By Robert Freedman, Senior Editor, REALTOR® Magazine Federal banking regulators’ proposed qualified mortgage rule, which comes out of the big Wall Street reform act last year, is all about ensuring lenders only write loans that borrowers can reasonably be expected to repay. NAR’s

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Harris Real Estate University students…I love this article. Mr. Freedman (as usual) does and excellent job explaining a complex subject.

Why should you care about the QRM rules?

Simple, if they go into effect as written nearly every mortgage will require 20% down. Agents, what effect do you think this will have on your real estate market?

By Robert Freedman, Senior Editor, REALTOR® Magazine

Federal banking regulators’ proposed qualified mortgage rule, which comes out of the big Wall Street reform act last year, is all about ensuring lenders only write loans that borrowers can reasonably be expected to repay. NAR’s interest in the rule is pretty simple: ensuring that the requirements protect borrowers while balancing lenders’ incentive to lend to more than just the most creditworthy borrowers. NAR also wants to ensure sellers who occasionally provide financing to buyers don’t inadvertently get caught in the rule’s requirements.



All this is fairly straight-forward, but if you stop for a minute and think about the QM rule it’s really an astonishing piece of work—not the rule itself but that Congress and the Administration felt there was a need for it. It’s a little like the department of motor vehicles in your state writing a rule making it illegal for you to drive your car off a cliff. You would think your own self-interest would keep you from doing that, but if enough people are driving off a cliff, then, yes, the DMV might feel it must step in and tell you not to.

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The comparison between the rule and an overly protective DMV is apt because QM requires lenders to do what they should be doing anyway, at least if they want to stay in business: make loans that are reasonable for borrowers to pay back. That means limiting the loan amount based on how much borrowers earn, verifying those earnings, and imposing terms that make sense.

Yet, as we all know, during the housing boom lenders weren’t doing that. They were making no-down, stated-income loans to borrowers who had poor credit histories and little income. Why would they do that?



We already know the answer to that, too: Wall Street investment banks wanted those loans because they could package them into securities and sell “tranches” of the securities, divided up by risk level, to investors. The highest rated tranches were considered the safest and they received a Triple-A rating, and lower-rated tranches were considered more risky and investors got a better risk-reward ratio for those.

All this sounds fine except maybe those Triple-A rated tranches. Triple-A means there’s very little likelihood of default. Germany has a Triple A rating. So does ExxonMobil. And up until just a month or so ago the United States had a Triple A from Standard & Poor’s. So, investors were supposed to believe that those Triple-A tranches, which in some cases were comprised of as much as 85 percent subprime loans, were as little likely to default as Germany. By what calculation could Standard & Poor’s and other rating agencies reasonably determine that those tranches were safe?

According to All the Devils are Here by Bethany McLean and Joe Nocera, the rating agencies didn’t know exactly what was in these securities, called collateralized debt obligations (CDOs), when they rated them. Not only was the exact mix of loans opaque, but the loans themselves could be replaced over time, so that the security that a rating agency like Standard & Poor’s would be rating at its initial offering could include a different mix of loans two years later. “One astonishing fact is that CDO managers didn’t always have to disclose what the securities contained because these contents could change,” Nocera and McLean write in their book, which came out earlier this year. (We talked with McLean about the book in this blog shortly after it was published. You can read that piece here.)

But there’s another aspect to the ratings that, in retrospect, made little sense. Rating agencies assumed that the Tripe-A tranches would always be protected from default because all of the investors in the lower-rated tranches would have to be wiped out before trouble came knocking on the door of the Triple-A tranche holders, and no one had ever seen that happen before. That logic proved dubious because no one before had ever seen hundreds of billions in securities underwritten almost entirely with no-down, stated-income, interest-only, or negative amortization loans to borrowers with poor credit histories.

WARNING: Short Sales – love em or hate em, they’re here to stay! Go beyond the basic short sale designation. Watch the FREE Short Sale video and download the FREE Short Sale training guide. NOTICE: Free book guaranteed for first 100 agents only.

What All the Devils are Here and another book on the mortgage crisis, The Big Short by Michael Lewis, make clear is that the ratings were meaningless in the context of a systemic meltdown, which is what happened. The securitizers believed a meltdown wasn’t possible because risk had been spread so far and wide. With so many investors in so many countries sharing the risk, no single entity would bear more than a fraction of risk, so a systemic meltdown wasn’t conceivable. But what actually happened from a risk standpoint was the exact opposite. Because risk was shared by so many, when home prices stopped rising and borrowers started defaulting in large numbers, the widespread sharing of risk made the resulting impact an instantaneously global problem. Instead of spreading risk away, it had the effect of spreading the problem.

Exacerbating the situation even further was a category of security called synthetic CDOs. These were a fairly new invention and they were called synthetic because they’re not comprised of actual mortgages like a regular mortgage-backed security. Instead, they simply reference certain pools of mortgages, enabling investors to make side bets on the success or failure of the pools. What made these such a central part of the mortgage meltdown was their synthetic nature: since lenders didn’t have to actually originate loans for these securities, there was no limit to the number of side bets that could be placed on them. Thus, one pool of mortgages could have hundreds of side bets on it. That means if that pool goes bad, all of those investors who are on the wrong side of the side bet take the losses. So, not only are those investors holding the actual collateralized tranche taking a loss, hundreds of other investors are taking the loss on those same mortgages. That’s a very efficient way to spread a problem, not a risk.

The Big Short and All the Devils are Here make for sobering reading but they draw an informative picture of the many decisions made by lenders, Wall Street bankers, and the rating agencies, among others, that led to the financial crisis from which we’re still trying to recover. There isn’t much that’s positive to take away from that picture but one point that’s clear is that this crisis was driven by bankers on Wall Street who were personally making millions of dollars managing bets on subprime loans. Real estate professionals can take some satisfaction in the fact that, throughout the wide scope of both books, the real estate industry is almost completely absent from the story. In the one time a real estate agent comes up, it’s to quote her warning that the craziness needs to stop. That’s essentially what NAR was saying to Congress years before problems in the mortgage market started emerging. At the height of the boom NAR was warning Congress and the Administration of dangers posed by subprime mortgages to the borrowers themselves and to the housing industry. As then-NAR President Pat Combs testified before the Senate Banking Committee in early 2007, “NAR supports eliminating abusive and problematic mortgages made without sufficient regard to whether the borrower can afford the loan and avoid foreclosure.”

Well, Congress acted and the result is . . . QM. Now NAR is working to ensure that bankers don’t just keep their cars parked in the garage by only making loans to those with the best credit histories.

The new Consumer Financial Protection Bureau is supposed to come out with a final rule by 2013. Even if it misses that deadline, the statutory authority for QM still takes effect. Read a summary of the proposed rule. Read NAR’s comments to it. Watch a video walk-through of it.

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