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A Capital Idea
Research and Commentary on Financial Capital and Its Impact on People and Places

UNC research supports revised mortgage risk retention rule

By Roberto G. Quercia
Director, UNC Center for Community Capital

Financial institution regulators have taken another step toward restoring a sound and vibrant U.S. mortgage market with a regulation "reproposal" that our research indicates will limit risk of foreclosure while maintaining broad access to mortgage credit.

Specifically, the revised proposed risk retention rule aligns the definition of a Qualified Residential Mortgage (QRM) with the Qualified Mortgage (QM) definition called for by the Dodd–Frank Wall Street Reform and Consumer Protection Act's ability-to-repay rule.

The net effect is to remove key provisions from their original (2011) proposal -- particularly requirements for a 20 percent down payment and a pristine credit history -- that our research showed would have excluded a large portion of the potential mortgage market while having limited impact on foreclosures rates.

As we discuss in a new report, Risk, Access and the QRM Reproposal, QM requirements alone will exclude the riskiest, worst-performing loans while low-down payment loans, when underwritten and structured to QM requirements, can perform well, according to research we conducted with the Center for Responsible Lending (CRL).

However, some observers worry that this approach will not go far enough to prevent risky lending. And the reproposal document references a U.S. Securities and Exchange Commission (SEC) analysis that suggests defaults may occur at a rate higher than our research shows because it looks at a much narrower slice of loans and does not fully capture the effect of QM.

For those reasons, it is worth reviewing the evidence to gauge the proposed QRM reproposal's impact on default risk and risk to the market from excessively tight credit.

Research shows poorly underwritten and non-traditional loan products led in defaults; QM excludes the worst performers

Securitization markets play an important role in providing mortgage credit. Selling mortgages on the secondary market frees capital that lenders can use to make more home loans and can also lower the cost of credit.

However, a misalignment of incentives and risk in mortgage lending and securitization can lead to harmful consequences for consumers, investors, financial institutions and, indeed, the entire housing finance system, as the financial crisis demonstrated clearly.

It is that toxic combination of risky mortgage products, loose underwriting and complex mortgage-backed securities, which were poorly understood and valued by investors, that regulators seek to avoid in the future.

Toward that end, Dodd–Frank requires federal regulators to set a QRM standard. For loans that do not meet the standard and are securitized through the private market, banks and other issuers will have to retain 5 percent risk capital. The intent of the rule is to promote sound mortgage lending practices by forcing issuers to have "skin in the game," retaining some risk for the loans they make.

Separately, Dodd–Frank requires the Consumer Finance Protection Bureau to adopt a rule that requires all mortgages to be based on the borrower's ability to repay. That Ability-to-Repay standard is presumed to be met for loans designated as a "Qualified Mortgage," or QM – mortgages without risky product features (such as negative amortization, interest only, high fees and more) for borrowers with debt-to-income ratios of no more than 43 percent.

In 2011, as CFPB was finalizing the definition of QM, regulators proposed a QRM definition that would have required 20 percent down payments as well as strong credit histories and debt-to-income ratios. In our 2011 testimony to regulators on the provision, we took issue with the QRM definition that was being proposed because of the data and rationale that led to it. For one, regulators were basing that rule on an analysis of loans held by Fannie Mae and Freddie Mac, not where the most reckless lending was concentrated.

In an effort to provide better information for regulators on the potential effects of the rule they originally proposed, our center teamed with CRL to analyze a nationally representative group of 19.5 million loans originated from 2000 to 2008, including both prime and subprime loans.

That study, Balancing Risk & Access: Underwriting Standards and Qualified Residential Mortgages, found that applying the QM definition by itself to this broad universe of loans reduced the overall default rate by nearly half, to a 5.8 percent level.

It is important to note that both the SEC study and ours show that a restrictive QRM definition would exclude a large percentage of loans; indeed, the SEC report finds that less than 1 percent of the loans in their sample would qualify under the original proposed QRM definition.  

However, the SEC analysis suggests that the reproposal will result in a much-higher 34 percent default rate among their defined pool of QM loans compared to our default rate of just 5.8 percent.

The difference in default rates can be explained by two key factors. First, the SEC study includes loans with risky features linked to default as part of their QM sample, even though these features are actually restricted under QM. Second, they use a very different and narrow sample of loans (only private label security mortgages originated primarily in 2004, 2005 and 2006, the height of the subprime boom). Such mortgages are the worst of the worst. We maintain that analysis of the broader mortgage market is the best measure of the impact of the proposed rule(s) on access to credit and safety and soundness.

Loans with lower down payments can perform well when properly underwritten, structured and serviced

Our research also finds that borrowers who put down less than 20 percent can and have maintained homeownership, even through the recent economic upheaval. 

When we looked at the universe of borrowers who met QM guidelines and were successfully making their payments, requiring high down payment requirements (10 percent and 20 percent) would have excluded 60 percent of creditworthy, performing borrowers.

The results were particularly striking for African American and Latino home buyers. A mandatory 20 percent down payment requirement would exclude about 75 percent of African American and 70 percent of Latino borrowers who proved to be successful homeowners.

Our analysis of various down payment and underwriting scenarios showed that the basic QM definition would achieve the optimal balance between risk and access to QRM loans. The revised rules reflect that.

Broad access to quality mortgages is critical for economic mobility and housing market recovery

Homeownership and the housing finance system play a unique role in ensuring strong families, strengthening neighborhoods and boosting the overall economy. For this reason, it is critical to redesign the system to account for shifting demographics and changing consumer profiles and not exclude these families from the mainstream mortgage market going forward.

Our research shows that aligning QRM and QM will effectively eliminate the worst-performing mortgages with the least risk of reducing access to credit for a large share of creditworthy borrowers.

Given the fragility of the current market, the revised rules offer the potential to restore access to credit more equitably, support broader homeownership and help the market recover, without compromising systemic safety and soundness.

– Mortgage finance expert Roberto G. Quercia directs the UNC Center for Community Capital. He is also professor and chair of the University of North Carolina at Chapel Hill's Department of City and Regional Planning and a Faculty Fellow at the Center for Urban and Regional Studies.



In "Regaining the Dream, center researchers explain what caused the foreclosure crisis and the key elements their research reveals are necessary for a safe, sound and vibrant mortgage market.

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