Asymmetrical Information - Megan McArdle

01.14.13

The Four Most Important Things You Need to Know About the New Mortgage Rules

The mortgage market is going to change. But not yet.

Last week, the Consumer Financial Protection Bureau released what it calls "one of our most important rules to date", the "Ability to Repay" criteria.  Here's what you need to know:

1.  This will probably make it harder to get a mortgage, particularly if you are poorer  Under the new rules, a "qualified" mortgage cannot push the borrower's debt-to-income ratio north of 43%.  In plain english, that means that monthly debt payments, including your mortgage, cannot take more than 43% of your annual income.  Now, 43% sounds enormous to someone like me, with little debt other than a modest mortgage.  But it might be an impossible hurdle for a lower-middle class striver with two cars and some student debt.  There's no way to say for sure how much more difficult it will be, because it's not clear what role the "qualified" mortgage will eventually play in the mortgage market of a decade hence.  It may be hard to get a "non-qualified" mortgage, or it may merely be slightly more expensive than the qualified kind. However, these rules are designed to make risky mortgages harder to get, and I think that we can presume they will succeed to at least some extent.

2.  Nonetheless, it will not do that much to prevent default  Arnold Kling, a former Freddie Mac economist who has long been my favorite source on housing finance, points out that debt-to-income ratios aren't a very good predictor of default risk.  

As I point out in a new essay, mortgage defaults are driven largely by the borrower’s loss of equity. Thus, the most important risk factor at the time the loan is made is the size of the down payment. The rules ignore that. Instead, the focus in the borrower’s debt/income ratio, which is far and away the least predictive of the major factors used in predicting default (the down payment is most useful, followed by credit score and then by loan purpose, although the effects of these variables interact with one another so that it is not so easy to rank-order their importance).

3.  The government can continue writing mortgages under the old rules  AEI's Ed Pinto notes that government entities like the Federal Housing Administration are grandfathered for up to seven years (or until they write their own final rules).  So while it's probably going to get harder to obtain a new mortgage, it won't get much harder for quite some time.  These days, federal government is effectively almost the whole market for mortgage originations.  As long as they don't have to follow these new standards, borrowers with high debt-to-income ratios will still have options.

4.  The new rules tell you a lot about how the CFPB thinks  The new rules are part of the CFPB's drive to create "qualified" mortgages: low-risk, easy to understand products that will prevent consumers from getting themselves into trouble.  Their mandate is not to protect banks (and savers) from default; it's to protect borrowers from themselves.  That's why their approach is focused on the household income statement.  

I go along with the CFPB in saying that even if you aren't likely to default, you should not have a debt to income ratio that approaches 50%.  It's bad for your financial health.  Too much of your income is tied up in long-term fixed obligations which cannot be shed without major financial repercussions.  That leaves you extremely vulnerable to any sort of financial shock: a job loss, a family member who needs expensive care, an emergency.  People whose debt-to-income ratios are so high are almost certainly skimping on necessary line items like savings.  

The difference between the CFPB and me is that I wouldn't mandate it; I don't like rules that make some people worse off, in order to protect still other people from themselves.  But this sort of paternalism has strong support in a lot of the wonkosphere, most notably from Elizabeth Warren, the intellectual progenitor of this agency.  They have clearly embraced financial paternalism as a core part of their mission.  And this rule reflects that emphasis.