What Makes a Mortgage a Good Risk, Anyway?

Posted by Jim DeBellis on June 8th, 2011

How can we cure the housing problem when the medicine is so hard to swallow? The debate is heating up on the “QRM” proposal to help prevent another mortgage meltdown. In order for a mortgage to be categorized as a “Qualified Residential Mortgage” it would be subject to stringent rules, including a 20 percent down payment and a monthly payment that is less than one-third of the borrowers income. This, presumably, would make the loan very safe and the default rate very low.

So, what difference does it make if it is called a QRM or not? A lot. Lenders would be required to keep five percent of mortgage loans with lower down payments on their books, selling only 95 percent of it to Fannie or Freddie. This would leave them with less money to lend and expose them to more risk from defaults – which is exactly the point. Banks would be less likely to give loans out like candy if they had to suffer the consequences of the bad paper they created.

But banks have a high aversion to risk, and the fear is that they would either stop lending to to creditworthy people with lower down payments or charge a ridiculous premium for it, which would make homeownership unaffordable for millions of creditworthy people. This would also cripple any chance for a housing recovery, as it would disproportionately affect most middle class Americans, including first-time buyers and minorities, who don’t have $35,000 to $55,000 saved up for a down payment. After all, according to Lending Tree, 80 percent of all mortgages written from 1997 to 2009 had less than a 20 percent down payment and would not have qualified for QRM status. That leaves affordable homeownership mostly to the rich, while those who have less money would have to pay more or just stay out of the market.

The result would likely be to shift almost all mortgages over to FHA, where a 3 percent down payment is still possible, which means that the government would still be in the business of guaranteeing a very high percentage of American mortgages.

Historically, sensible guidelines and underwriting standards have worked well. Creditworthiness, combined with reasonable verified income, is the best gauge of a quality mortgage. The default rate for mortgages with 20% down in 2006 and 2007 was 0.14 percent for people with good credit, while it was still a very acceptable 0.26 percent for creditworthy people with a lower down payment – far from the overall default rate of 8.32 percent for all mortgages in the first quarter of this year.

It’s a dilemma, as many lenders and lawmakers will want to make it too easy to get a mortgage. Easy money could indeed help to jump-start a sluggish housing market (although 50-year low interest rates and low prices don’t seem to be helping much right now), but we can’t just set ourselves up for another big fall.