In an attempt to correct problems encountered during the Housing Boom and later Foreclosure Crisis. the government, in its infinite wisdom, has issued for review new guidelines for mortgages. These guidelines, as a part of Dodd-Frank, distinguish between Qualified Residential Mortgages (QRM) that the Agencies would buy, and all other mortgages which are not eligible to be purchased by the Agencies. Risk Retention is also addressed.

There has been controversy about the new regulations, primarily from groups that would “suffer” from the changes, but the program has had little review of details in public forums in detail. This is an attempt to bring light to the subject.

The loan underwriting guidelines in the proposal were established for QRM’s. The guidelines were spelled out in specific detail and provided reasons for adopting them. Loans meeting the guidelines meant that the loans were of sufficient Credit Quality for the Agencies to purchase. The following are specific guidelines for the QRM.

• The loan can only be a first mortgage, owner occupied, 1-4 unit with a maturity no greater than 30 years. There can be no subordinate financing for a purchase loan. For a refinance, a previously existing second like a line of equity can be subordinated to avoid the borrower having to take out another after the loan closes.
• FICO scores will no longer be used. Instead, the guidelines require that the borrower not be currently 30 days on any debt, and no 60 day late on any debt within the last 24 months. No bankruptcy, foreclosure, short sale or deed in lieu within the last 36 months. No State or Federal issues allowed either.
• Cannot be interest only loans, negative amortization loans or balloon payment loans. No prepayment penalties allowed.
• Fixed rate or adjustable rate mortgages can qualify, with only an increase of two percent per year, up to six percent total. Adjustable rate mortgages fixed for up to five years only.
• Purchase LTV’s to 80%, rate and term refinances to 75%, and 70% for cash out refinances.
• Purchases require closing cost money, as well as 20%. No seller credit.
• Front End Debt Ratio of 28% and 36% for the Back End Debt Ratio
• Verified Income and Assets only, No stated loans
• Points and fees can be no more than 3%. Included in points and fees are rebates, non-interest finance charges, and other items.

Review of the new QRM guidelines shows that loans subject to purchase by the Agencies will be underwritten under greatly increased standards. This has been done to lessen default risk, and every such change made does actually decrease risk. Some points to ponder.

FICO scores are no longer used. This is actually one of the best decisions made. FICO scores are not representative of loan default risk for mortgages. They were designed for consumer and revolving credit, and applicable for only the first two years of new debt.

FICO has been replaced by actual credit history, requiring that all credit be paid up to date, and no 60 day lates in the past 24 months. This leaves a major issue unaddressed. A person could have twenty 30 day lates in the last 6 months, but as long as they were now current, then the QRM standard would be met. Furthermore, such issues as consumer balances to total debt are not addressed. Such information could show that the borrower is living off credit cards, and even if debt ratios are fine, the borrower could still have risk issues.

Debt ratios have been reduced to 28/36%. This is fine, but it can also be deceptive. A lower income borrower will have significantly less “residual income” after accounting for all pay check deductions and debt service, when compared to a higher income earner. Less residual income may mean an inability to meet monthly living expenses. Combine this with the above issues related to credit history, and you may have a borrower headed for default, even though he has a QRM.

Worst of all, all new underwriting guidelines are treated as separate issues, and not really integrated together to create a precise picture of default risk. In fact, from the actual notice,

“Any set of fixed underwriting rules likely will exclude some creditworthy borrowers. For example, a borrower with substantial liquid assets might be able to sustain an unusually high DTI ratio above the maximum established for a QRM. As this example indicates, in many cases sound underwriting practices require judgment about the relative weight of various risk factors (e.g., the tradeoff between LTV and DTI ratios). These decisions are usually based on complex statistical default models or lender judgment, which will differ across originators and over time. However, incorporating all of the tradeoffs that may prudently be made as part of a secured underwriting process into a regulation would be very difficult without introducing a level of complexity and cost that could undermine any incentives for sponsors to securitize, and originators to originate, QRMs.”

Therefore, the notice admits that there is still significant potential risk, but they are not concerned with it. The claimed reason for not using such a method is that it is “too complex and costly”, and it would dissuade sponsors and originators from originating QRM’s. Here is the real reason:

Such a method would mean that many people being approved under the new guidelines would not be approved by using such a method. The Default Risk would be too high, when all factors are integrated. (There is a solution that I will detail below.)

For loans that do not meet the QRM guidelines, Agencies will not purchase them. These loans must be held either by the lenders as Portfolio Loans, or else sold and securitized. If the loan is securitized, then the Sponsor must maintain a certain interest in the loan, known as Risk Retention. The minimum amount of Risk Retention is 5%, but could be greater under certain circumstances. The stated objective is to force a lender or Sponsor to take greater care in underwriting and servicing of a loan.

There is an underlying motive to this new program. If one understands Agency lenders, and how they have operated over the past 20 years, the Agencies have tried to “corner the mortgage market” time and again. (For better understanding, read Gretchen Morgenson’s book, “Reckless Endangerment”. It highlights their repeated efforts.) This new program is typical of Agency operations.

Under this program, the QRM’s would almost always be sold to the Agencies. The Agencies would be getting the “cream of the crop” mortgages, with greatly reduced Default Risk. Lenders would sell to the Agencies to avoid any risk of having to keep an interest in a loan.

Loans not meeting QRM requirements would have four different options. These options are being kept as Portfolio Loans, sold to FHA and/or VA, or to be securitized in Wall Street offerings. Currently, securitization is for all purposes non-existent. Lenders, due to liquidity issues are unable to keep many new loans in their portfolio. Either the other government agencies would take the loans, or the loans would not get funded.

I am certainly in agreement that loan standards need to be tightened up. We must go back to realistic underwriting. However, does it make sense to turn home lending completely over to the government agencies? Were they not a part of the problem?

We need to be able to restart securitization to offer competition to the Agencies. Restarting securitization is going to require a consolidated effort whereby loans will be properly underwritten, with default risk known, loan level characteristics properly revealed, proper verification techniques, and most important, proper grading of the securities. Until this is done, securitization cannot be restarted.

Different companies are involved in providing much of the information that is needed to restart securitization. However, there is one area that up until now has been ignored. That is a way of quantitatively determining the default risk of individual loans.

LFI Analytics has been working on this issue for over a year. Using information gleamed from reviewing thousands of loans, both performing and non-performing, we have developed such a scoring system for Default Risk, the LDR Score, that the authors of the QRM program said could not be done without excessive cost. The LDR Score has the ability to quantify the Default Risk of individual loans, based upon loan level characteristics and borrower characteristics.