Editor: David Reiss
Brooklyn Law School

August 30, 2013

If QRM = QM, then FICO+CLTV > DTI ?@#?!?

By David Reiss

The long awaited Proposed Rule that addresses the definition of Qualified Residential Mortgages has finally been released, with comments due by October 30th. The Proposed Rule’s preferred definition of a QRM is the same as a Qualified Mortgage. There is going to be a lot of comments on this proposed rule because it indicates that a QRM will not require a down payment. This is a far cry from the 20 percent down payment required by the previous proposed rule (the 20011 Proposed Rule).

There is a lot to digest in the Proposed Rule. For today’s post, I will limit myself to a staff report from the SEC, Qualified Residential Mortgage: Background Data Analysis on Credit Risk Retention, that was issued a couple of days ago about the more restrictive definition of QRM contained in the 2011 Proposed Rule.  The report’s main findings included

  • Historical loans meeting the 2011 proposed QRM definition have significantly lower SDQ [serious delinquency] rates than historical loans meeting the QM definition, but applying this definition results in significantly lower loan volume than QM.
  • FICO and combined loan-to-value (CLTV) are strong determinants of historical loan performance, while the effect of debt-to-income (DTI) is much lower.
  • Adding FICO or CLTV restrictions to the QM definition reduces SDQ rates faster than the loss of loan volume: max ratios achieved at 760 FICO and 55% CLTV. (2)

Certainly, some readers’ eyes have glazed over by now, but this is important stuff and it embodies an important debate about underwriting.  Is it better to have an easy to understand heuristic like a down payment requirement? Or is it better to have a sophisticated approach to underwriting which looks at the layering of risks like credit score, loan to value ratio, debt to income ratio and other factors?

The first approach is hard to game by homeowners, lenders and politicians seeking to be “pro-homeowner.” But it can result in less than the optimal amount of credit being made available to potential homeowners because it may exclude those homeowners who do not present an unreasonable risk of default but who do not have the resources to put together a significant down payment.

The second approach is easier to game by lenders looking to increase market share and politicians who put pressure on regulated financial institutions to expand access to credit. But it can come closer to providing the optimal amount of credit, balancing the risk of default against the opportunity to become a homeowner.

It would be interesting if the final definition of QRM were able to encompass both of these approaches somehow, so that we can see how they perform against each other.

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