With the looming debt ceiling pigfight consuming a lot of financial media bandwidth, some important stories are not getting the attention they warrant. One is on the hard fought and finally settled qualified mortgage rules just finalized by the Consumer Financial Protection Bureau. Georgetown law professor Adam Levitin in a new post describes how the new QM rules are a defacto usury law for the 21st century. Despite his good discussion of the QM and the history of usury laws, however, he peculiarly does not explain why usury laws are a good thing. Perhaps it seems obvious, given the explosion of economically unproductive consumer debt since they’ve effectively been eliminated.
Let me give you the reason why well designed usury laws are desirable, then I’ll turn the mortgage-related issues specifically.
One of things that early economists agreed on was the necessity and importance of usury laws as a foundation of a healthy, productive economy. Their reasoning was simple. Lenders would tend to seek out the highest return they could get, in light of repayment risk. Even a very successful business or venture could afford only so much in the way of interest payments on borrowers. If creditors could lend at any rate to any borrower, they would prefer wealthy speculators (in those days, aristocrats with gambling habits) to loans that would support trade and enterprise.
And we’ve seen how lending has followed that pattern. Consider credit cards. Levitin points out that usury laws were vitiated between 1978 and 1982. Even so, banks (which at that point still held credit card loans on their balance sheets) were somewhat restrained in their behavior until later in the 1980s. They all stuck with a maximum interest rate of 19.8% and charged annual fees. The fees were critical to the pricing structure, since it meant that credit card companies made money on every type of customer: one that used the card only sporadically, say for airplane tickets or when he was caught without cash, the one that used cards regularly but paid off his balance in full every month, and ones that ran balances occasionally. Banks did not find it attractive to have customers carry balances all the time; even at 19.8% (with higher risk free interest rates than in the early-mid 2000s), perma borrowers were seen as risky and default-prone.
The market saw a race to the bottom when no-fee cards were introduced. Suddenly, the intermittent-use customers were money-losers and the “pay in full” types not so attractive. The banks began to seek out customers who’d use their card to run occasional balances or become credit addicts, and they changed their fee structures and interest payment schedules to suck more out of them before the ones who couldn’t get out of their borrowing tar pit went under for the final time. We saw a variant of this pattern in “private label” (non Fannie, Freddie, FHA) mortgages, in which lenders sought out higher interest rate, non-Fannie and Freddie loans. For the most part, they kept the ones on balance sheet that they thought were higher quality (home equity loans, “jumbo” loans) and securitized the rest. We know how that movie ended. A small private label MBS market developed, became speculative, and hit the wall at the turn of the millennium; the second go at a private label market started in 2003 and helped set off the global financial crisis (note bad MBS were not sufficient to create that scale of calamity; credit default swaps increased the level of financial exposure to a significant multiple of the value of real economy loans made).
What has been stunning about the period after the crisis is the failure to do anything to address the defects of the private label market. There’s a reason the mortgage market is still on government life support; investors were burned badly and won’t consider these investments unless real reforms were made, and the so-called sell side has fought those reforms tooth and nail (it also does not help that despite widespread misrepresentation of the quality of mortgages in SEC documents and other marketing materials, that they few investors who have pursued litigation have found it costly and difficult to obtain redress due to various legal and practical impediments, and the fact that regulators and prosecutors have made only token efforts in this arena).
Now in fairness, despite the fact that a what amounts to a government operated mortgage market may sound like a really bad idea, in fact, that was the way the US market functioned prior to 2003; the 1990s subprime market was so small as to be seen as a sideshow. At a conference I spoke at last year, bond investment giant Pimco’s mortgage chief Scott Simon said, repeatedly, that the housing market worked just fine without a private label mortgage market and he saw no good reason to revive it.
What Levitin tells us is how the new QRM rules are a de facto usury law and how they will restrict the mortgage market to government-insured loans. This is the guts of his explanation:
Significantly, the CFPB rulemaking distinguishes between regular QMs and high-cost QMs (150 bps over prime for first liens, 350 bps over prime for junior liens). Thus, the mortgage world is now like Gaul, divided into three parts: non-QM, high-cost QM, and regular QM. Non-QMs lack a safe harbor for ability to repay. High-cost QMs have a rebuttable safe harbor for ability to repay. And regular QM have an irrebuttable safe harbor for ability to repay. The result of all of this is to increase the risk of making non-QMs or high-cost QMs relative to the situation that exists today. That means there is no change in the law for regular QMs, as failure to ensure ability to repay has not previously been a defense to foreclosure.
Much of the commentary to date has been about the scope of the safe harbor, which is wider than consumer groups had wanted/banks had feared. I think it all kind of misses the point, as the QM rulemaking represents a significant expansion of lender liability and is a major step forward in creating a fair and stable housing finance market…
What I find interesting about the QM rulemaking is that it represents a return to the traditional mode of consumer credit regulation—usury, and eschews the 20th century’s disclosure-based regimes, including its behavioral economic tweaks. Indeed, the influence of behavioral economics is virtually undetectable in the rulemaking with one very small exception.
Now before I write anything more here, let’s be clear. The QM rulemaking is not a usury law as traditionally understood. Indeed, the CFPB is expressly prohibited by statute from enacting usury regulations. Mind you, Congress never defined what a usury law is, but I don’t think anyone could reasonably characterize QM rulemaking as a usury regulation of the sort Congress prohibited.
Yet the basic thrust of the QM rule—distinguishing in the legality of high cost and low cost QMs is the same move as usury laws: high cost products prohibited, low cost products allowed. This is a new 21st century style usury law that represents a type of back-to-the-future move in consumer finance.
Levitin tells us that this change will perpetuate the Federal government’s support of mortgage finance and how that it not a bad thing:
Perhaps the most immediate effect of the QM rulemaking is that it makes the privatization of Fannie and Freddie (always a pipedream) truly impossible. The reason for this is simple. Private risk capital is unwilling to fund the credit and rate risk on mortgages structured as QMs on a substantial enough scale to support even a fraction of the US housing market. The only loans the private, non-GSE market has only ever supported in any scale are bullet loans–short-term, non-amortizing loans. This is what the market looked like before the GSEs. (Yes, S&Ls offered some longer term, amortizing loans, but this was a fraction of the market.) And this is what the private label-securitization market of the 2000s looked like. The infamous 2I do /28s and 3/27s were really just 2-3 year bullet loans that had to be refinanced if they were not to explode. We have never seen the private market provide long-term, amortizing loans in large volume. The private Jumbo market is relatively small compared with the entirety of the US housing finance market, and it piggybacks off of the presence of the GSE market. And this isn’t even raising the issue of fixed-rate vs. adjustable-rate; there are few places in the world where the private market provides fixed-rate loans in any scale. All of this means that as long as there is the QM rulemaking in place, it really isn’t possible to eliminate the GSEs. They can and should be restructured, but the QM rulemaking will hopefully force us to be realistic about the role private risk-capital can play in the housing finance market.
I do want to differ with Levitin a tad. He mentions but does not tease out the fixed rate issue. If the Fannie and Freddie haters really wanted to get rid of the GSEs, it might be possible (without various headfake proposals of the sort we’ve debunked that just create GSE 2.0: they maintain a government guarantee but somewhat change the terms under which they’d operate). But you’d need to give up the 30 year fixed rate mortgage. I don’t see that as big a loss as some do; personally I think a good alternative is a floating rate mortgage with floors and ceilings (the cost of the interest rate cap is paid for by giving up the full benefit of falls in interest rates). My first mortgage was of this type (co-op loans in NYC in the early 1980s were overwhelmingly floating rate; you wouldn’t want a fixed rate given how high long term rates were then). You’d also need restrictions on refinancings. These are actually good products for consumers but politicians are not willing to wean consumers off of the popular government-created-and-sponsored 15 to 30 year fixed rate mortgage.
Levitin concedes that the QM rules will reduce mortgage availability, but as we’ve said repeatedly, any move to more prudent standards means less lending; that outcome is a feature, not a bug. He also argues that de facto usury standards are preferable to other approaches:
But most convincing to me is another argument: certainty and administratibility. Usury laws are bright line rules that allow for business planning. We can try to police the same problems on an ad hoc equitable basis using doctrines like unconscionability, but these fuzzy standards make it very hard for businesses to know what is allowed and what isn’t. It might chill socially beneficial behavior, and it might also result in inconsistent results. While a business might prefer to operate with zero regulatory constraints, as between a bright line rule and a fuzzy standard with substantially the same substantive result, I would think that the bright line rule would be preferred.
I do think Levitin underestimates Wall Street’s ability to find stuffees. Since they could find buyers of risky tranches of CDOs, they can no doubt find investors for non-QMs, but that market would presumably be sufficiently small so as to limit the harm done to consumers and the risks to the economy overall. And if his general assessment is correct, this will indeed prove to be a meaningful accomplishment.