On “Regulatory Burdens to Obtaining Mortgage Credit”

Committee on Banking, Housing and Urban Affairs
United States Senate

Chairman Shelby, Ranking Member Brown, and distinguished members of the Committee, I thank you for the invitation to submit testimony to today’s important hearing. I am Mark Calabria, Director of Financial Regulation Studies at the Cato Institute, a nonprofit, non-partisan public policy research institute located here in Washington, DC. My comments are solely my own and do not represent any official policy positions of the Cato Institute. In addition, outside of my interest as a citizen, homeowner and taxpayer, I have no direct financial interest in the subject matter before the Committee today, nor do I represent any entities that do.

Mortgage Reform and the Financial Crisis

Many, if not most, accounts of the financial crisis of 2008 include a prominent role for the U.S. residential mortgage market. While other U.S. property markets, such as commercial and retail, exhibited similar boom and bust patterns, the elevated level of defaults and associated costs borne by the taxpayer have brought a particular emphasis on American single-family mortgage finance policies. It should be of little surprise that the Dodd-Frank Act contains multiple provisions related to mortgage finance. Any attempt to return to the mortgage lending standards of 2006 would be a grave public policy mistake.

We must, however, be clear about what particular standards contributed to the crisis and which did not. Fortunately the hard-working analysts at Congress’ own Government Accountability Office (GAO) have provided some objective analysis of such1, as well as examining the potential impact of Dodd-Frank’s mortgage provisions2. What should be clear from GAO’s work, which is consistent with literally dozens of academic studies3 on mortgage default, is that the main drivers of default are borrower credit quality and borrower equity. As the Committee is aware, both the Qualified Mortgage (QM) and Qualified Residential Mortgage (QRM) rules, as implemented, essentially “punt” on these issues. Based upon GAO’s analysis, my estimate is that, all else equal, the QM/QRM rules as proposed would reduce default probabilities by around 1 percentage point.4 The simple fact is that most of the loans features addressed by QM/QRM are not the primary drivers of default and essentially amount to little more than rounding errors.

That estimate assumes lenders discount the significant legal risk that accompanies QM/QRM loans. As the QRM is an amendment to the 1934 Securities Act, mortgage-backed securities issues that are later determined to be non-QRM would subject the issuer to liability under SEC Rule 10b-5. Given the subjectivity in some of the documentation requirements under QRM and potential Rule 10b-5 liability, lenders can expect increased documentation and verification costs. Issuers may not possess crystal balls, but what is clear to most potential MBS issues is that non-agency pools will generate significant class actions on the part of investors during the next downturn in the housing market. While this might be great for some lawyers, it is not so great for lenders or borrowers. Such provides a powerful incentive for lenders to avoid loans with any significant risk of default, unless those loans can be passed along to the Federal Housing Administration (FHA) or the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac.

This is perhaps the most harmful aspect of current mortgage reform efforts. The worst loans, in terms of low down-payments and low FICOs, are being passed along to entities directly backed by the taxpayer. We have a perverse mortgage finance system where a lender can only make shoddy loans if the taxpayer is placed directly on the hook. Ideally we should want the opposite, where lenders bear the bulk of the risk and the taxpayer bears little, if any.

Additionally of concern is that Dodd-Frank’s Section 1413 allows borrowers an additional delay to the foreclosure process. A longer foreclosure process increases the borrower’s incentive to default, which of course should be obvious and reflects little more than basic economics. Keys, Piskorski, Seru and Vig (2012) document this increase in “strategic default” during the recent crisis.5 Dodd-Frank’s Section 1414(g) notice on anti-deficiency and the increased delays to foreclosure may well increase strategic defaults more than an amount to off-set reductions resulting from the QM/QRM provisions. As Gerardi, Lambie-Hanson, and Willen (2011) have demonstrated, delays in the foreclosure process largely extend the process, raising the overall level of loans in foreclosure at any one time, without significantly improving final outcomes for the borrower.6 Dodd-Frank could very well result in an increase in the level of mortgage defaults during the next housing bust, relative to the recent crisis.

Let me emphasis at this point that I am not suggesting that we “turn back the clock” on mortgage reform. What I am suggesting is that so far Congress and regulators have made the wrong reforms and left the system (and taxpayers) at even greater risk than before the crisis. While I did not advocate then nor do I now advocate such, had policy-makers done nothing, we would have been better off. The key is to actually do the correct thing.

In order to assist policy-makers in choosing the appropriate reforms, I will first briefly note some longer term objectives and then offer a few modest proposals that can be addressed in the short run.

Long term reforms

If we wish to avoid or at least minimize financial crises that are associated with housing booms and busts, we must ultimately reduce the leverage in our mortgage finance system, both on the part of the lender and the borrower. We must, as importantly better align the incentives of all participants in our mortgage market. That implies that parties that reap the up-side of risk should also bear the down-side.

In order to accomplish the preceding all existing mortgage subsidies, including FHA and the GSEs, should be eventually eliminated. These subsidies have not added significantly to the homeownership rate, but have rated induced families to take on even greater leverage. As Senator Warren noted over a decade ago, our various mortgage subsidies largely result in families simply entering “bidding wars” for homes fueled by debt.7 Our system of mortgage finance has not offered opportunity for long-term wealth building, but rather more opportunity for long-term debt building.

Other long term reforms should include if not an outright repeal of the Consumer Financial Protection Bureau, at least some increases in its accountability to Congress (who are after all elected by the American people). Such would include changing its structure to a board that is subject to the Congressional appropriations process (as intended by our Constitution). The CFPB should also be subject to cost-benefit analysis.

Short term reforms

Exempt QM for loans held in portfolio. Occasionally the correct insight that risk and reward should be align can be found in Dodd-Frank, hence the risk retention requirements under the QRM. There is no better alignment of risk for a lender than when a lender holds that loan. Since QM applies whether a loan is sold or not, it undermines this discipline. In fact it makes it worse by encouraging a lender to sell that loan to an exempt entity, like Fannie Mae or Freddie Mac. According, Congress should exempt all mortgages held in portfolio from QM as long as those loans are held in portfolio.

Allow QM as bar to foreclosure for only material defects. Lenders should not lose the ability to foreclosures simply because a “t” wasn’t crossed or an “i” dotted. Nor should a borrower be able to evade their obligations because of clerical mistakes. QM should serve as a bar to foreclosure only when a borrower has suffered material harm that has arisen as a direct result of the asserted error. Better yet, simply repeal Dodd-Frank’s Section 1413. As the recent crisis proved, borrowers already possess plenty of opportunities to delay.

Increase QM small loan definition. While QM should be repealed, in the interim the definition for a small loan subject to the points and fees test is simply too low to cover the increased costs resulting from Dodd-Frank and other recent regulations. While the points and fees under the test should also be raised, as suggested by the House under HR 685, I would recommend raising the small loan exemption to match the GSE conforming loan limit, since that limit is supposed to be the dividing line between mortgages for the middle class and those for the wealthy.

Actions that should be rejected

While I have some sympathy with the concerns of both consumer advocates and lenders toward the reduction in mortgage access for high risk borrowers, the solution should not be to reduce underwriting or pricing standards for mortgages where the taxpayer is directly at risk. Congress would be wise to mandate a reversal of the recent reduction in FHA’s premium, as well as bar the GSE from making loans with down-payments below 5%, if not permanently, then as long as those entities are in conservatorship. Let us not forget the very nature of a conservator is to reduce the risk of the entity under conservatorship, which of course found itself in conservatorship due to excessive risk-taking.


Despite years at attempted “reform” the taxpayer remains as exposed to the mortgage market as ever. Reforms have failed to protect the taxpayer, while also unduly increasing the costs of mortgage lending. In the 1970s, the spread of the 30 year mortgage over the 10 year treasury averaged about 130 basis points. Today that spread is closer to 170 basis points. That is a cost that is directly passed along to the consumer. And this is in an environment of record low interest rates. While considerable work remains left undone in reforming our nation’s mortgage finance system, I commend the Committee for considering even modest steps in the right direction.

Notes1 See United States Government Accountability Office. 2009. Characteristics and Performance of Nonprime Mortgages. Report to Congress GAO-09-848R; and United States Government Accountability Office. Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data Sources. Report to Congress, August 2010. GAO-10-805.
2 United States Government Accountability Office. 2011. Mortgage Reform: Potential Impacts of Provisions in the Dodd-Frank Act on Homebuyers and the Mortgage Market.. Report to Congress, July 2011. GAO-11-656.
3 For instance see, Hatchondo, Juan Carlos, Leonardo Martinez, and Juan Sanchez. 2011. Mortgage Defaults. Working Paper 2011-019A. Federal Reserve Bank of St. Louis; Bajari, Patrick, Sean Chu, and Minjung Park. 2010. An Empirical Model of Subprime Mortgage Default from 2000 to 2007. Federal Reserve Board of Governors Working Paper; and Christopher Foote, Kristopher Gerardi, Lorenz Goette, and Paul Willen. Subprime Facts: What (We Think) We Know about the Subprime Crisis and What We Don’t. Federal Reserve Bank of Boston. Public Policy Discussion Papers. May 20, 2008.
4 See Mark Calabria, “Mortgage Reform Under the Dodd-Frank Act,” in Perspectives on Dodd-Frank and Finance, edited by Paul Schultz, The MIT Press. 2014.
5 Keys, Benjamin, Tomasz Piskorski, Amit Seru, and Vikrant Vig. 2012. Mortgage Financing in the Housing Boom and Bust. National Bureau for Economic Research.
6 Gerardi, Kristopher, Lauren Lambie-Hanson, and Paul S. Willen. 2011. Do Borrower Rights Improve Borrower Outcomes? Evidence from the Foreclosure Process. Federal Reserve Bank of Boston Public Policy Discussion Paper Series, paper no. 11-9, (2011).
7 See Elizabeth Warren and Amelia Warren Tyagi, 2003. The Two-Income Trap. Basic Books, specifically pages 132 to 133.