What Are “Qualified Mortgages”, and What Purpose Do
In 2013, the
Dodd-Frank Wall Street Reform and Consumer Protection Act
introduced the qualified mortgage concept, which was
designed to eliminate the market abuses that had led to the
financial crisis a few years earlier. Like most
crisis-induced legislation, Dodd/Frank is replete with
flaws, and the qualified mortgage concept (henceforth QM) is
one of them.
Rationale of the Concept: One
striking feature of the financial crisis was the
extraordinarily high default rates on all the high-risk
mortgage types that had emerged during the preceding go-go
years. These included a variety of approaches designed to
keep mortgage payments low in the early years of the loan.
Option ARMs, for example, allowed borrowers to make payments
that did not cover the interest, resulting in negative
amortization. When house prices started to decline, the
default rate on option ARMs exploded.
The QM was a reaction to that experience. The idea
was to define a class of mortgages that contained only
low-risk features, which would constitute the core of a
market that would be invulnerable to the forces that had
generated the crisis. As inducement to participate, lenders
were offered liability protection – “If the loan goes bad
but it is a QM, you won’t be held liable.”
Definition of QMs: QMs are
defined in terms of features that they must have, and
features they cannot have. The most important feature they
must have is compliance with an ability-to-repay rule or
ATR. In making a reasonable good-faith determination that a
mortgage borrower has the ability to repay, the lender must
consider 8 features of the loan specified in the rule,
document compliance, and retain documents for 3 years.
Indeed, the legislators who drafted Dodd/Frank viewed this
rule as so essential that they decided to apply it to all
home loans, not just QMs.
Features that QMs cannot have include mortgage
payments that are not fully amortizing, which eliminates
negative amortization or interest-only payments. Terms
cannot exceed 30 years, lender fees cannot exceed 3% of the
loan amount, and the borrower’s debt-to-income ratio cannot
I ignore the many qualifications and exceptions to
these rules, because they are not germane to the issue in
question: does the QM approach to market regulation make
sense? In my view, it does not, for three reasons.
QM Wasn’t Needed to Protect the System Against
Another Financial Crisis: The financial
crisis reflected an unusual set of conditions: a sustained
house price rise for over 8 years, and the absence of a
national decline in house prices for over 70 years. This
combination underlay the mindset that house prices could
only continue going up, and therefore all mortgages were
good. It is unlikely that that mindset will emerge again for
at least 30 years, when the current generation of lenders is
gone from the scene.
QM Would Not Protect the System In Any Case:
Dodd/Frank did not eliminate risky mortgage
loans, what it did was segment the market between lenders
who make QMs and lenders who make non-QM loans. If I am
wrong and the mindset of perpetual house price increases
takes hold in the near future, the non-QM sector would take
off just as the sub-prime sector did in the early 2000s. The
only significant difference would be that the large
mainstream institutions would be mainly QM lenders, though
nothing would prevent them from having non-QM affiliates.
There is a way to protect the system against a new crisis
episode, but the QM approach is not it.
QM Distorts the Market, to the Disadvantage of
Weaker Borrowers: The probability that a
loan will be repaid as scheduled depends on many
inter-related factors. A weakness in one factor does not
mean that the probability is low if that factor is offset by
strength in other factors. Balancing the various factors
that affect this probability is what underwriters (and
automated underwriting systems) do.
QM, in contrast, deals in absolutes. If the
debt-to-income ratio is 44%, the loan does not qualify, even
if the borrower is putting 40% down and has a perfect credit
record. The borrower in this case would have to go to a
non-QM lender. Based on a comparison I did yesterday of QM
versus Non-QM prices, the rate penalty would be about 1.5%.
The same point can be made about all the QM
requirements. Before Dodd/Frank, for example, interest-only
payments for the first 10 years of a 30-year fixed-rate
mortgage was a common provision, for which the borrower paid
1/8% or 1/4% more in rate, Today, she will pay about
1.5% more. The difference can be viewed as a
Dodd/Frank-induced private tax.
Perhaps the worst consequence of the Dodd/Frank
absolutist approach to mortgage quality is its requirement,
imposed on all mortgages, that borrowers fully document
their income. One result has been to deny credit to many
self-employed borrowers with excellent credentials in all
respects except that they cannot document much income.
Conclusion: The QM concept serves no useful purpose./span>