Borrowers just aren’t defaulting like they used to. This is obviously good for the economy and good for the mortgage industry, even if it is not the best news for those of us working in default. According to Black Knight, August 2019 saw foreclosure starts hit their lowest level in 18 years. October 2019 saw national delinquency fall to near the record low, which had just been set in the previous May. There are many reasons for this, from a strong economy to the success of the myriad regulations placed on the mortgage industry following the crisis a decade ago.
But there is another more surprising reason. Certain borrowers are not defaulting in the way Congress expected, specifically high debt-to-income (DTI) borrowers. Simply put, the Consumer Financial Protection Bureau (CFPB) requires lenders to perform a DTI calculation to assess the risk of borrower default. The CFPB prevented lenders, with the notable exception of the GSEs, from offering qualified mortgage loans to borrowers with a DTI ratio higher than 43%, with the theory being, the lower the DTI ratio, the less chance a borrower would default.
This, however, has not proven to be true. In the three years immediately following the implementation of the Qualified Mortgage (QM) GSE Patch, which exempted Fannie Mae and Freddie Mac from the 43% threshold, the 90-Day default rate for GSE purchase originations with borrower DTI over 45% was significantly less than the same originations for borrower DTI between 30% and 45%. In 2016, for example, the ratio of default for borrower DTI over 45% was as little as half that of DTI 30% to 45%.
This pool of high DTI borrowers is by no means insignificant. It was estimated by CoreLogic that roughly 16% of all 2018 home originations stemmed from the GSE Patch, amounting to approximately $260 billion worth of loans. That percentage of originations would likely be much higher, but the CFPB legislation surrounding the QM GSE Patch has, thus far, kept private lenders from providing qualified mortgages to these individuals.
However, if this pool of borrowers isn’t particularly risky, why then are private lenders being prohibited from granting them qualified mortgages? The answer to this question does not seem to be particularly clear, unless one posits that Congress just got it wrong. While DTI can certainly be a useful statistic, it by no means should be the seminal one when determining which borrowers should or should not receive a mortgage. Readily available data, such as a FICO score or simple loan-to-value ratio (LTV) have been shown to be much more effective predictors of default. Frankly speaking, DTI caps are just plain unnecessary.
This unresolved issue is reaching a level of urgency with the GSE Patch set to expire on January 1, 2021. This large segment of borrowers, undeservedly stigmatized, will have even fewer options should the Patch expire with no changes to the DTI requirements. Though borrowers would be able to qualify for mortgages with FHA, VA, and USDA, a large portion would be forced to explore the non-QM space. This would require lenders in turn to expand a space structured for a smaller pool of non-W2 borrowers into one able to accommodate an increase of literally one-sixth of the number total originations. This expansion would be a boon to private mortgage lenders, to be sure, but an expansion with unnecessary growing pains.
A much simpler solution would be to modify Appendix Q to significantly raise, or drop altogether, the DTI Cap. As it stands, Appendix Q—which sets the standards for determining debt and income for potential borrowers—contains requirements for employment history verification, income stability, and qualifiers on non-standard full-time employment. These standards could be left fully intact and used to calculate DTI for a higher ratio, such as 50%, with little else needed to maintain effective regulation. Based on the statistics from 2018, this would account for over 300,000 additional borrowers having access to private QM lending, who otherwise would be dependent on GSEs or Non-QM.
The bottom line is that a large pool of high-quality borrowers with a low rate of default exists, and private lenders are willing to lend to them, but the government is standing in the way. The expiration of the GSE patch is a step in the right direction, but a step that will leave everyone off balance if it is not also accompanied by changes to Appendix Q. It would behoove everyone if Congress stopped extending deadlines and started revisiting DTI, so that an orderly transition can be made on January 2021 with a solution that benefits all parties.