“What is your assessment of the new set of regulations issued by CFPB?” 

My quick reaction to the hundreds of new mortgage rules recently issued by CFPB, contained in 804 densely packed pages, is that the agency has done a creditable job in an incredibly difficult situation. The rules cover a lot of territory, but those pertaining to borrower affordability probably have attracted the most attention. This article will comment on the new affordability rules, leaving other important issues for future columns.

The regulatory focus on affordability reflects our recent experience with a housing bubble -- a period of self-reinforcing home price escalation. The bubble induced lenders to liberalize mortgage underwriting rules, relax enforcement of the rules, and approve loans to borrowers who could not afford them. The bubble burst early in 2007 when house prices stopped rising and started to decline.

The Dodd-Frank bill passed in 2010 was a reaction to the excesses of the bubble period. Among other things it authorized a new Consumer Financial Protection Bureau, which it charged (among other things) with formulating and clarifying mortgage affordability rules. Dodd-Frank also required CFPB to define “qualified mortgages”, which are mortgages that lenders can make with no or minimal risk of legal liability for violating the affordable loan rules.

In my view, the Dodd-Frank approach to home mortgages was a knee-jerk reaction that was ill-advised. A nationwide housing bubble is a rare episode in our financial history. One has to go back to the 1920s to find anything at all comparable. While revamping the rules to prevent a recurrence of that event, even if it happens only once a generation, might make sense if the new rules were a standby, to be applied only when the situation demanded them, that is not the case. The new rules will take effect January 10, 2014. They were ill-advised because the problem today is the opposite of the one for which the rules were intended.

When the bubble burst early in 2007, the excessive liberality in mortgage lending practice was quickly replaced by its opposite – excessive restraint. The problem today is that many perfectly good loans are not being made because of the heightened risk aversion of lenders, and the tightened affordability rules already in place.

The lender response reflects the heavy losses realized on loans made during the bubble period, plus the fines and legal expenses they have incurred in its aftermath. The tightened affordability rules by regulators and by Fannie Mae and Freddie Mac, issued after the bubble burst, were based on the premise that “although we should done this 5 years ago, better late than never.” In fact, never would have been better than late.

A central characteristic of the current affordability rules is their rigidity. A loan applicant who does not measure up on the affordability scale will be rejected, regardless of the strength of other transaction features. As an important example, I have received scores of letters from self-employed borrowers with high credit scores who were willing to put as much as 40% down but could not get a loan because the income they were able to document was viewed as insufficient.

Rejecting applicants who have a past record of meeting obligations, and are willing to bet on their ability to afford a loan by placing substantial equity at risk, is absurd. CFPB was obliged under Dodd-Frank to set new affordability rules despite the fact that the existing rules are unduly restrictive. Its implicit challenge has been to minimize the extent to which the new rules make a bad situation worse.

From all indications, CFPB has done this pretty well.  It has declared that qualified loans cannot have any of the following provisions: interest-only, balloon payment, negative amortization, term exceeding 30 years, zero documentation, lender fees exceeding 3% of the loan amount (unless that amount is less than $100,000). or low “teaser” rate on an ARM. These options will either disappear, or be substantially over-priced. However, very few loans are being made today with any of these features, so that the loss is small.

Furthermore, there are several glimmers of hope that the new rules may actually alleviate some of the excessive stringency in the current market. The rule on balloon payments is subject to an exception wherein such loans are qualified if they are made by small banks in rural areas. This exception was required by Dodd-Frank and may or may not reflect an intention by CFPB to carve out additional exceptions in the future.

A further glimmer is that the new rule says that “no-doc” loans cannot be qualified, which is very different from declaring that qualified loans must be “full-doc”. There is a range of documentation options between these two extremes. These include stated income/documented assets, which was widely used before the crisis to qualify self-employed borrowers. The option disappeared in the regulatory excesses of the aftermath, which made full documentation the universal rule.

This raises the possibility that CFPB at some future time might define loans with only partial documentation as qualified if they meet certain conditions. To have a significant impact, however, Fannie Mae and Freddie Mac would have to do the same.