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Editor’s note: The following piece is excerpted from Paul H. Kupiec’s testimony yesterday before the House Financial Services Subcommittee on Monetary Policy and Trade. Click here to read the full testimony.
The Consumer Financial Protection Bureau’s (CFPB’s) new rules for mortgage lending practices will not deter predatory lending and will significantly increase many small banks costs of mortgage lending. The Qualified Mortgage (QM) and the Ability-to-Repay (ATR) rules, which went into effect on January 10, 2014, set minimum underwriting standards that are far weaker than underwriting standards consistent with prime, low default-risk mortgages. As currently written, the rules would qualify a high percentage of borrowers who would likely default and lose their homes should we again experience a stress similar to the recent financial crisis. In addition, the QM and ATR rules will force many small banks to abandon the mortgage business, reducing mortgage credit availability for low-risk borrowers in geographic markets without a large bank presence.
The legislative intent behind the QM and ATR rules is the prevention of predatory mortgage lending. If banks underwrite mortgages that comply with minimum QM and ATR regulatory standards, there is the presumption that borrowers have the ability to repay the mortgages. In practice, the final form of the QM and ATR regulations set a remarkably lax, though onerous, government standard for mortgage underwriting. It was designed to aid government policies that encourage lending and minimize home price declines by easing constraints on a borrower’s ability to qualify for a loan. However, the QM rule stretches underwriting standards to allow overextended consumers to continue purchasing houses that would otherwise be unaffordable.
Borrowers can satisfy QM standards with only a 3 percent down payment and a subprime (580 FICO) credit score. It is doubtful that the QM rule offers borrows much protection against predatory lending. Regulatory estimates show that, of the Fannie Mae and Freddie Mac mortgages guaranteed between 2005 and 2008, 23 percent of those that met current QM and ATR rule standards defaulted or became seriously delinquent.[i]
In addition to not deterring predatory lending, the QM and ATR rules may prevent some low-risk borrowers, who depend on community banks for financial services, from qualifying for a loan. In order to limit exposure to predatory lending allegations, a mortgage underwriter must ensure that a loan satisfies the QM and ATR rules. Large organizations use scorecard-based underwriting models as a means to standardize the loan underwriting process and, when designed properly, impose controls and discipline on the many loan officers or mortgage brokers whose decisions are otherwise not easily monitored. These resources are not always readily available to community banks and the increase in compliance costs will likely force many of these institutions to abandon the mortgage business altogether.
It is well-known that smaller banks, so-called community banks[ii], specialize in relationship lending, or the use of “soft information” to underwrite loans. Qualitative information is gained through social and business interactions with potential borrowers and is used to assess a borrower’s “character,” the strength of the informal financial support a borrower might receive from family or relatives, or the quality of an entrepreneur’s small business plan. Unlike credit scores and income data that reflect past experiences, qualitative information can be forward looking and identify issues that are not yet reflected in public databases. This community banking process is especially helpful for assessing a borrower’s ability to repay a loan when verifiable data on income, the value of collateral, or formal guarantees from co-signatories are not available.
Relationship lending differs from high-volume model/scorecard-based lending which assesses the quality of a loan application based on data from credit bureaus, public records, and potentially verifiable information on income, expenses, and assets provided by the borrower.
While the QM and ATR rules do not prohibit the use of qualitative information in the underwriting process, a lender must adopt the technology and expense of a scorecard-based underwriting model if the lender wants safe harbor against potential litigation. While the small bank underwriter may feel confident in the borrower’s ability to repay the mortgage loan, “soft information” may not be sufficient or verifiable. The ATR and QM rules make it risky to underwrite mortgage loans based on qualitative information gathered through the bank-customer relationship. These requirements impose significant new costs on many smaller institutions, and, for small volume banks, these costs may not be recoverable even if mortgage origination fees are increased to the maximum permissible under QM rules.
The unintended negative consequences of the ATR and QM rules far outweigh any meager protections they may offer consumers. Many well-qualified borrowers are at risk of losing access to mortgage credit if their local community bank stops making mortgages. A recent academic study finds that 16 percent of the community banks that responded to its survey have stopped or plan to stop making mortgages as a result of the new regulations.[iii] In rural America and many small town markets, community banks are the only institutions providing financial services. The cost of scorecard-based origination mandated by the new mortgage rules is prohibitive for small volume lenders as it removes the soft information advantage of the community bank underwriting approach. As the economy continues to stabilize, federal housing finance regulations should not create barriers to entry for low-risk borrowers attempting to enter the mortgage market.
Paul H. Kupiec is a resident scholar at the American Enterprise Institute where he studies systemic risk and the management and regulations of banks and financial markets.
[i] See the discussion in Edward J. Pinto, Peter J. Wallison, and Alex J. Pollock, “Comment on Proposed Credit Risk Retention Rule,” AEI, October 30, 2013.
[ii] There are different definitions of community banks. A common definition used by the Federal Reserve is banks with under $10 billion in assets.
[iii] Hester Peirce, Ian Robinson and Thomas Stratmann (2014), “How are small banks faring under Dodd-Frank?,” Mercatus Center Working Paper No. 14-05, George Mason University.
The Consumer Financial Protection Bureau’s (CFPB’s) new rules for mortgage lending practices will not deter predatory lending and will significantly increase many small banks costs of mortgage lending.
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