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 exceed 43%.

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.