Risky mortgages shouldn’t be anchored in a safe harbor.
The draft of a sweeping regulatory reform bill unveiled this week by Senate Banking Committee Chairman Richard Shelby would water down limits on which mortgages receive legal protections afforded to “qualified mortgages,” so long as lenders hold on to them. While investors might hope banks win some regulatory relief, this goes in the wrong direction. It trades a bit more leeway in lending for what could be a lot more risk.
The Dodd-Frank Act sought to shore up underwriting by requiring banks to assess whether a borrower can afford a home loan. It created a category of “qualified mortgages” for those that meet pre-established standards deemed safe for consumers. Lenders are free to use their own standards to assess affordability. But these don’t get the automatic protection against legal challenges alleging predatory lending that qualified mortgages get.
The boundaries of the qualified-mortgage safe harbor were set by the Consumer Financial Protection Bureau in 2013. The loans must be fully amortizing and have a term no longer than 30 years. Lenders must verify a borrower’s expected financial position. Affordability is measured against the maximum payments due during the first five years. Plus, the rule limits the points and fees that can be charged, and caps the borrower’s ratio of debt to income at 43%.
The draft legislation relaxes those rules so long as the lender keeps the loan on their own balance sheet or sells it to someone who does. Both the five-year affordability test and the limit on points and fees are dropped. Most strikingly, the debt-to-income cap is eliminated.
Why give banks extra legal protection for the loans they hold on their books? The underlying assumption is that banks won’t engage in irresponsible lending if they can’t push the risk off to others. Since any losses on the loan will sit with lenders—rather than get bundled up as mortgage-backed securities and sold off—they will act as stewards of their own underwriting. In other words, they will have to eat their own cooking.
That assumption, though, fails the test of recent history. The financial crisis showed banks will sometimes take on short-term risks in the hope of immediate reward even if it risks their long-term health. And in euphoric markets, banks can underestimate their risks. That can have disastrous consequences for the firms, their investors and the broader economy.
Recall that nearly all the largest banks not only owned subprime mortgage originators, they also held huge mortgage portfolios and suffered sometimes-devastating losses when home prices plunged. Even if banks learned their lesson, another risk to them and their investors lurks in Mr. Shelby’s proposal.
This involves the illiquidity of qualified-mortgage loans. A bank facing financial distress wouldn’t be able to sell these to investors without losing the legal shield. This would make them far less valuable to outside investors than the banks themselves.
That in turn means they could only be sold at a loss—perhaps a big one. This illiquidity would be bad enough for performing mortgages; a rule that forces banks to hang on to distressed assets is potentially toxic. Banks might be forced to sell better-performing assets while holding on to worse ones—a recipe for disaster, especially in a time of stress.
Just how at odds with the interests of both creditors and equity investors this would be is highlighted by the one scenario where the bill allows for mortgages to retain their protected status in a sale: when a bank has failed and is being resolved by regulators. That would preserve the value of a failed bank’s qualified mortgages, reducing the cost of resolution.
But that would come too late for creditors and investors. Given that, they would be better off if banks were never encouraged to take on a new class of illiquid loans in the first place.