The CFPB’s New Stealth Usury Law on Mortgages and Why It’s Desirable

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.

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  1. jake chase

    Except that usury seems alive and well even under the 6 QM standards, which makes sense since CFPB is just a fig leaf and usury is the foundation of modern finance capitalism.

    Incidentally, what exactly is meant by “DTI<43%"?

    1. Yves Smith Post author

      The standards have just been implemented, so it’s hard to see the basis for your assertion.

      1. jake chase

        Do you disagree that usury is the foundation of modern finance capitalism or that the CFPB is a fig leaf?

        As to both, the basis for my assertion is experience with fifty years of “reform”.

        1. reprobate

          Lotta not factually grounded ‘tude on display.

          Since usury laws weren’t gutted till the late 1970s, it’s not 50 years. And that was not the result of deregulation but a Supreme Court decision.

          And behavior didn’t start changing until the securitization markets took off. 1980s for credit cards. Mid 1990s for non gov’t guaranteed securities. Biggest non-gov’t guaranteed securities market by far was the mortgage market. That’s dead, as this post tells you. So more like 20 years.

          And this rule would seem to prove the CFPB is not a fig leaf, since it will seriously dampen the revival of the private label mortgage market.

          1. jake chase

            Another defender of the faith, which is not even being attacked. And if you think by ‘reform’ I meant only the mortgage market, you misconstrue my point. Modern finance also relies upon securities laws, the gutting of which has been going on systematically, since the 1960s, with every gutting trumpeted as a reform. So, we’ll see.

    1. Yves Smith Post author

      Whitney’s post is remarkably confused.

      The Obama administration has been very clear it is pulling out all stops to reflate the housing market. The Fed has despite its nominal independence has been compressing the hell out of mortgage spreads. Fannie and Freddie have been offering refis on generous terms, as has the FHA, even on underwater loans up to a certain LTV.

      This has been in place for a while and has absolutely nothing to do with QM in general or the usury/impact on the private label mortgage market generally.

      And notice who isn’t complaining. None of the consumer groups have weighed in as particularly upset. They don’t have any particular problem with the definition of QM.

      The gripes about lack of down payment or credit score requirements are silly. A 20% downpayment doesn’t say anything about ability to meet monthly payments. It just says the borrower had a pool of cash at the time of closing. And the idea of putting credit scores explicitly into QM is just silly. Credit scores were a lousy tool, as the crisis showed. So we want to institutionalize them? Is a QM to require a FICO of 660 or only 620? Is that in any way meaningful information about ability to repay? Or does it just speak to past repayment history? The QRM rulemaking will presumably involve a downpayment requirement, but that’s about investor protection, not consumer protection.

      1. diptherio

        Whitney does seem to be confused on the credit score front. I worked on a couple of consumer-advocacy campaigns in which credit scores played a part (insurance and rental housing), and what I learned is that they are very poor metrics, susceptible to error and manipulation and often a mill-stone around consumers necks (since low credit scores = high insurance and rental rates or outright denial). I don’t think they should be used for anything, really, and I think most consumer advocates would agree (feel free to correct me).

        But he does point out some troubling things. One is the legal “safe harbor,” get-out-of-jail-free clause. What is the valid rationale for giving banks this protection from legal liability?

        This bit also caught my eye:

        There’s one more tidbit in the new QM rule that’s worth noting, a provision that states that “loans would be deemed qualified mortgages if borrowers are spending no more than 43% of their pretax income on monthly debt payments.”

        That does seem troubling. First, why look at pretax income at all? What is the point of taking into account money the borrower will never see in calculating their ability to repay the loan? And does the 43% of pretax income going to debt include all debt payments (credit cards, student loans, car loans, etc.) or just the mortgage in question? If it’s the latter, that percentage would seem to be a little on the high side. I remember being taught that you shouldn’t spend more than a third of your (after-tax) income on housing. But then again, 43% may be an improvement over current standards, idk.

        Any thoughts on those issues, anybody?

        1. jake chase

          In a nutshell, the 43% ‘requirement’ means that anyone with an income is fair game for an insured mortgage which he is unlikely ever to work out of unless his financial status keeps improving. Most mortgage borrowers are simply betting on continued housing price appreciation to bail them out.

          As Keynes told us, the future is simply unknowable. Only hindsight will tell us who was right.

          1. Chris

            I’m sorry, but that’s simply inaccurate. a 43% total debt ration (and to clarify for the comentor above – it is 43% of total debt service not just housing debt) IS NOT a guarantee of inability to repay. It’s completely doable and though on the slightly higher end of reasonable, it is a reasonable monthly debt service. Total debt service at that level worked for a very long time before the issues of the early 2000’s.

          2. Chris

            Additionally, the 43% reguirement absolutely does NOT make “anyone with an income fair game.” The rules are still fairly restrictive (as they should be) in terms of qualifying based on debt ratio. I agree completely with the comments about using pretax income…that really makes no sense at all…but the reality is, that percentage of pretax income worked quite well for a long time prior to recent abuses.

  2. Tom

    I am not thrilled that floating rates ought to be the standard fair when buying a house. As a homeowner, it is much more uncertain to be looking at fluctuating interest, particularly when in an environment of increasing interest the rates escalate immediately and may be due to other sectoral changes unrelated to my immovable asset home. Then, when general interest rates fall, it takes forever for them to fall with some excuse by the lender that we can’t lower your rates. I would rather have a higher degree of certainty that my payments are not going to shoot up when already strapped with level or declining wage scales.
    Why does the financial industry always wish to put up a screen to hide a possible bubble development….wait, sorry…answered that for myself already.
    In my view, Housing and actual property that most of us use as part of our survival (food, shelter, water,’energy’) should not be put onto the speculative market – a market yes, but not a speculative one.
    I know, I really failed to develop that last thought.

    1. diptherio

      I think the capped variable rate that Yves refers to could be a good compromise, if handled properly. If the minimum and maximum payments were laid out clearly (in nominal dollar terms, not in terms of APR) and the maximum was set within your likely ability to repay, then it could be a win-win. FWIW, I don’t think we’re gonna need to worry about high interest rates for quite awhile.

      And I strongly agree with your last point, although I would make it even stronger. Food, water, shelter, clothing, health care, education and related basic human needs should never be distributed by a market (at least not one where ability to pay is based on possessing dollars). Markets are just games for grown-ups, essentially, and some things are just too important to play around with, imho.

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