HR 3915 Would Stick it to Blemished Borrowers

November 19, 2007

Editorial Note August 17, 2010: HR 3915 was not passed but almost all of it was incorporated into the "Restoring American Financial Stability Act of 2010," see "Will the Financial Stability Act of 2010" Improve Mortgage Disclosures?

The Market Has Turned Against Blemished Borrowers

In the wake of the sub-prime crisis, the market has turned against all except "cream-puff borrowers" -- those with no weaknesses. The cream-puffs can borrow today on pretty much the same terms as before the crisis. But borrowers with blemishes on their applications are paying much higher prices, and face a much higher risk of being turned down altogether.

As if that is not bad enough, The Mortgage Reform and Anti-Predatory lending Act of 2007 (HR 3915), now winding its way through Congress, would worsen their plight. That is not the intention, of course, but the law of unintended consequences has a home in the home loan market.

Blemished borrowers have one or more of the following risk factors: they can only make a very small or no down payment; they cannot fully document their income and assets; their property is something other than a single-family home; their loan is intended to raise cash or to purchase an investment property; they have low credit scores; their income is low relative to their expected total obligations; and their mortgage carries an adjustable rate that will result in substantially higher payments in a few years.

Changing Attitudes Toward Risk

During the go-go years 2000-2005, the mortgage market was extraordinarily tolerant of risk factors. It was not unusual to see 5 of them present in an accepted mortgage, a phenomenon termed "risk layering". Lending to a borrower who had no money for a down payment, who could not document adequate income and had a poor credit history was a kind of market insanity associated with the rapid run-up in house prices. Inflation of house prices converts even the worst loans into good loans.

When the housing bubble burst in 2006, the chickens came home to roost in the form of mortgage defaults. These are rising to levels not seen since the depression of the 1930s.

Markets tend to over-react. Just as the housing bubble was accommodated by insanely liberal lending terms, the pendulum has now swung toward Scrooge-like stringency. The price increments associated with risk factors are now 2 to 3 times as high as they were a year ago, and risk layering has gone way down. Roughly speaking, if you have two risk factors the price is substantially higher, and if you have three, the deal is rejected.

Already Clobbered by the Market, Blemished Borrowers Would Be Blindsided by HR 3915

A major provision of HR 3915 establishes "minimum standards for mortgages", which include requirements that borrowers have an "ability to repay", and that they receive a "net tangible benefit" from a refinancing. What these rules have in common, in addition to their discriminatory impact on borrowers already victimized by misfortune, is their vagueness and lack of specific operational guidelines. In an article I wrote recently on the net tangible benefit rule, I gave example after example where the ultimate determinant of whether or not there was a net benefit to the borrower could not be known by the lender without reading the mind of the borrower. Editorial Note August 17, 2010: the net tangible benefit rule was not incorporated in the Restoring American Financial Stability Act of 2010.

The inability to know whether or not they are in compliance creates risk for lenders which must translate into higher costs for borrowers. But HR 3915 also provides a way to avoid this risk. It offers a "safe harbor", which is a presumption that the standards have been met, provided that the loan at issue is a "qualified mortgage" or a "qualified safe harbor mortgage".

A "qualified mortgage" is one with an interest rate that does not exceed the rate on Treasury securities, or an average mortgage rate, by more than 3% or 1.75%, respectively. On second mortgages, the maximum spreads are 5% and 3.75%.

A "qualified safe harbor mortgage" is a loan that is fully documented, is not a negative amortization ARM, and either meets an income adequacy test, has a fixed payment for at least 5 years, or is an ARM with a margin of less than 3%. The overlap between qualified mortgage and qualified safe harbor mortgage will be very high.

The combination of vague standards and a safe harbor means that lenders will classify loans with regard to whether or not they belong to the safe harbor. Loans that do not belong will pay a higher price or not be made. Loans that won’t qualify for the safe harbor are those with the most significant blemishes.

The safe harbor removes some of the sting from the imposition of vague standards, because most loans will qualify for the safe harbor. But not all will qualify -- a new sub-class of mortgages will be created which will either be priced even worse than they are now, or will disappear. These are mortgages with multiple blemishes. Already clobbered by the market, they will get the coup de grace from the Congress. 

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