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One big question mark could, if handled poorly, end up ushering in a new era of a dual lending market that excludes people of color and low-wealth people.  Regulators are in the process of defining which mortgages are “safe” enough to receive the government stamp of approval as a Qualified Residential Mortgage (QRM).  The theory is a good one: the foreclosure crisis started in part because lenders didn’t care whether the loans they originated ultimately defaulted or not—since they were able to sell all of the risk to investors, they had no skin in the game. This led to risky loans being made with no hope of being sustainable in the long run.

The authors of Dodd-Frank created a provision to require lenders to be more invested in the performance of the loans they originate. Lenders will now have to retain five percent of the risk of each loan, with a few exceptions. Fannie Mae, Freddie Mac, FHA, and VA loans will be exempted from risk-retention requirements, as will QRMs. QRMs are loans with characteristics that have been proven to have low default rates historically. Certain loan characteristics—such as high debt-to-income ratios, exploding monthly payments, or negative amortization—have been associated with the high rates of default that kick-started the foreclosure crisis. QRMs should incentivize banks to make fewer loans with risky characteristics and more safe and sound loans with fixed interest rates and careful underwriting.

Unfortunately, regulators went overboard in defining the QRM. Their proposed definition would require a loan to have a 20 percent down payment in order to qualify, vastly limiting credit to tens of thousands of creditworthy borrowers. The National Association of Realtors found that it would take a median-income family 14 years of saving $3,000 a year to save for a 20 percent down payment on a moderately-priced home of $170,000. In particular, low-wealth Americans, first-time homebuyers, or current homeowners that lack significant equity in their home due to declining home values will have considerable difficulty providing 20 percent down payments even for homes that are modestly priced.  In Illinois, people of color are far less likely than white people to possess assets, such as savings, that could be used to meet this new down payment requirement.  While 19 percent of white families in Illinois are considered asset poor, 48 percent of Latino families and 51 percent of African American families are asset poor.

It’s likely that non-QRM loans will be more expensive than QRMs since lenders may raise prices to compensate for having to retain some risk and it may crowd out smaller lenders who can’t afford to retain risk, shrinking the mortgage credit market. More importantly, a 20 percent down payment doesn’t significantly lower the default rate. Mark Zandi of Moody’s found that default rates for prime, fixed-rate loans with a 5 percent down payment were less than 3 percentage points higher than default rates for loans with a 20 percent down payment.

It’s important to curtail the recklessness that caused the financial crisis, and that means making it more expensive to make risky loans. However, well-underwritten loans with low down payments didn’t cause the financial crisis—exploding ARMs and no-doc loans did. We need to include safe low down payment loans in the QRM definition in order to not unduly restrict credit to people of color and low-wealth people, not just create a low-cost Cadillac mortgage for the wealthy.  Regulators are accepting comment on the QRM proposal until next Friday, June 10, and we encourage you to send in your comments. If you need help writing a comment letter, please contact Tom Feltner at 312-368-0310 or tfeltner@woodstockinst.org.

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