By John P. Carey, Chief Administrative Officer, North America Consumer Banking

Although the definitive history of the financial crisis and ensuing global recession has yet to be written, there is almost universal consensus that imprudent practices by many participants in the United States (U.S.) mortgage lending market were a major factor in triggering the events of the last few years. The U.S. housing market still has not recovered. Millions of families have lost their homes through foreclosure, and more than one in four families owe more on their mortgage than their home is worth. It was, therefore, no surprise that one of Congress's first responses to the crisis was to focus on reforming the mortgage finance system.

Traditionally, mortgage lenders in the United States (banks, savings & loans, mortgage bankers and credit unions) generally made a loan to a borrower under guidelines provided by investors, including government sponsored entities (GSEs) such as Fannie Mae or Freddie Mac, or made a loan according to their own institution's guidelines. In either case, the lender certified that the loan met the applicable guidelines. Many of these loans were sold and the lender used the money to make more loans. This system was called the "originate-to-distribute" lending model.

When Congress investigated the causes of the financial crisis, the originate-to-distribute model was seen as a contributing factor to imprudent lending. Many members of Congress, academics and policymakers believed that if lenders had "skin in the game" (i.e., kept a percentage of these loans on their books as "risk retention" in the event of default), these lenders would have had the incentive to make better, more responsible loans, because they, and not just the investors who purchased the loans, would also suffer any losses.

The Dodd-Frank Act attempts to address the perceived problems with the originate-to-distribute model by requiring securitizers of loans to retain "an economic interest in a portion of the credit risk" of the loans being securitized. Residential mortgage loans that had characteristics that indicated a "lower risk of default", called Qualified Residential Mortgages (QRM loans), would be exempt from this "skin in the game" requirement.

The law gives regulators a broad outline of what types of risk mortgage loan originators should retain. Translating this concept into concrete rules for a mortgage market that is still struggling to recover has been challenging.

Earlier this year, six federal regulators issued proposed regulations to implement the risk retention rules. The proposal defines QRM loans as those that are "plain vanilla," meeting historically conservative underwriting guidelines such as:

·         30 year maturity or less

·         Fixed rate only

·         Fees and points of 3% or less (these could include appraisal fees, loan originator compensation, hazard insurance and other items above and beyond the standard closing costs and points)

·         Loan to value (LTV) less than or equal to 80% on purchases (or 20% down); 75% for refinances with no cash out; and 70% for cash out refinances

·         Borrower's total debt to income (DTI) ratio of less than 36% (to understand more about DTI and calculate your own, Bankrate's website has a number of useful financial tools)

·         No 30 days past due obligations at time of application; no 60 days past due obligations over the prior two years

Loans exempted from the QRM loan requirements under the proposed rules include loans originated and insured by The Federal Housing Association (FHA), Veterans Administration (VA) loans and loans securitized by either of the GSEs. The proposed rule has proven to be contentious.

Many argue that by defining QRM loans too narrowly, regulators may overly restrict access to credit for many lower income borrowers, those who lack the requisite down payment, and/or those who may have less-than-pristine credit profiles as a result of the financial crisis.

The QRM loan rules, when finalized, will help shape market dynamics - originators will need to determine whether or not they want to make non-QRM loans, and what they would need to charge in order to make up for the retained risk. This will ultimately affect how easy it is for consumers to get a mortgage and what the price of that loan will be. In order for the housing market and economy to recover, there needs to be sufficient credit available for creditworthy people to obtain mortgages to buy homes. However, as we learned in the last decade, credit underwriting criteria that are too lenient can have unintended consequences.

What do you think? Has the right balance been struck between the need for mortgage credit and the risk of default? Share your thoughts below.

Other Reading Material:

There are a number of studies and analyses by various parties on the web that discuss the proposed rules. Here are several that might be of interest:

·         The Mortgage Bankers Association (MBA) has drafted an analysis of the proposed rule, which can be found here. Citi is a member of the MBA.

·         A broad alliance including realtors, mortgage lenders, civil rights groups, consumer advocates and others formed the Coalition for Sensible Housing Policy to campaign for changes to the proposed rules. 

·         Moody's published a paper entitled "Reworking Risk Retention" which provides recommended changes to make the QRM loan rules more effective. The paper can be found on the Moody's Analytics website.

·         The Federal Reserve Board received over a hundred comments on the proposed rules, including some from financial services trade associations of which Citi is a member. These comments are posted to the Federal Reserve Board's comment section. 

·         The United States Government Accountability Office released a study on the potential impacts of the QRM rules and other Dodd-Frank Act requirements on homebuyers and the mortgage market, which can be found here.