Two separate but parallel top-level reviews of mortgage-related regulations may yet allow community banks, credit unions and other proponents of “soft” information in loan underwriting to broaden credit access and permit small lenders to regain the competitive advantage they lost to big banks following adoption of the Dodd-Frank Act mandates, but industry observers say it’s a tall order.
A year ago, Mark Calabria – then the Cato Institute’s director of financial regulation studies – authored a paper where he asserted that the expansion of automated credit scoring has turned mortgage underwriting into “an assembly line” with a reliance on “hard” information (strictly financial) over “soft” or subjective information where lenders at the local level use less tangible data (such as “character”) to base credit decisions to approve low-income or thin credit-file borrowers.
“Subjective, or soft, information is difficult, if not impossible, to utilize in a securitization-based system. Expanding access responsibly requires gathering that subjective information,” wrote Calabria. “It also requires that mortgage lenders have appropriate incentives to review soft information and, when appropriate, extend credit based upon it.”
Calabria – who was tapped earlier this year to be Vice President Mike Pence’s chief economist – argued that the mortgage space has substituted investor due diligence with a misplaced faith in regulators and politicians.
“The Dodd-Frank Wall Street Reform and Consumer Protection Act creates new standards for mortgages under the qualified mortgage and qualified residential mortgage rules. But…these new rules are unlikely to increase credit quality and may even increase delinquencies in the next downturn,” wrote Calabria. “Any reformed mortgage finance system must align the incentives of investors, borrowers, lenders and taxpayers. Insulating investors from credit risk fails to do so.”
Calabria maintains the originate-and-hold lending model represents the best avenue to successfully incorporate soft information into lending decision making. While he is by no means the first to promote the untapped potential of soft information, Calabria now holds a position of influence in a White House that has pledged to recalibrate the nation’s housing policy.
In February, President Trump signed an executive order directing the Secretary of the Treasury to review and consult with regulatory agencies to identify changes to Dodd-Frank and potential areas of regulatory relief. Meanwhile, the Consumer Financial Protection Bureau (CFPB) is ramping up for its own Dodd-Frank mandated review of significant mortgage regulations, including the ability-to-repay (ATR)/qualified mortgage (QM) rule.
Small Lenders, ‘Soft’ Advantage
Small banks – particularly those with less than $1 billion in assets – are more likely to engage in relationship banking, which involves more one-on-one interaction with customers, according to the Government Accountability Office (GAO).
“Large banks are more likely to engage in transactional banking, which focuses on the provision of highly standardized products that require little human input to manage and are underwritten using ‘hard’ statistical information,” explained GAO in a December 2015 report. “In relationship banking, banks consider not only hard information, but also ‘soft’ information that is not readily available or quantifiable and is acquired primarily by working with the customer.”
Soft or qualitative information is gained through social and business interactions with potential borrowers and is used to access, for example, a borrower’s “character ” or the strength of the informal financial support a borrower might receive from family or relatives, according to Paul Kupiec, a resident scholar at the American Enterprise Institute (AEI).
“Unlike credit scores and income data that reflect past experiences, qualitative information can be forward looking and identify issues that are not yet reflected in public databases,” explained Kupiec. “It is especially helpful for assessing a borrower’s ability to repay a loan when verifiable data on income, the value on collateral or formal guarantees from co-signatories are not available.”
The problem with using “soft” information in making mortgage lending decisions lies in the difficulty of objectifying that information sufficiently to overcome regulatory or judicial charges of discrimination based on irrational or prejudicial considerations, such as race, gender or marital status, noted Bert Ely, a financial institutions consultant and adjunct scholar at the Cato Institute.
“Character judgments, which we make all the time, whether consciously or not, ultimately come from the gut… like falling in love. Falling in love is a judgment call,” Ely explained. “For that very reason [judgment based decisions] are usually very hard to explain, much less defend, especially in today’s regulatory environment for mortgage lending.”
According to Kupiec, the CFPB’s ATR/QM regulations have made it quite difficult from a risk perspective for small lenders to effectively capitalize upon their soft information advantage in mortgage underwriting.
“The ATR rule does not prohibit the use of qualitative information in the underwriting process, but if the lender wants safe harbor, it must adopt the technology and expense of a scorecard lender even if the true loan underwriting decision is based on soft information,” Kupiec noted in a 2014 research brief.
Under the ATR/QM rules, lenders must make a good-faith effort to establish that a borrower has a reasonable ability to repay the loan by considering eight (8) underwriting criteria, including the applicant’s income, assets and employment status. If a lender’s loan is a QM, it is presumed that the lender complied with the ATR requirements.
Kupiec noted the data items that must be collected, verified and maintained are similar to data that would normally be used to underwrite a loan using a model or scorecard.
“Should the borrower’s data not be sufficient or verifiable under the ATR guidelines, a soft-information lender is exposed to the costs of future litigation should the loan become non-performing,” explained Kupiec. “In addition to creating potentially prohibitive compliance costs, many community bankers believe that the QM and ATR rules preclude them from using soft information to gain a competitive advantage over larger scorecard-based lenders.”
The National Association of Federally-Insured Credit Unions (NAFCU) agrees. In an April 14 letter to the Treasury Department, the NAFCU noted the ATR/QM rule “has limited the appeal of soft information” for its credit union members.
“An expected rise in compliance costs is consistent with credit union and community bank responses to new mortgage related rules in 2015,” wrote NAFCU. “Without relief from mortgage-related regulations, credit unions may find it increasingly difficult to serve their communities.”
In a move separate to President Trump’s executive order-mandated regulatory review, the CFPB is preparing for its own examination of Bureau regulation. The Dodd-Frank Act requires the CFPB to assess all its rules to ensure they are meeting the purposes and objectives of the DFA and the specific goals of the subject rule. January 2018 will mark five (5) years since the ATR/QM rule was finalized.
Chartered by Congress as an independent agency, the CFPB is not bound by President Trump’s executive order on reducing regulation. However, given the administration’s public promises to cut the Bureau down to size, as well as persistent, widespread industry complaints about the cost of regulatory compliance, the CFPB review of ATR/QM may not be a predetermined rubber stamp, according to Ballard Spahr attorney Pavitra Bacon.
“Given presidential pressure to reduce regulatory burdens and the fact that the CFPB’s mortgage rules have been criticized by financial industry participants and consumer advocates alike, the CFPB review of the key mortgage rules warrants close attention,” noted Bacon on the Washington, DC law firm’s Consumer Finance Monitor.
Despite the increasing volume of calls for regulatory relief by industry voices, Ely warns that any effort to soften up the current regulatory stance favoring hard information in underwriting could be a tough sell politically as well as practically.
“I think that for folks on the left, there is a large degree of skepticism and that they would see it as an effort to undercut the regulations and examination guidelines designed to eliminate discrimination in lending,” said Ely. “The thrust over the last 30 years has been to take judgment out of the underwriting process. The question is, can you bring it back in a defensible manner?”