Undoing Dodd-Frank: Are Portfolio Lenders More Cautious?

April 26, 2018

Dodd-Frank was a Congressional over-reaction to the financial crisis of 2008-9, and a process of amelioration is underway. Under the proposed Economic Growth, Regulatory Relief and Consumer Protection Act, introduced by Senator Mike Crapo, certain provisions of Dodd-Frank would not apply to mortgage lenders whose assets total less than $10 billion – which includes most lenders – provided that the loans are retained by their originators rather than sold.

Documentation Requirements Prior to Dodd-Frank

In the decade prior to the financial crisis, documentation requirements evolved from full doc for every borrower to a range of requirements, from full doc to no doc. The less complete the documentation, the higher the price of the mortgage and the larger the required down payment and credit score. These three poles of the underwriting system were flexible in the sense that a good score on one could offset a poor score on another.

This sensible market-based system worked well until the housing bubble emerged in the early years of this century, when large numbers of borrowers elected less than full documentation so that they could exaggerate their incomes and purchase more costly houses. Many lenders accommodated them by relaxing their standards and reducing their surveillance. When the bubble burst in 2006, mortgage defaults and foreclosures rose to levels not seen since the 1930s.

The Dodd-Frank Response

 Dodd-Frank introduced the concept of “qualified mortgages”, which were mortgages that carried low-risk features and provided the lenders making them a “safe harbor” from potential liability if things went wrong. Qualified mortgages could not have interest-only or negative amortization features, for example, and had to be fully documented. Full documentation, furthermore, was an absolute requirement in the sense that weak documentation could not be offset by good credit or a large down payment.

A major consequence of this rigid rule on documentation is that lenders who offer only qualified loans reject self-employed loan applicants who cannot document their income adequately. Such applicants are rejected even if their credit is pristine and they are putting 20% down or more.

The Proposal to Relax the Rule

Under the proposed legislation, applicable to lenders with less than $10 billion of assets, qualified mortgages retain most of the required low-risk features stipulated in Dodd-Frank, but full documentation is no longer required. As I read it, these lenders will once again be able to adjust their documentation requirements to other features of the transaction.

In my view, this elimination of excessive rigidity in documentation rules is as it should be, but excluding the largest lenders makes no sense. The rationale, if there is one, seems to be that relaxing the documentation rule allows firms to take more risk, and since the failure of a very large lender is a systemic threat while the failure of a small firm is not, the privilege should not be granted to the very largest firms.

The fallacy of that argument is that firms viewed as systemically important are subject to special regulatory oversight by the Federal Reserve, the focus of which is their overall risk exposure. The Fed does not need Congress making risk-based rules for specific parts of a lender’s portfolio.

Limitation on Mortgage Sales

The other unwarranted restriction in the proposed legislation is that the lenders who take advantage of the more flexible documentation requirements lose the safe harbor if they sell the mortgage. The premise underlying this restriction is that lenders who retain loans in their portfolios will exercise greater prudence in assessing the qualifications of borrowers because they take the loss when borrowers default, rather than passing it along to those who buy the mortgage.

It is true that virtually all the sub-prime mortgages originated during the go-go years preceding the financial crisis were  securitized. Default-imposed losses were borne by the security holders, and by originators who were caught with unsaleable loans when markets collapsed. But portfolio lenders who retained the mortgages they originated also suffered major losses on loans they later regretted having made. The most toxic of all the mortgages that prospered during the go-go years, the option ARM that allowed negative amortization, was a portfolio product that was retained by the firm that originated them.   

The correct lesson from that recent history is that market euphoria arising from persistent increases in home prices affects permanent and temporary lenders in the same way. They read the same news and attend the same conventions. In a normal market, there is zero reason to believe that the standards imposed by those who buy mortgages from originators are any less strict than those who originate for their own portfolios.

Conclusion: A regulation that makes a mortgage less valuable if it is sold is a step in the wrong direction.

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