The Housing Lobby is once again in a bout of hand wringing, this time over the scheduled expiration of the Qualified Mortgage “patch” in January 2021.
As was noted in a recent Mortgage Media Post: “Perhaps one of the greatest short term risks that could upset the entire ecosystem of lending between bank and non-bank, where mortgage volumes go in the capital/secondary market, and what happens to credit availability in this country, is the renewed focus on the QM Rule. Particularly, on ‘the patch,’ the provision established under the previous CFPB Director that exempts loans eligible for sale to the GSEs from the limitations of the written rule itself.”
Dave Stevens, the post’s author, correctly noted that I have called for an end to the patch and have warned that the “patch” is leading to increased credit risk in a pro-cyclical manner. I have also noted that the “patch” has been a major contributor to the current home price boom, particularly for entry level homes attractive to first-time buyers. Since traditional debt-to-income ratios were abandoned in the mid-1990s — anyone remember 28/36? — we have had two home price booms. In the first, taxpayers have already paid dearly. In the second, taxpayers are on the hook for potential losses on the trillions of dollars in FHA, Fannie Mae, and Freddie Mac mortgages backed by the Treasury Department. Finally, I have called for the CFPB to provide ample notice of its intent to allow the Patch to sunset in 2021.
Spoiler alert: letting the patch expire in 2021, combined with dropping FHA’s DTI limit to 50 percent, will lead to about the same number of homes being sold, purchase loan volume will be largely unchanged, FHA’s volume will about unchanged, and the increase in entry-level home prices will be more in sync with rising borrower incomes.
It is time to separate fact from fiction about the impact of the patch lapsing in 2021.
Eliminating the GSE conventional loan patch and, at the same time limiting FHA borrowers to a maximum 50 percent DTI limit (down from the current maximum of a 57 percent) will not result in the dire consequences predicted by the Housing Lobby.
First, more than half (about 53 percent) of those affected would adjust their consumption of housing and debt so as to be within the new DTI limits, thereby reducing risk layering. This is what normally happens in markets when prices are going up more rapidly than incomes — a household substitutes chicken for steak.
Those unwilling or unable to adjust consumption (about 29%) would continue renting, however given the dearth of entry-level supply, other first-time buyers would take their place, albeit at somewhat lower prices due to reduced upward price pressure. These replacement first time buyers will be less leveraged, with less risk layering than the ones they replace.
About 13 percent of conventional buyers affected will choose FHA (but have lower risk profiles than most current FHA buyers) and be roughly off-set by the 16 percent of affected FHA borrowers who will continue renting. The remaining 5 percent of those affected are already homeowners will choose to stay put.
Contrary to assertions by some members of the Housing Lobby, risk layering matters when it comes to DTIs. This is demonstrated by a review of the default rates through 2017 for fixed-rate, “plain vanilla” GSE Purchase Loans for 2006-07 based on full loan counts. As Table 3 from the FHFA Working Paper demonstrated, defaults generally increase as DTI increases. For example, for a loan with a CLTV greater than or equal to 96% and credit score of 720-769 or 660-689, moving from a DTI of 39-43% to 44-50% results in a nearly a one-in-five risk of default (an increase of 16%) and a nearly one-in-three risk of default (an increase of 9%) respectively. Increasing DTI from the more traditional 34-38% to 44-50% results in an increase in an 36% and a 22% increase in default risk respectively.
Who are the winners?
- Entry-level buyers in general, with somewhat less access to income leverage, will pay less for their homes during seller’s market conditions.
- Since the patch was announced on January 2013, a national seller’s market of historic proportions for existing homes has prevailed, generally standing at 3.5-4.5 months of remaining inventory.
- The seller’s market has been even stronger for the entry-level home market attractive to first-time buyers. Here month’s remaining inventory is even lower, generally at 2-3 months. Demand created by an expansive credit box, especially for first-time buyers is running full-tilt into this tight supply.
- The result has been higher prices that warranted by income growth alone. With the patch effectively on auto-pilot during this lengthy seller’s market, the perverse result has been to drive up the price of entry-level homes the fastest. Since Q4:12, prices of entry-level homes have increased by 44 percent, about 14 percent faster than the rate for medium-high and high-priced homes. This result is not unsurprising, as would be obvious to anyone who has taken Economics 101.
- Not only has the patch has not protected consumers, it has operated as a tax on first-time buyers. The faster rate of price increase has resulted in adding an extra $21,000 to the average cost of today’s buyer of an entry-level home.
- Given the strong seller’s market for the last 6 years, particularly for entry-level homes, about the same number of homes would have been sold had the Patch never been promulgated.
- Less exposure to mortgage risk on the over $6.5 trillion in mortgage loans they guarantee.
- Reduces the dangerous race to the bottom between the GSEs and FHA for higher risk borrowers
- The patch-induced boom in home prices potentially exposes taxpayers to losses on the trillions of dollars in FHA, Fannie Mae, and Freddie Mac mortgages backed by the Treasury Department. The patch’s expiration will help reduce home price volatility by resisting the tendency to allow mortgage risk to increase as the cycle matures.
- Banks, credit unions, mortgage insurers, PMBS issuers, and others with skin in the game
- The patch has promoted crowding out of the private sector by the GSEs. Its expiration will allow these skin-in-the-game institutions to expand their footprints as they will know be better able to compete for an increased supply of prime loans as the GSEs lose the patch’s competitive advantage.
- The patch’s expiration will help reduce home price volatility by resisting the tendency to allow mortgage risk to increase as the cycle matures. This reduces credit losses.
- While its share of the purchase market will be little changed, FHA ends up with borrowers with substantially less income leverage than today. As a result, its underwriting policies will be less pro-cyclical than currently, thereby tamping down unsustainable home price appreciation during a seller’s market.
- Specifically, it loses about two-thirds of the nearly 30 percent of its current high risk borrowers with DTIs >50 percent (accounting for about 4 percent of combined 2018 FHA and conventional purchase volume). Most of these are currently FTBs who will continue to rent, while some are current homeowners who will choose to stay put. The other one-third will adjust their consumption, thereby qualifying for an FHA loan with a DTI of 50 percent or less.
- It picks up about 20 percent of the conventional purchase loan volume with DTIs above 43 percent and less than or equal to 50 percent, most of which comes from the GSEs (23 percent of current conventional loan purchases and about 3 percent of combined 2018 FHA and conventional purchase volume). About 60 percent will adjust their consumption, thereby qualifying for a GSE or conventional loan with a DTI of 43 percent or less. About 20 percent (about 4 percent of combined 2018 FHA and conventional purchase volume) will either continue to rent, or if a current homeowner, will stay put.
- If in addition to reducing its DTI limit to 50%, FHA were to also address the valid concerns of depository institutions regarding the False Claims Act, FHA originations by depository institutions should increase somewhat relative to non-depositories (independent mortgage bankers).
Both winners and losers:
- The GSEs
- While the GSEs will lose about 40 percent of the loans they currently acquire with DTIs above 43 percent (about 7 percent of combined 2018 FHA and conventional purchase volume), they will be reducing their dangerous competition with FHA for higher risk business.
- Mortgage originators and real estate agents
- Home sales and loan production will remain at about the same level.
What about the approximately 7 percent of conventional and FHA home purchasers who continue to rent? While no one knows when the boom will end, those who are “last in” with the riskiest mortgages (mostly first time buyers) stand to bear the brunt of the price correction that follows. Under the patch, not only was the income leverage of these borrowers high, but risk layering was prevalent. The renters represented by this 7 percent are those who did not adjust consumption in order to qualify under the revised DTI rules.
The following graphic shows these shifts:
Mortgage policy should work towards reducing unsustainable home price volatility by resisting the tendency to allow mortgage risk to increase as the cycle matures. Allowing the Patch to expire and providing ample notice of this intent would be a positive move in that direction. Further keeping a 43 percent DTI threshold as part of the QM Rule remains a simple, automatic and effective way to apply counter-cyclical friction in the future.
 Davis, Larson, and Oliner “Mortgage Risk Since 1990” (FHFA Working Paper 19-02). Here “plain vanilla” means 30-year, fixed rate, fully amortizing, fully documented, loans to primary owner occupants.
 Source: AEI Housing Center
By Edward J Pinto
American Enterprise Institute (AEI) resident fellow Edward J. Pinto is the codirector of AEI’s Center on Housing Markets and Finance. Along with AEI resident scholar Stephen Oliner, Pinto is creator of the Wealth Building Home Mortgage, a new approach to home finance designed to serve the twin goals of providing to a broad range of homebuyers – including low-income, minority, and first-time buyers – with a more reliable and effective means of building wealth than currently available under existing policies, while maintaining buying power similar to a 30-year loan. He is currently researching approaches to increase the supply of market rate economical apartments for hourly wage earners. Active in housing finance for 45 years, he was an executive vice president and chief credit officer for Fannie Mae until the late 1980s, Pinto has done ground breaking research on the role of federal housing policy in the 2008 mortgage and financial crisis. He is now conducting research on the current house price boom that began in 2012. Pinto has a J.D. from Indiana University Maurer School of Law and a B.A. from the University of Illinois at Urbana-Champaign. He can be reached at email@example.com.