Newly published research on reforms enacted after the subprime mortgage crisis suggests rule-makers took the best predictors of loan default risk off the table when crafting the new federal guidelines.
As a result, the regulations are missing important safeguards that would align interests of loan originators with those of investors to deter risky lending practices, says Joshua White, an assistant professor of finance.
“We’re sort of where we were in 2007 in that the same types of mortgages that caused the financial crisis can be securitized with no risk retention, just like it was before,” he says.
In 2012, White worked for the Securities and Exchange Commission as a financial economist. His co-author, Ioannis Floros, was a visiting scholar. They were tasked with conducting a cost-benefit analysis to aid regulators in the rule-making after the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed two years earlier.
With access to massive data at the SEC, their research identified which factors are most important in predicting whether or not a residential mortgage will default.
This information was presented to regulators writing the definition of a qualified residential mortgage (QRM), a new type of securitized loan created by Dodd-Frank that is exempt from risk retention.
“Any way we did the analysis, it kept coming back to the same conclusion,” White says. “There are really only two things that matter the most when assessing the default risk of a securitized mortgage: 1) the borrower’s credit history and 2) the loan-to-value ratio, which is directly determined by the down payment.
“So guess which ones they left out of the final rule? Those two. If you’re outside of Washington, you’re thinking this is absurd because that’s what caused the financial crisis.”
White says he believes the decision to leave these risk factors out of the rule was a casualty of politics – on both sides of the aisle.
Democratic lobbyists were worried about disproportionately affecting low-income and minority borrowers with strict qualifying rules. Republican lobbyists were averse to additional government regulation. And many inside the Beltway were concerned with stymieing the housing market so shortly after it began its recovery.
“I was surprised that the factors we found to be so important were not included in the rule,” White says. “But I felt comforted by the fact that, whatever decisions they’ve made, even if they were politically based, they had full knowledge. The economist’s job at the SEC is to inform the decision-makers, not to be the decision-maker.”
The regulators did include a stipulation that the definition of a QRM be reviewed every five years. In 2019, the policy could change. Using the model that White and Floros created, the most prevalent determinants of default risk can be re-examined with updated data.
“Even though the outcome is not what I expected it would be, I think that we’re getting to a better place where economic analysis matters more to financial policy decisions, and it’s conducted more rigorously,” White says.
“Qualified residential mortgages and default risk,” published in the Journal of Banking and Finance this September, was included in the pre-reading packet for this year’s G-20Y Summit.
“From an academic standpoint, our paper is the first to really stand back and study these factors, specifically for the definition of a QRM,” White says. “We also document a lot of things that weren’t in the academic literature before. There’s a lot of analysis right now about what mattered during the crisis. I think ours is one of the first to look at what we could change moving forward.”
White continues to consult with the SEC.
“I enjoy doing this work,” he says. “If research can help prevent a financial crisis from happening again, then I feel like I’ve at least made a contribution toward that.”