More than seven years after the subprime bubble began to deflate, lenders and borrowers will begin operating under a new set of rules. Phasing in starting on Jan. 10, these regulations will take direct aim at boom-era lending habits that allowed borrowers to take on more debt than they could handle, with disastrous consequences for homeowners, lenders, and the broader economy. The highlight is that a modicum of logic will become standard: Lenders will no longer be allowed to sell a mortgage that a borrower can’t reasonably repay.
The 2010 Dodd-Frank financial overhaul law called for the newly created Consumer Financial Protection Bureau to write the rules, which will require lenders to evaluate whether a loan is affordable. As commonsensical as that sounds, it was optional in the past. After more than two years of comments, lobbying, and drafting, the bureau released its final regulations in early 2013. Lenders must now verify and document at least eight specific criteria, including income, assets, credit history, other debt obligations, and employment status, to determine whether a borrower has a reasonable chance of repaying the loan. If the lender doesn’t do all that, a homeowner who has trouble repaying the loan has grounds for a lawsuit.
The CFPB has also issued guidelines for “qualified mortgages” that offer lenders additional protection from lawsuits. In a qualified mortgage, a borrower can’t spend more than 43 percent of his monthly income making payments on his debts, including the new mortgage and credit card balances. Some features that proved risky in the housing bubble are banned: terms longer than 30 years; the option to pay less than the full monthly interest; balloon payments; and fees and points that add up to more than 3 percent of the loan. If lenders follow the criteria for mortgages set at the rates commonly available for borrowers with good credit, they will have strong protection from lawsuits by consumers. If the loan has a higher, subprime interest rate, borrowers will have more legal options to challenge the lender on how it determined the loan was affordable.
Not surprisingly, some lenders say the rules will restrict credit too much, particularly for minority borrowers. “Policymakers don’t seem to understand what they’re doing,” David Stevens, head of the Mortgage Bankers Association, said in an Oct. 28 speech at his group’s annual convention. He said regulators want more lending to “the marginal borrower,” yet the ability-to-repay requirements “come with extraordinary penalties should a lender make even a minor error or dare consider a compensating factor.”
Regulators say that’s rubbish. The CFPB and other bank overseers don’t believe the rules will conflict with fair lending requirements, and CFPB Director Richard Cordray said in a speech to the mortgage bankers’ convention that “the vast majority of loans made in today’s market” already comply with the rules. He said lenders can still sell mortgages that aren’t qualified and, if they use sound underwriting standards, “will have little to fear.” The potential liability is so low that Senator Elizabeth Warren (D-Mass.) has said it may not provide “an adequate check on overly risky lending.”
Safe, profitable mortgages that aren’t qualified will create new opportunities for “a savvy entrepreneur” or bank, according to a recent white paper published by the housing data firm CoreLogic (CLGX). As the paper puts it, “Making sure a borrower has the ability to repay is good business.”
More changes for lenders and borrowers are still to come. Regulators are working on yet another set of rules that will force banks to keep some skin in the game when they bundle mortgages into securities. Rather than letting banks pass all of the risk on to investors who buy the securities, banks will be required to keep 5 percent of the deals on their own books. Certain safer loans, however, will be exempt from that requirement. Just how large regulators should make that loophole is hotly contested.