It was regulatory whipsaw. * The mortgage industry was looking for clarity and regulatory restraint in new rules to govern how and when sponsors would need to keep 5 percent of the credit risk in new securitizations of mortgages in order to better align incentives to originate good credit-quality mortgages. * It was hoped that when the rules were proposed, they would be reasonable and have demarcation lines that would be bright and definitive, while also being flexible enough to allow markets to function. This hoped-for approach was seen as a necessary next step to pave the way for a revival of the private-label residential mortgage-backed securities (RMBS) market and a strengthening of the struggling commercial mortgage-backed securities (CMBS) market. * Expectations that new risk-retention regulations would clear away the uncertainty in the markets and spark a private-sector securitization revival were raised with the release of a Treasury white paper in February. The paper made it clear the ultimate end game for policy proposals was to phase out and wind down Fannie Mae and Freddie Mac, and take steps to revive private-sector mortgage securitization as the key driver of funding for mortgages in a new mortgage finance system. * Such hopes were put on hold, however, when the proposed risk-retention rules were unveiled March 31. Mortgage bankers and other financial institutions were astonished at a plethora of onerous provisions that they said would essentially prevent a significant rebound of the private-label market for RMBS and entrench the government and government-sponsored enterprises (GSEs) as the dominant providers of mortgage credit--with the taxpayer on the hook indefinitely. * Furthermore, the regulators, without specific congressional authority, expanded the scope of the rules from what was required under Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Rules were not proposed just for mortgage securitizations but for virtually every type of securitization that exists, including securitized auto loans and collateralized loan obligations--businesses that did not contribute to the financial crisis--as well as asset-backed commercial paper.
In the world of mortgage banking, the regulators, without specific authorization from the statute, also proposed a narrow set of underwriting guidelines in their definition of a Qualified Residential Mortgage (QRM). Under Dodd-Frank, securitizations of these mortgages would be exempt from the risk-retention requirement. The regulators proposed that to meet the QRM carve-out, a mortgage should come with a 20 percent down payment for home purchases. For refinancings, the home-owner's QRM-eligible mortgage must not exceed 75 percent of the value of the home. If there is a cash-out, it cannot exceed 70 percent.
Under the proposed rule, the QRM also threw out borrowers who were late on any bill by more than 60 days in the past two years and set strict debt-to-income (DTI) ratios of 28 percent for the mortgage and 36 percent for all household debt.
The regulators exempted loans sold to the government-sponsored enterprises Fannie Mae and Freddie Mac from having to comply with the risk-retention rules while the two remained in conservatorship.
The 376-page proposed rule, as published by the Office of the Comptroller of the Currency (OCC) within the Treasury Department, was also proposed by five other regulators, each with its own varying constituency of regulated entities: the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC), the Department of Housing and Urban Development (HUD) and the Federal Housing Finance Agency (FHFA).
A chorus of critics
Not surprisingly, a gusher of criticism has erupted in response to the proposed rules. Indeed, the outcry was such that the regulators extended the deadline for submitting comments to them on the proposed rule from June 10 to Aug. 1.
The exemption of Fannie and Freddie loans (while in conservatorship) from risk retention was one of the areas of controversy.
"How dumb can you be?," asks Alex Pollock, resident fellow at the American Enterprise Institute (AEI), Washington, D.C., and former president and chief executive officer of the Federal Reserve Bank of Chicago. "On the one hand, we say we want to phase out Fannie and Freddie. And then we take regulatory action that guarantees they will actually dominate the market," he says.
"It's clearly a fundamental logical inconsistency. You can't both want to phase out Fannie and Freddie and provide them with an advantage in terms of risk retention, which is a capital advantage, which guarantees their domination. You logically can't want both at the same time," says Pollock.
The proposed exemption for Fannie and Freddie derives from another policy misunderstanding embodied in Dodd-Frank, according to Pollock. "The fundamental mistake is to mandate such things [as risk retention] instead of facilitating them," he adds.
"I am a huge supporter of the idea that you have a superior alignment of interests when the originator of the loan--that is to say, the entity actually making the credit decision--retains a significant and preferably a life-of-loan credit interest in the loans," says Pollock. "However, personally I'm opposed to any mandates of such things, since all such mandates distort what would otherwise be the market outcome."
On the other hand, he adds, "I'm vastly in favor of facilitating structures in which the lender retains a credit Interest--such as, for example, covered bonds, on which the lender retains 100 percent credit interest in the loan."
The 5 percent risk retention is, in fact, mandated in Dodd-Frank. Regulators were not in a position to facilitate rather than mandate the risk retention, Pollock concedes.
"So the first mistake of the Docld-Frank Act in this respect was to try to mandate something instead of trying to facilitate something. Now, let's say you have, however, mandated a credit retention the way they did. And then let's say you propose to exempt Fannie and Freddie from the scheme," says Pollock. "And there, the important thing is not Fannie and Freddie themselves, who of course have 100 percent credit risk retention on the mortgage-backed securities [MBS] they sell, but the effect on originators and sellers to Fannie and Freddie," he explains.
"Basically, what the current regulatory proposal says, as I interpret it, is, 'If you are a lender, you can escape credit-retention discipline altogether by selling to Fannie and Freddie,' whereas, if you do any other kind of credit financing, you must have significant credit retention," Pollock says.
"I think a mortgage financing system in the overall market that had in it a meaningful part where originators voluntarily retain credit risk, because they viewed credit risk as a business they could make money at, would be very healthy," the former home loan bank president says.
Pollock thinks regulators could have mitigated the potential damage and unintended consequences of an inflexible mandate by creating a larger space for the Qualified Residential Mortgage. However, instead of doing that, the regulators defined the QRM narrowly in the proposed rule.
One of the six regulators--HUD--sought comment on an alternative adjustable-rate mortgage (ARM) that would require only a 10 percent down payment instead of the 20 percent backed in the proposed rule issued by all the other regulators.
Jeff Lebowitz, founder and principal of MORTECH LLC, a market research firm in Bend, Oregon, believes that regulators are missing the mark with the proposed risk-retention rule. "I think they are a bit out of touch with what lenders can do, and how they feel about some of the reforms and how it affects their business and their ability to interpret and comply with Dodd-Frank and its progeny," he says. (Lebowitz spent an earlier part of his career working at Fannie Mae)
MORTECH's most recent survey of mortgage lenders finds that the vast majority "feel they have contributed nothing to the problem [of originating bad loans], and yet they have to carry a burden" based on the bad lending done by "a number of adventurous lenders."
The firm surveyed 300 mortgage lenders, including mortgage bankers, commercial banks, thrifts and credit unions, all of which originate at least $50 million a year in mortgages. MORTECH found that only about one in...