A signature piece of the Dodd-Frank financial reform bill mandates that if lenders want to package loans to sell to investors -- what's known as securitization -- they will now be allowed to only sell off 95 percent of the loan, and must keep the other 5 percent on their own books. The idea is that by requiring lenders to keep at least a 5 percent piece of "skin in the game," they'll be less likely to hand out loans to just about anyone (see: the housing bubble.)
But the reform bill also provides a workaround for lenders who don't want to keep any skin in the game. Dodd-Frank allows lenders to securitize the whole enchilada as long as they follow new underwriting guidelines laid down by federal regulators. And it's those rules that have just been floated in Washington and are now up for a 60-day comment period.
Here's what the new rules propose:
Get used to the acronym Qualified Residential Mortgage (QRM). This is Washington-speak for a lower-risk mortgage that will still be allowed (qualified) to be 100 percent securitized.
A crucial point to understand is that lenders will still have the freedom to make loans that don't meet QRM guidelines. But it's likely that the terms of those loans would end up costing consumers more. No one knows for sure how it would play out, but those non-QRM loans might carry higher interest rates, be for shorter terms (say 20 years rather than 30), or charge borrowers to lock in a fixed interest rate for the loan term.
To steer clear of any of those possibilities, you'd need to be able to close a deal that would give your lender a QRM it could fully securitize. The key QRM rules:
- The mortgage must be for a primary residence. No second homes or investment properties allowed.
- You'll need to make a 20 percent down payment for a new mortgage, a 25 percent down payment if you're looking to refinance, and 30 percent down if you're looking for a cash out refinance and your lender wants it to meet the QRM standards.
- No piggyback second mortgages would be allowed to finance the down payment.
- Your mortgage, property tax, and insurance costs can't exceed more than 28 percent of your gross (pre-tax) monthly income. Those housing costs and all your other ongoing debt obligations can't exceed 36 percent of your gross income.
- You need to be current on all your existing debt payments. And if you were ever more than 60 days late on any loan payments within the past 24 months, your loan won't be QRM-eligible. Same goes if you have filed for bankruptcy in the past 36 months, or gone through a foreclosure, short-sale, or deed-in-lieu of foreclosure.
Interestingly, there's no explicit credit score requirement in the proposal. The regulators went to great pains to make it clear they are aware that credit scores are a great predictor of future ability to repay a loan. The proposal notes that during the housing bubble from 2005-2007 borrowers with FICO credit scores of at least 690 with loans that would have met the QRM standards had a delinquency rate under 3 percent, while borrowers with lower FICO scores had a higher delinquency rate of 8-11 percent. Yet the Feds couldn't see their way to rely on credit scores that are run by private firms that have total control of how the black boxes work. So no FICO score requirement in the QRM regulation.
The new QRM proposals are essentially hypotheticals for the short term. From a practical standpoint, the regulators gave the housing market a reprieve. While Dodd-Frank mandated that the rules had to be proposed by April 1, the regulators decided to give a blanket exemption to these rules to any loans that are guaranteed by Fannie Mae and Freddie Mac, as well as loans insured by the Federal Housing Administration (FHA). That's 90 percent of the current market. But if plans to reform, if not eliminate, Fannie and Freddie altogether play out in the coming years, QRM will become a bigger factor in shaping the housing market.
Dodd-Frank also created a 5 percent skin in the game rule for auto lenders. If an auto lender wants to get out of that requirement so it can securitize 100 percent of the loan, the borrower must meet the following requirements:
- A 20 percent down payment and cash to cover the tax, title, and license fees. According to the latest Fed data, the average auto down payment is already right around 20 percent, though as recently as early 2008 it averaged just 5 percent.
- Documented proof that the borrower's total debt payments for all loans do not exceed 36 percent of gross monthly income.
- A loan term of no more than five years. Right now the average loan term according to Federal Reserve data is a smidge more than 62 months. If it's a loan for a used car, the length of the loan plus the age of the car can't exceed five years.
- No late debt payments of 60 or more days during the past 24 months.
- No bankruptcy, foreclosure, short-sales, or deeds in lieu of foreclosure during the past 36 months.
No one can yet say for sure what the potential impact in terms of different loan terms may be, let alone what the final proposals may look like after a 60-day comment period that is likely to spark spirited feedback from the banking and real estate industries. But if the proposed rules do in fact become law, the upshot is that the cost of borrowing -- be it a bigger down payment or a less advantageous loan terms for partially securitized loans -- is likely to rise as a consequence of pushing lenders to be more careful in how they write loans.
Photo courtesy Flickr user Star5112
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