One of Congress’ main responses to the 2008 mortgage crisis was Title XIV of the Dodd-Frank Act, a section known as the Mortgage Reform and Anti-Predatory Lending Act.

This title was based on the narrative that a primary cause of the crisis was creditors knowingly steering customers into high-risk mortgages. Thus, Title XIV purported to protect the economy from another financial crisis by controlling mortgage quality. 

The substance of Title XIV was implemented by regulations promulgated by the Consumer Financial Protection Bureau in January 2013 (the Qualified Mortgage or “QM” rule).

Two provisions of note are the setting of a maximum debt-to-income ratio of 43% (of pretax income) and providing safe-harbor protection for QM loans that were not considered higher-priced, meaning that the interest rate on the loan could not exceed 1.5 percentage points above the average prime offer rate. 

This second provision assumes that loans will be priced for risk, thereby obviating the need to set minimum standards based on traditional risk factors, such as borrower equity or credit history.

Finally, a loan that failed to meet both tests was defined as a “higher-risk mortgage.”

Here we are, six-plus years later and (a.) 37% of home-purchase loans guaranteed by taxpayers—Fannie Mae, Freddie Mac, Federal Housing Administration, VA, and Rural Housing Service (referred to here as “the five agencies”)—are in excess of the QM’s 43% maximum, (b.) 73% of first-time-buyer loans guaranteed by the five agencies have down payments of 5% or less, and (c.) the Federal Housing Administration’s median credit score for first-time buyers is 660, meaning half have subprime credit. 

Yet, all of these loans meet the QM definition and, therefore, are not considered “higher-risk mortgages.”

It’s no coincidence that we also find ourselves in the midst of the second-biggest house-price boom since World War II. The reason is simple. Aside from laying out a few specific loan characteristics for the QM, Congress gave federal regulators a great deal of discretion to create the final QM standard.

The first thing the Consumer Financial Protection Bureau did was to exempt the five agencies from QM’s 43% rule, an exemption now commonly known as the “QM patch.” The Federal Housing Administration, the VA, and the Rural Housing Service subsequently promulgated their own QM rules to replace the bureau’s 43% rule.

Thus, the effect of the patch was to allow any conventional loan with a debt-to-income ratio  greater than 43% to be classified as a QM loan, provided that the loan met Fannie Mae’s or Freddie Mac’s (i.e., the government-sponsored enterprises’) underwriting requirements.

However, the bureau insisted that the patch was supposed to provide “a reasonable transition period to the general qualified mortgage definition, including the 43% debt-to-income ratio requirement,” and it set it to automatically expire in 2021.

From the very beginning, though, Fannie, Freddie, the Federal Housing Administration, and the VA, along with the housing lobby, viewed the 43% debt-to-income requirement as too restrictive and took advantage of the various exemptions.

The percentage of loans exceeding the patch not only failed to decline, but rose from about 23% in January 2013 to 37% today.

And with the patch’s expiration date rapidly approaching, the special-interest groups are ramping up the pressure to modify and extend the government-sponsored enterprises’ patch.

That fact is bad enough, given that high debt-to-income ratio loans are some of the worst-performing loans during an economic downturn.  What makes this effort even more dangerous, though, is that many of these groups are trying to persuade the administration to eliminate the debt-to-income ratio requirement completely.

They want to rely instead on a single interest-rate metric that defines lower-risk and higher-risk loans. Karan Kaul, a senior mortgage researcher at the Urban Institute, puts the idea as follows: 

The idea is that instead of relying on [debt-to-income ratio], if you rely on the [annual percentage rate] on the loan, then you could say the loan is not a high-priced loan, it’s not a risky loan, so it’s a good candidate for QM. If you have a loan with a very high [debt-to-income ratio], it probably is going to be a higher-priced loan, and that loan will not be QM.

Several groups have seized on this idea and are now proposing to substitute the existing average prime offer rate safe harbor for the current QM patch. In other words, they want to replace the existing patch with a new one that relies solely on whether a loan’s interest rate is more than 1.5 percentage points greater than the average prime offer rate.

Under this approach, as long as the loan meets the basic QM requirements and its interest rate does not exceed the average prime offer rate by 1.5 percentage points, it will still have QM status even with a debt-to-income ratio that exceeds 43%.

This scheme is highly flawed. The debt-to-income ratio provides a proxy of credit risk inherent in mortgage loans; the average prime offer rate does not.

The American Enterprise Institute’s mortgage risk index data clearly show that an average prime offer rate rule of this nature would not be calibrated to default risk.

For example, for loans with a credit score between 660 and 689, which is where the Federal Housing Administration and government-sponsored enterprises most directly compete with each other, default risk increases as down payment declines and the debt-to-income ratio increases, but no such pattern is discernible with respect to the average note rate premium over the average prime offer rate.  

Further, this scheme would provide plenty of room for further risk expansion, because the vast majority of agency QM loans with both high and low mortgage-risk indexes are well below the cutoff of 1.5 percentage points above the average prime offer rate.

None of this is too surprising, given the federal government’s insistence that agencies (and the government-sponsored enterprises) either avoid pricing loans for risk or provide substantial cross-subsidies.

Regardless, it’s crystal clear that replacing the debt-to-income ratio cap with an average prime offer rate cap will do nothing to protect against a flood of risky loans on the market.

The evidence suggests that the housing lobby’s latest idea, replacing the sunsetting patch with an average prime offer rate loan-rate rule is just a veiled attempt to have the federal government continue providing leverage support during the ongoing house-price boom.

If the administration truly values taxpayer safety and housing affordability, it will reject this idea and simply let the QM patch expire.