The Dodd-Frank “Act” Strikes Again?

Story Highlights:

• The Dodd-Frank Act has created a litany of new regulatory bodies and regulations. The Fed released yet another proposal this week.
• The “Ability to Repay” proposal weighed in at 474 pages, but was largely devoid of any formulas or ratios to give lenders a framework to determine lending standards.
• While a no-regulation regime isn’t ideal, we believe banks, know their business best and don’t actually want to have a bunch of loans default.
• This rule seems more like politics as usual than smart, home-owner focused reform.

If the US government’s goal in enacting Dodd-Frank Reform Act was to create jobs, then we’d say it’s been a success thus far—save for one small caveat. The jobs being created are mostly lobbyists and proposed government sector jobs to carry out the litany of studies the new law mandates. For example, the Act has created numerous new regulatory organizations that will need to be staffed, adding to the existing alphabet soup of financial industry regulators and regulations. And the Fed added another wrinkle to one rule Thursday.

Under Regulation Z of the Dodd-Frank Act (specifically the “ability to repay” provision), the Federal Reserve released a new proposal (weighing in at a thrilling 474 pages) to set minimum standards for residential mortgage loans. The regulation was mandated by legislators to combat what they saw as problematic mortgage underwriting practices believed to have exacerbated the financial crisis. (Mind you, nowhere did they mention a key driver of the credit crisis, the disastrous accounting rule FAS 157.) In our view, this proposal is rife with the “well, duh” factor. Lenders should confirm borrowers have the ability to repay loans. Is anyone disputing this? One wonders why it took 474 pages to detail this. What’s more, despite its hefty size, the proposed rules (like many parts of Dodd-Frank) leave a lot yet to be defined.

For example, the rules say lenders must verify current income and/or assets, current employment status, and monthly debt obligations. Great! We concur. Fact is, lenders all pretty much already do this now (gone are the days of the NINJA loans—No INcome, Job or Assets—banks figured out on their own they mostly got burned on those). But there were no specifics as to debt-to-income ratios or codified standards borrowers must meet. A lack of specifics isn’t particularly bad (and we can imagine much worse specifics they could have codified). We can also see how a lack of clarity leave rules open to interpretation, which doesn’t always result in the best application (ahem, FAS 157).

Some other key points:

• Creditors will also be limited to charging 3.0 total points. Fair enough—no one likes points. But in a situation where more points are warranted to mitigate bank risk, we’d wager banks get around this simply by raising rates.
• For adjustable-rate mortgage borrowers, underwriters must consider a fully amortized payment with the maximum interest rate over five years. This could disqualify some borrowers based on debt service ratios, even though borrowers can lock in an “adjustable rate” for 5, or even 10 years.

Ultimately, if investors hope the government can “protect” them from future crises, Reg. Z and “ability to pay” likely aren’t the keys. Nor can any regulation really insulate us from uncertainty, volatility, occasional bouts of corporate irresponsibility, or more frequent bouts of political stupidity. Frankly, in our view, that’s as it should be. We believe banks, know their business best and don’t actually want to have a bunch of loans fail and lose shareholder value, etc. It’s just not in their best interests. We’re not advocating a zero-regulatory regime. Far from it! However, while banks have been known to get overly loose when it comes to lending standards (again—NINJA loans, also called “liar loans”), it’s unlikely regulators can best optimize lending parameters. If lending standards are too tight, it might weigh on the economy. Too loose, and they don’t serve much purpose at all.

This proposal seems more like politics as usual—the Fed simply paying lip service to appease legislators, who nearly always want to appear to be earning their paychecks by reining in perceived risks and problems. Then again, maybe that’s why they call legislation an “act” of Congress.