There is a fight under way right now between banks, regulators and Congress concerning the new residential mortgage rules lenders will need to follow in order for the loans they are originating to be considered "qualified mortgages."
The principal debate concerns whether or not lenders will have to retain risk in the mortgages they originate with less than a 20% down payment or equity in the property by the borrowers. As currently proposed by the Consumer Financial Protection Bureau (CFPB), the rule is that lenders will have to retain a 5% principal risk in loans with less than a 20% equity stake provided by the borrowers.
How this is worked out will impact the cost of debt to individuals, the profitability of lenders, and the amount of consumer credit that is available for purposes of other than financing residential real estate. It's a big issue for the banks and the housing sector as well as the broad economy.
If the banks are required to reserve 5% of the outstanding balances of the mortgages they originate, they will be left with less capacity to make other kinds of loans and the interest rates on the mortgages being originated will have to increase to offset this. An increase in mortgage rates that is not caused by an increase in economic activity will provide a drag on housing and the economy.
This is known as a pro-cyclical event; the corrective action of requiring lenders to retain risk actually causes the total risk to increase. Making mortgages more expensive to access reduces economic activity and increases the risks of making those same loans.
That doing so is being debated even as the Fed is continuing to implement counter-cyclical policies through quantitative easing designed to make mortgages less expensive is troubling.
On top of that, the CFPB is an arm of the Federal Reserve itself. So we now have one part of the Federal Reserve trying to implement procyclical policy while another part, the Federal Open Market Committee (FOMC), is trying to implement counter-cyclical policy.
This is as good a definition of the right hand not knowing what the left hand is doing as I can imagine. Even more troubling, though, is that the corrective action required to preclude the necessity of lenders retaining risk in mortgages they originate was already implemented when making no income verification loans was disallowed under the qualified mortgage rules.
The principal issue giving rise to the mortgage and housing crisis was the devolution of underwriting guidelines that allowed loans to be approved without borrowers having to prove and document the character, capacity and collateral required to do so. Now that mortgagors are again being required to document all three Cs, the necessity for lenders to hold back risk is redundant. Thus, it's not only counter-productive but it will cause the problems the proposed corrective actions are claimed to pre-empt.
The most troubling aspect of all of this is that it illustrates a lack of awareness by all of the parties involved in this debate as to what caused the mortgage and housing crisis of the last decade. I don't know how this is going to be worked out, but if the 5% risk retention rule is left in place, the first place investors will take a hit is in the equity prices of the stocks of the lenders that are most closely aligned with residential mortgage origination.
Ranked in hierarchy of priority those are Wells Fargo (WFC), Bank of America (BAC), JPMorgan Chase (JPM), and Citigroup (C). These organizations will also have to pass on higher costs of debt capital to the regional and local banks they wholesale mortgage funds to and the entire banking industry will experience an increase in costs and decrease in profitability.
At the time of publication, Arnold held positions in JPM Bonds.