originated between 1997 and 2009 would qualify for QRM status today, according to research by Standard and Poor's, and only 30 percent of first-time homebuyers put down more than 10 percent in 2010, Findlay says. That would potentially leave the other 70 to 80 percent of borrowers to face steeper down-payment requirements and higher interest rates—as much as 3 percent above current rates, according to a JPMorgan estimate. There's also concern that lenders, deterred by the 5 percent risk-retention rule, may focus only on issuing QRM loans, further restricting the availability of credit for prospective homebuyers and driving down demand for homes. That's not good news for a housing market swollen with vacant homes, foreclosures, and distressed properties.

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With the housing market still struggling, the stakes are high when it comes to housing-finance regulations. A motley crew of regulators and policymakers tasked with fixing the housing market recently extended the comment period for the proposed risk-retention and QRM rule to August 1, giving them more time to hash out the intricacies of the proposals. "There's a huge debate going on right now over exactly what is a 'qualified residential mortgage," says James Angel, associate professor at Georgetown University's McDonough School of Business. "If they make the definition so narrow that nothing qualifies, then nobody can get a mortgage. If they make it too broad and you get a lot of junky stuff pushed through, then we have the same problems that led to the meltdown."

Despite concern about the potential long-term impacts of QRM, some experts say the short-term effects will be limited. That's because loans originated by Fannie Mae and Freddie Mac—the government-sponsored mortgage giants that back more than 90 percent of home loans today—are exempt. Also, the Federal Housing Administration, which aids lower-income borrowers and first-time homebuyers, will likely remain in place.

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Although some see the projected 80 percent of borrowers who won't qualify for QRM loans as a hindrance to the housing-market recovery, others argue that QRM standards could trigger the rebirth of the nearly non-existent private-label mortgage market. If a narrow QRM definition prevails, that leaves a sizable market share for private lenders to go after. "The Fed has said, 'Don't look at the QRM market—it's 20 percent of the market. You can make QRM loans, but we'd rather you focused on the 80 percent of the market that needs to be served privately," says Keith Gumbinger, vice president of mortgage information website HSH.com. "Find ways to go serve those guys profitably."

But in this odd economic recovery improvement will be gradual, meaning a revival of the mortgage market could still be many years away. "That's where the crux of the argument is," Gumbinger says. "Is it an enhancement of the marketplace? Does it foster a willingness of the part of lender to go after these non-QRM private mortgage originations? Or does it completely shut down the marketplace for non-QRMs [with] lenders only focus[ing] on making [loans] that qualify."

While experts don't expect to see a finale for the housing market drama for quite some time, most agree that efforts like QRM and risk-retention rules for lenders are a step in the right direction. Americans can only hope for a happy ending.

Twitter: @mmhandley