No Agreement over “Plain Vanilla Mortgages”

Remember all that talk about plain vanilla mortgages and skin in the game? As it turns out, both of these concepts were incorporated into the Dodd-Frank Financial Reform Bill, which became law this past summer. Unfortunately, regulators have yet to agree on a set of standards and definitions for the new bill. How this debate is resolved will significantly affect the landscape for mortgage lending going forward.

At the heart of the debate is disagreement over the term Qualifying Residential Mortgage (QRM). The idea is that QRMs can be originated and securitized by lenders just like under the current system.  Non-qualifying mortgages, on the other hand, will be subject to certain “risk retention” rules, which is basically a fancy way of saying that lenders will be required to keep a portion of these loans on their own balance sheets for a certain period of time. In this way, they will they will be directly exposed to the risk of default and will be less likely to underwrite such loans.

Perhaps the biggest point of contention concerns the mandated down-payment size. Naturally, large lenders are arguing for a minimum of 30%, based on the principle that this will make it harder for borrowers to walk away from their mortgages. Consumer groups and smaller lenders are pushing for a smaller down-payment – perhaps as low as 5% – to be supplemented by private mortgage insurance (PMI). They argue that credit quality and borrower financial characteristics are better predictors of default that the size of one’s down-payment. To be fair, if a borrower doesn’t have the means to make payments on his mortgages, no level of home equity will prevent him from defaulting.

All parties are in agreement that non-standard loans – such as “those with negative amortization loans, pre-payment penalties or balloon payments” – will be excluded from the QRM category. It’s not yet clear how interest-only loans will be treated. “Strong credit scores will also be a must as well as effective verification of borrower income.” However, a minimum credit score threshold has not been established, and regulators haven’t yet decided how many months (12?/24?) of borrower income will need to be verified.

These might seem like trivial points, but the implications for borrowers are significant. Those that are unable to fulfill the requirements of a QRM will either be shut out of the mainstream mortgage markets and steered into non-traditional or FHA loans, or will be forced to compensate lenders for the added risk by paying a higher rate of interest.

On the other hand, borrowers that qualify should receive attractive terms and a standard low rate of interest. For better or worse, the majority of these loans will be be 30-year, fixed-rate mortgages. Borrowers will have less choice, but the overall system should discourage excess risk-taking and should be more stable.