1% justiceThe Consumer Financial Protection Bureau may relent to a bipartisan desire to provide proactive legal immunity to mortgage lenders who originate qualified mortgages under a new rule from the Dodd-Frank law. Lenders who meet certain conditions on a mortgage they sell would get safe harbor, immunizing them from any private right of action over inaccuracies or fraudulent behavior associated with the mortgage.

The potential move, which would be a partial victory for mortgage lenders, is part of a broader effort to write new rules for the U.S. housing market in the wake of the mortgage meltdown. The proposal for the first time would establish a basic national standard for loans, known as a “qualified mortgage.”

As part of its deliberation, the Consumer Financial Protection Bureau is considering providing a full legal shield for high-quality loans that qualify, mandating that judges rule in lenders’ favor if consumers contest foreclosures, these people say.

For a smaller category of loans that still meet the “qualified mortgage” guidelines but carry higher interest rates—a group similar to “subprime loans”—lenders would receive fewer protections. In those cases, consumers could argue in court that lenders should have known that they couldn’t afford the mortgage.

It’s important to define terms here, because in its infinite wisdom, the Dodd-Frank law defined two classes of mortgages with almost the same name, that different parts of the regulatory apparatus control. This is easy to confuse, and I think I’ve been guilty of confusing them before. There’s the “qualified mortgage,” set by the CFPB, and the “qualified residential mortgage,” set by a different committee of regulators. This short primer from the Virginia Association of Realtors explains the difference.

The standard for QMs is fairly broad: A lender must ensure that any borrower has the ability to repay the loan. (There are nine standards that determine this.)

Just about every loan is going to be a QM — there are legal penalties for banks that write loans that don’t meet the standards. And by meeting the standards, lenders are shielded from some liability. (Borrowers won’t be able to say “The bank should have known I couldn’t pay.”)

QRMs, on the other hand, are a subset those loans. They have to meet stricter standards — standards that still haven’t been determined, and could include the infamous 20%-down requirement.

Banks and other lenders are free to make non-QRM loans, but there are discouragements. For one, the lender could only sell 95% of the loan to the secondary mortgage market; it would have to keep 5% on its books as “skin in the game.”

More importantly, neither Fannie Mae nor Freddie Mac will buy any part of a non-QRM loan. Considering they own 90+ percent of the secondary mortgage market, that means it will be pretty hard for any lender to sell a loan that doesn’t meet QRM standards.

The part I highlighted the blockquote is pretty revealing. The industry assumed last year that lenders would get a shield from liability on qualified mortgages. But the statute always granted an undefined set of protections from liability, presumably just on the concept of ability to repay, as stated above.

But there’s no real reason to provide this gift to the mortgage industry for doing their job. Mortgages happen to be more profitable than ever; the spread between what lenders get for selling loans in the secondary market and what they charge in an interest rate to a borrower have never been higher. Every major bank that reported earnings this quarter so far showed that their mortgage business brought in massive profits. Lenders will be enticed to sell qualified mortgages because there’s lots of money to be made in qualified mortgages.

But lenders want something more. They want to basically short-circuit the judicial foreclosure process as much as possible, getting a blanket safe harbor for as many qualified mortgages as possible. Liability wasn’t determined specifically in the statute, so the rule has some leeway here. The Mortgage Bankers Association is quoted in the WSJ piece as seeking protections for subprime loans as well as higher-quality ones.

The Federal Reserve originally wrote the qualified mortgage rule. It excludes such loans as “option ARMs” and “interest-only” loans, which were among the exotic products that fed the housing bubble. But these haven’t really returned to the market. Under the Fed standard, practically every mortgage written in 2010 and 2011 would have been considered a qualified mortgage, per the Government Accountability Office.

CFPB re-opened comment for the ability-to-repay rule in late May of this year, based on new data from the Federal Housing Finance Agency. CFPB has until January 2013 to promulgate this rule. And they’re proposing some interesting ideas, like incorporating an individual’s full debt status into the equation. They could exclude from the “qualified mortgage” standard any loan for an individual whose debt-to-income ratio (DTI) exceeded 43% of their pretax income.

However, they’re also poised to deliver more liability protection than devised in the statute. According to WSJ, CFPB is considering making designations within the qualified mortgages, giving much more legal immunity to higher-quality products. But those lower-quality, subprime products that would enjoy less legal protection only made up 3.7% of the market in 2011, down from 29% in 2006, at the height of the bubble. In other words, the loans being discouraged here are ALREADY GOING AWAY, without the blanket safe harbor.

This has been pushed by small and midsize banks, actually, who want the protection so they can compete with the bigger banks, who can more easily deal with lawsuits. And they’ve rallied a bipartisan group of lawmakers to their cause.

But again, outside of ability-to-repay, why would you hand out legal immunity for lenders to participate in their lucrative business? If you want to encourage well-qualified mortgages, the QRM rule, with its risk-retention rules, seems to get you there. Do lenders really need safe harbor from QMs as well?

Obviously CFPB is concerned about writing a rule that leads to a perception of constricting credit. But they are going way too far in the direction of leniency toward the banks. The last industry to which anybody should be granting legal safe harbor is the mortgage industry, given past (and present) experience. This just invites lax lending standards and all the abuses of the bubble years, without any of the aftermath for lenders.

CFPB’s credibility is on the line with this rule.

David Dayen

David Dayen