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QM Isn't "Plain Vanilla"

posted by Adam Levitin

The American Banker's lead article today is about how the Qualified Mortgage (QM) concept is really an enactment of the "plain vanilla" mortgage provision that the White House had unsuccessfully pushed to have included in what become the Dodd-Frank Act. That's just wrong. 

"Plain vanilla" was a behavioral economics move. The concern was the borrowers would go to a lender and be steered to an exotic mortgage product, having no idea that the product was so exotic or of the risks the product entailed.  The conceptual solution was to require lenders making mortgage loans to offer a "plain vanilla" product (whatever exactly that is), so that there would be a baseline for comparison for consumers offered an alternative mortgage products.  For example, if a lender offered a 3/27 ARM with a prepayment penalty, it would also have to offer the consumer a 30-year fixed-rate mortgage with no prepayment penalty. The thinking behind plain vanilla was that having the plain vanilla comparison would help "debias" consumers and highlight the risks to them. Note that plain vanilla did not prohibit or otherwise impair alternative mortgage products. It merely required the offering of a plain vanilla product.   

There were real problems with the plain vanilla concept even as a behavioral move, and this explains why the idea did not garner support among consumer groups:

  • Unless the plain vanilla product were competitively priced, it would make the alternative product look more attractive. In other words for plain vanilla to work would have required price regulation of lenders' offerings. 
  • There was lots of room for slick salesmanship, e.g., "The government requires us to show you this so-called plain vanilla product, but if I were a young couple like you with a bright future ahead, I'd go with the pick-a-pay product. It will give you more flexibility and choice. The plain vanilla is really what I'd put my grandma in." 
  • There was no empirical research indicating the extent to which plain vanilla would have changed consumer behavior on mortgages. 

Irrespective of whether plain vanilla was a good idea, it's just wrong to claim that it is embodied in the QM concept. Plain vanilla is a behavioral economics move, and there is not an ounce of behavioral economics to be found in the QM concept. QM grants a regulatory safeharbor to the Dodd-Frank Act's Ability to Repay (ATR) requirement. ATR is a generally applicable requirement for residential mortgages:  if a lender fails to ensure that the borrower has the ability to repay the loan, then the borrower has a setoff or recoupment defense in foreclosure. (It's not a very potent defense, methinks, but that's for another blog post.) If a mortgage is a Qualified Mortgage, however, it gains immunity from this ATR defense. (For high-cost mortgages, it is a rebuttable immunity.)  

QM isn't about debiasing consumers. It's about easing a regulatory burden on lenders that offer safer products. The fact that it might achieve a similar consumer protection outcome to plain vanilla through anchoring the market to a safe product is extraneous. Plain vanilla was meant to anchor individual consumers' choices. QM is meant to anchor the market, but not individual consumers. (Note that the market has already been anchored around the fully-underwritten, fully-amortized 30-year fixed-rate mortgage for decades.) Plain vanilla would have anchored the market using a very different mechanism than QM, and it's not clear to me that QM will in fact serve as the market's anchor in the long run. Whereas plain vanilla would have required all mortgage lenders to offer plain vanilla loans, there is no requirement that a lender make QMs. Lenders can make non-QM loans. Given how weak the remedy is for failure to verify a borrower's ability to repay, the QM safeharbor is of limited value. There's an increased risk (and one I think most lenders are overestimating), but some lenders might decide that it is a worthwhile risk to assume, depending on loan pricing. If one is lending to a safe borrower pool (e.g., high FICOs, low LTVs), then the fact that a mortgage isn't QM probably doesn't matter very much. 

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