Let Market Forces Regulate – Mortgage Standards

Part II of Free Our Markets argues that regulation by market forces outperforms government regulation. One of several reasons why governments make bad regulators is that two or more of the government restrictions, prohibitions, or mandates that bear on a particular kind of business may conflict with one another. That conflict can make it difficult, or impossible, or at any rate illegal, for those businesses to create some of the goods and services their customers would like.

A friend recently sent me a link to an article on banking regulation that illustrates the problem.

In this case, described by Clifford Rossi at American Banker, the conflicting regulations are 1) the Qualified Mortgage rule imposed by the Consumer Financial Protection Bureau and 2) the disparate impact doctrine imposed by the Department of Justice and the Department of Housing and Urban Development. The Qualified Mortgage rule forbids what the disparate impact doctrine requires.

Under the Qualified Mortgage rule “a loan must not have a debt-to-income ratio [known as “DTI”] exceeding 43%.” If you are a bank and you lend a customer an amount exceeding 43% of his or her income, you can be sued by the CFPB on the grounds that such a loan is too difficult for the customer to repay. But if you don’t make any loans with DTI greater than 4%, you can be sued by Department of Justice or the Department of Housing and Urban Development on the grounds that you are discriminating against a protected class of borrowers, whose members earn disproportionately low income—that’s a “fair lending” violation.

Rossi explains that the Qualified Mortgage rule is stupid (that’s my term; he says “poorly designed”). Why?

Because it completely ignore[s] the concept of compensating factors, a longstanding approach used in prudent underwriting practices. A loan with a 44% DTI, a 750 credit score and a 70% loan-to-value ratio is a high quality mortgage, according to the default risk profile, and should be approved.

(Mortgage applicants with this sort of profile, it seems, ironically need protection not from banks but from the Consumer Financial Protection Bureau.)

The disparate impact doctrine is misguided, too. It conflicts with the core economic principle that in a world of scarce resources, loans should be made in keeping with borrowers’ ability to meet their repayment obligations—to pay the money back—regardless of race and ethnicity patterns. Improvements in material well-being for everyone depend largely on how well we use scarce investment capital.

The first comment on Rossi’s article sums up the situation nicely: “The QM vs Disparate Impact = Damned if you do, damned if you don’t.”

Another commenter points out that a likely consequence of this misregulation is less mortgage lending (and hence higher mortgage interest rates):

One option that is not discussed is a board of directors deciding to exit the mortgage line of business because it is subject to a myriad of new compliance, underwriting, monitoring, class action and regulatory enforcement risk burdens (to name only a few) whose costs outweigh the revenues generated from that line of business.

Government bodies are lousy regulators. Far better would it be for us to ban government restrictions and mandates and prohibitions from mortgage lending, apart from enforcing contracts and preventing fraud. Market forces would then regulate mortgage lending standards much better than legislators and bureaucrats possibly can. Banks whose lending standards were too strict or based on non-economic discrimination would miss opportunities to make profitable loans; banks whose standards were too loose or overly “progressive” would lose money on bad loans. Prudent and non-discriminatory mortgage lending standards would thereby be discovered, not legislated, and “enforced” not by force, but by the relentless arithmetic of profit and loss.

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