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MORTGAGE REFORM AND CONSUMER SPENDING BEHAVIOR

The turmoil in the mortgage markets triggered by liberal policies and lax lending standards is undoubtedly the origin of the financial crisis. Since the crisis, there has been a shift in the mortgage market. This shift, which exists both in the regulatory front and the demand-supply front, is poised to alter the industry. The article is focused more on the changes that are being proposed by the regulators to the mortgage industry and what the average consumer needs to comprehend to facilitate fiscally responsible decisions.

The mortgage market classifies borrowers into prime, sub-prime and Alt-A categories. These categories differentiate the borrowers based on their credit quality. Despite the FICO credit score being an important parameter to ascertain borrower quality, it is rather ironic that the market, in the run-up to the meltdown, created huge incentives for borrowers with poor credit quality to become proud owners of expensive homes. This was partly driven by the booming securitized markets with investors seeking more of the MBS and its derivatives since they possessed attractive return profiles. In hindsight, there were large inconsistencies in the market with the homebuyers and investors having different goal sets and each was pursuing these goals hoping that their paths would never cross.

The revival of the housing market is pivotal to economic growth. The financial regulators are now actively engaged in making proposals to reform the mortgage industry mainly with a view to dissuade the lenders and banks from bad practices. The proposals are being designed to facilitate safe lending while also ensuring and preserving access to financing for qualified home buyers. The difference now exists in how the market defines a "qualified" home buyer. The terms "Qualified Mortgage (QM)" and "Qualified Residential Mortgage (NYSEMKT:QRM)" are being referenced quite often in the realm of mortgage reform. The regulatory agencies have sensed an impending need to align these two terms. They are hoping to synchronize these rather complex terms in order that lenders make safe loans to borrowers that would ultimately perform well for the investors. The QM defined by the CFPB (Consumer Financial Protection Bureau), as required by the Dodd-Frank Act, was intended to set a minimum loan standard. It has a borrower's "ability-to-pay" provision that can be complied with by meeting specific underwriting standards. Its aim is to protect consumers from unsustainable loans. The QRM is intended to set a standard for loans placed in an MBS that have a low credit risk.

In a preliminary proposal in 2011, a Qualified Residential Mortgage referred to those mortgages that had at least a 20% down-payment and no more than a 36% DTI ratio. Among other provisions, it excluded risky loan terms such as the no-doc loans, negatively amortizing loans and the interest only loans. The 20% down payment requirement lent itself to a lot of criticism owing to the term's propensity to limit access to credit for the average American thereby making home ownership a very tall order. With a view to promote responsible lending, banks and bond issuers that securitize these mortgage were required to hold 5% of the mortgages that are sold to investors.

The proposal was recently revised to eliminate the down payment requirement and the DTI ratio was raised to 43%. Subsequently, the regulators expanded the risk-retention provision to apply the 5% requirement only to those loans that do not meet the underwriting standards to qualify for the QRM status. While the spirit of mortgage reform is much needed and appreciated, the course of these revisions may be indicative of a fragile legislative process. The critics of the revised standard opine that the risk retention rule has no meaning if it is going to exempt most or all the mortgages. If the need is to establish a strong linkage between borrower quality and risk retention by banks, these revised proposals could effectively be diluting this linkage. Requiring no down-payment and the softened risk retention rule has an increasing potential for the market to revert to the old practices. All categories of borrowers could start falling under the purview of a "Qualified borrower". Should things go awry, the market could once again face a preponderance of mortgage defaults. I believe, it is important to set standards that result in a visible positive transition in the functioning of the mortgage market. While everyone recognizes the need for major shift in rules and policies, efforts to expand the boundaries of the law to accommodate the needs of specific factions would undermine the purpose of reform.

To be more specific, if the zero down payment rule is here to stay in its final version, it is a huge victory for the home buyers. Putting aside the extensive lobbying that takes place which such reform efforts, the sense of accountability that the proposals are trying to enforce on loan originators and banks must also be extended to the borrowers in some form. Every facet of the mortgage market must assume responsibility. The home borrowers can assume responsibility by an external enforcement through a minimum down payment requirement that translates to making affordable and sustainable home purchases and by also making a conscientious alteration in their spending behavior.

The government, since the crisis, has been introducing a flood of paper money into the economy to stimulate growth and consumer spending. This will eventually increase the likelihood of the consumers to take on more debt. While it may be unrealistic for the economy like the US to switch to a deleveraging cycle to combat such crises, it has become evident that escalating the debt spirals to unsustainable levels can be exceedingly damaging. It augurs well, therefore, to realize that "living within your means" could solve much of the problem.