The Risks of Risk Retention

There is a lot not to like about the proposed risk retention rule and the Qualified Residential Mortgage (QRM) definition. And regulators are hearing all about it.

Mortgage Banking
July 2011

By Robert Stowe England

It was regulatory whipsaw.

The mortgage industry was looking for clarity and regulatory restraint in new rules to govern how sponsors could achieve a 5 percent retention level in 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 – a 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 rule. 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 homeowner’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) ration 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 August 1.

The exemption of Fannie and Freddie loans (while in conservatorship) from risk retention was one of the most vilified.

“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 notes.

“So the first mistake of the Dodd-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, ‘Well, 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 seven lenders said it had a problem with delinquencies on mortgages it had originated.

Lebowitz is also dismayed that criticisms of the proposed rule are being dismissed as “lacking judgment” by the regulators.

“What I get [from the regulators] is you have legislative-centric thinking,” he says. The regulators, he counsels, should instead take an approach that thinks of the financial institutions they are regulating as customers. “If you think of lenders as a constituency and not an enemy, you get a very different interpretation of what would apply,” he suggests.

By viewing the private sector as the enemy, regulators run into a dead end. “It’s not very useful as a framework. It becomes very politicized and therefore somewhat myopic,” Lebowitz says. With that approach, regulators issue rules that are “not very useful in the end,” he says. Instead, they should have taken an approach that treats the financial institutions that implement the legislation as “customers” and “partners” in enforcing the new law’s provisions.

The current rules will lead to a “government-dominated framework” that micromanages the mortgage finance industry, Lebowitz predicts.

The new system, however, is not likely to generate the kinds of investment in technology and innovations, such as automatic underwriting, that were pioneered by Fannie and Freddie prior to conservatorship and pre-Dodd-Frank.

Congress faults proposal

While industry complaints were to be expected, there was also a chorus of criticisms from lawmakers. Rep. Scott Garrett (R-New Jersey), chairman of the Subcommittee on Capital Markets and Government-Sponsored Enterprises for the House Financial Services Committee, blasted the regulators for ignoring the clear intent of Dodd-Frank that risk-retention rules would apply to Fannie and Freddie loans.

The exemption for Fannie and Freddie “will severely hinder ongoing efforts by the administration and Congress to encourage more private capital in our mortgage market and to reduce taxpayer risk,” said Garrett.

Garrett also faulted the regulators for adding rules to govern servicing practices in with the proposed risk-retention rule, when no authority was provided in Dodd-Frank for such provisions. The congressman advised that it was up to Congress to authorize any servicing rules.

A trio of key senators also sharply criticized the regulators for proposing a 20 percent down-payment requirement for the QRM carve-out from the risk-retention rule. Senators Kay Hagan (D-North Carolina), Johnny Isakson (R-Georgia) and Mary Landrieu (D-Louisiana), who sponsored the amendment that created an exemption from the risk-retention rule for QRM’s, wrote an op-ed on May 12 that appeared in both Politico and The Charlotte Observer.

“Regulators went for rigidity rather than a balanced, flexible approach,” the senators wrote. (See “Q&A with Senator Kay Hagan” in this issue of Mortgage Banking.)

“In contrast to our express intent--and despite repeated warnings from other members of Congress, consumer groups and bankers--regulators crafted a narrow definition that could unnecessarily slow the housing market recovery, increase costs to otherwise qualified homebuyers and dampen incentives for sound underwriting,” the senators wrote.

Further, Rep. Barney Frank (D-Massachusetts), ranking minority member of the House Financial Services Committee, penned an official comment April 15 to the regulators signed by 14 other Democrats objecting to the 20 percent down payment as “high.”

Other legislators have joined the bandwagon criticizing the proposed rule. Rep. Tom Price (R-Georgia) wrote an official comment letter April 15 to complain that the proposed rule exempts mortgages insured by the Federal Housing Administration (FHA).

Residential mortgages

Requiring mortgage securitizers to retain 5 percent of the risk poses its own set of risks – to borrowers who do not qualify for a QRM, to mortgage originators without a balance sheet and to the housing sector, should the rule prevent the revival of private-label securitization.

Given all that is at stake, is the idea of requiring 5 percent risk retention a good one? Well, in theory, the answer might be yes, according to Henry Cunningham, CMB, president of Cunningham & Co., Greensboro, North Carolina, and chairman of the Mortgage Bankers Association’s (MBA’s) Residential/Single Family Board of Governors (RESBOG).

“In theory, the 5 percent risk retention is logical, if what you’re trying to legislate [against] is bad behavior that resulted in the previous mortgage cycles where there was no skin in the game,” Cunningham says. “Lenders were willing to originate products that they wouldn’t have kept on their books.”

So, in the abstract, if you had to retain some risk, “you would be more mindful of the credit quality of the loans you are originating,” he explains. “That works in concept. The problem is that if you retain 5 percent on all loans, then obviously you are going to have to get some return on that capital,” he adds. “To get some return on that capital will, in turn, push up interest rates.”

The interest rate on securitized mortgages that do not meet the QRM definition could rise as much as 300 basis points, Cunningham suggests. That would mean that when a QRM has an interest rate of 6 percent, the non-QRM securitized mortgage might have an interest rate of 9 percent. While conceivably the premium might be lower than 300 basis points, “we can’t be sure” of that, according to Cunningham.

The risk-retention rule also eliminates some players from the mortgage market. For example, independent mortgage bankers are not depository institutions and they would not be able to retain risk because they do not have a balance sheet to support it, according to Cunningham.

“Community bankers would be in the same position,” he adds, because they would not have a sufficient balance sheet to retain the risks of the level of lending they have been doing and selling to Fannie and Freddie.

Under the proposed rule, Fannie and Freddie are exempt from the QRM rules while they remain in government control, but at some point conservatorship will end and it’s unclear what will happen to the huge share of loans they are buying after that.

With mortgage originators (mortgage bankers and community banks) knocked out of the picture, it would lead to a consolidation of the mortgage industry, Cunningham contends. This, in turn, “would reduce the number of choices for consumers,” in addition to pushing up interest rates, he argues, which means the idea “does not appear to be in the best interest of consumers.”

Cunningham suggests that the risk-retention rule should only be applied against loans that are truly risky. “I don’t think it makes sense to broadly apply risk retention to all loans.” Given that view, a very narrowly defined QRM misses the mark in terms of having the regulation serve its intended purpose, he explains.

Cunningham says it was to avoid higher mortgage costs and less mortgage credit available that he asked Sen. Hagan, the Democratic senator from Cunningham’s state of North Carolina, to co-sponsor the QRM amendment that was successfully made part of the Dodd-Frank bill.

“The intent of Congress was that lower-down-payment mortgages would be considered as a QRM,” Cunningham says.

When the amendment was crafted, the sponsors in the Senate specifically did not want to “hard-code qualified guidelines” into the law regarding down-payment requirements. Instead, Cunningham suggests, the lawmakers wanted to leave the details to the regulators so they would have the flexibility in proposing the rule that, in turn, would give lenders flexibility in their own underwriting guidelines.

Lenders need flexibility in evaluating the various elements that go into underwriting, Cunningham says, to meet market needs while ensuring good credit-quality loans.

After the regulators proposed the 20 percent down-payment requirement for QRM, Cunningham took a look at his own company’s 2010 book of business. “If I applied the proposed guidelines to our 2010 book of business, 58 percent of our purchase business and 74 percent of refinance business would have not have qualified as a QRM,” he says.

If the proposed QRM definition had been in place, it would have raised the cost of the majority of loans that Cunningham & Co. made in 2010.

Indeed, the vast majority of loans would probably not qualify across the nation for all lenders, according to Patrick Lawler, chief economist of the Federal Housing Finance Agency (FHFA). Lawler told the House Financial Services Committee during the April 14 hearing that if the 20 percent down payment provision had been in place in 2009, only 27 percent of homebuyers would have met the requirements for a QRM. For all loans, including refis, only 31 percent would have qualified.

The regulators’ view

Lawler, whose agency, the FHFA, was a party to the design of the proposed rule, pointed out the borrowers with low down payments would still be able to go to Fannie Mae, Freddie Mac and FHA. “When designing this, we didn’t mean for non-QRM loans to be unavailable, only that they would require risk retention,” he replied in answer to a question by Rep. Carolyn Maloney (D-New York), who was concerned that the rule would disadvantage the private sector.

Bob Ryan, the acting FHA commissioner, showed some flexibility on the 20 percent down-payment requirement at the April 14 hearing, even as the other regulators strongly defended it. “There’s no doubt we need to make sure we have tight, strong underwriting guidelines,” he said. However, “we absolutely need to make sure that we do not over-react.”

Ryan said that the regulators need to go back and re-examine the loan-performance data on lower down payments and “whether that adequately meets our consideration about quality underwriting and performance,” he said. HUD was the only regulator that requested comment on a 10 percent down payment alternative definition for the QRM.

FHFA’s Lawler, however, told the panel that the regulators had considered the 10 percent down payment and found that it “had a lot more default associated with it than the 20” percent down payment.

The rising chorus of criticism of the risk-retention proposed rule and other parts of Dodd-Frank prompted Neal Wolin, deputy secretary of the Treasury, to fire back at the critics.

“For the past nine months, regulators have been hard at work implementing [regulations] and many other critical reforms contained in Dodd-Frank,” he said in remarks made to Pew Charitable Trusts on April 19. “Yet today, even as millions of Americans are still recovering from the crisis, some on Wall Street, K Street and Capitol Hill seek to slow down, roll back or even repeal these crucial reforms.”

Wolin recounted the economic fallout from the financial crisis of 2008 and the failure of regulators to prevent the crisis, claiming that “there was no alternative to reform” and Dodd-Frank is that required reform. “Not only our economy, but also the lives and livelihood of millions of American families were devastated by the crisis,” Wolin said.

MORTECH’s Lebowitz believes that with that speech, Wolin was attempting to rally the public to “neuter” critics of regulations now emerging from Dodd-Frank. “The distinction between a general need for reform and a particular set of new rules is not made in his speech,” Lebowitz points out.

What the regulators are not considering, Lebowitz says, is the expense of complying with reform, the operational complexity created by a new set of rules and the chances that the rules will reduce the ability of lenders to lend to “qualified, but idiosyncratic loan applicants.”

Risk-retention options

The securitization industry and other players in the mortgage markets were generally pleased that in the proposed version of the rule the regulators offered five options to those needing to retain a 5 percent share of the risk in each transaction. The choices are:

• Vertical-slice option – In the vertical option, a sponsor of a securitization can satisfy the risk-retention requirement by retaining at least 5 percent of each class of asset-backed securities (ABS) in the transaction.

• Horizontal-slice option – The securitization sponsor can satisfy the rule if it retains a piece of the horizontal residual interest (the lowest tranches in the deal) in an amount equal to 5 percent of the entire transaction.

• Horizontal cash-reserve fund option – Instead of retaining a horizontal piece of the securitization transaction, the securitizer can set aside a cash-reserve account equal to at least 5 percent of the value of all the ABS interests. The cash account has to be held by a trustee for the benefit of the issuing entity and invested only in U.S. Treasury bills or deposits that are fully insured by the Federal Deposit Insurance Corporation (FDIC).

• L-shaped option – A sponsor can meet the requirement using a combination of the vertical-slice option and the horizontal-slice option (or the horizontal cash-reserve account option). The issuer has to retain 2.5 percent of each class of ABS and a horizontal residual interest equal to at least 2.564 percent of the par value of all ABS interests.

• Representative-sample option – In this case, the sponsor can meet the risk retention requirement by retaining a representative sample of the loans in the pool of assets set up for the securitization, as long as the value of the assets retained is at least 5.2643 percent of the unpaid principal balance of all the loans in the pool. There have to be a least 1,000 separate assets or loans retained.

One observer in the mortgage industry explained the impact of the options to one of the regulators that proposed them as follows: A sponsor is selling a buyer 100 cows and says he will take 5 percent of the risk. The sponsor offers the buyer several options. First, the sponsor can agree to take the first five cows that go down – the horizontal option. Or the sponsor can agree to take 5 percent of the loss of the first five cows that go down and the buyer pays 95 percent of that loss – the vertical option. Or the sponsor can identify which cows he wants to cover at random, then wait and see if any of those cows go down; if they do, he pays for the loss – that’s the representative-sample option.

The regulator reportedly laughed at the description, apparently recognizing the likelihood that securitizers would choose one of the options where risk retention is de minimis—making it risk retention in name only, according to the observer.

The real world impact

Analysts expect securitizers to choose the vertical-slice option. “The vertical retention is not really retention of the risk,” explains Ed Pinto, former chief risk officer at Fannie Mae, a mortgage industry consultant, and resident fellow at the American Enterprise Institute. “From a risk-sharing perspective, it does virtually nothing.” The first losses in any transaction will come from the lowest horizontal risk, so the odds that losses will hit the vertical slice are quite remote.

More importantly, Pinto says, the requirement to hold 5 percent risk will reduce the potential number of lenders and the volume of available mortgage credit. Once the securities are placed on the balance sheet, they have to sit there until the loan is paid off. This means that sponsors of securitizations will have be fairly large financial institutions with “a decent-size balance sheet,” Pinto says.

Then there’s the problem with the long duration of the asset tying up the balance sheet. If the securities are backed by 30-year fixed-rate loans, it amounts to keeping 30-year fixed-rate mortgages (FRMs) on your balance sheet, according to Pinto. However, 30-year loans rarely remain outstanding for all 30 years of their term.

With this rule, “the government is once again favoring larger institutions,” he says. The large financial institutions have a lower cost of borrowing--a pricing advantage conferred on them by the market, according to Pinto. “They can keep 5 percent on their balance sheet more cheaply than a small bank,” he explains.

The contrast between the very narrow proposed QRM definition and the almost infinite flexibility of options for risk retention is quite stark. Those choices would appear to undermine the idea of aligning interests to ensure good credit quality, according to Mike McMahon, managing director at Redwood Trust Inc., Mill Valley, California.

“If the idea is to get the sponsor to structure well-performing deals--good deals, deals that perform up to their expectations--it would seem to us that the best way to encourage a sponsor to do that is for the sponsor to retain the first-loss piece,” McMahon says.

“If you want investors to buy a deal and you are representing that it is a good deal, you should have the confidence to stand in front of them to take the first-loss pieces,” he says. “And so, clearly, if you stand first in line and you have all of your capital at risk, it would seem to us you would have a much better incentive to put together a good deal than if you stood by the side of triple-A investors and share (ital) pro rata (end) in losses,” as would be the case in the vertical option.

One reason most securitization sponsors want more options is based on how the horizontal option would be treated under accounting and bank capital rules. “If you take the bottom 5 percent of a deal and you are also the servicer of the deal, chances are that you are going to have to consolidate the transaction” on the balance sheet, McMahon says. “If you’re a bank and you have to consolidate, you are going to end up ballooning your balance sheet and probably worse--allocating more capital against the transaction than if you did not have to consolidate the transaction, even though the risk is exactly the same,” he adds.

Redwood Trust does not face the accounting and capital-treatment risk that banks face, because it is not a regulated depository institution and it does not have any regulated capital requirements. “As a practical matter, we allocate 100 percent capital to our investments anyway,” McMahon says. “That’s why we are alive today.”

“It would seem to us that rather than throw out the best form of risk retention [the horizontal slice], it is better to fix the accounting rule and keep the best form of risk retention,” McMahon contends.

“If the banks were to keep the lower-rated bottom horizontal piece of a deal, banks would have to set aside capital on a dollar-for-dollar basis against the risk,” McMahon points out. However, if they retain part of the AAA, then they only have to back it up with capital equal to 1.6 percent of the value of the retained asset.

“Banks prefer to have higher-rated assets than have lower capital costs. It gives them more flexibility than holding long-term, capital-consuming investments,” McMahon says.

So how could Washington go about getting the accounting rule changed? Could the Securities and Exchange Commission (SEC) call up the Financial Accounting Standards Board (FASB) and tell it this needs to be done?

“Yes, and there’s a good precedent for that,” McMahon says, pointing to the mark-to-market rule--Financial Accounting Statement (FAS) 157--which went into effect in 2007. “By 2009, the mark-to-market accounting was creating havoc for the regulated banking world; they were taking significant marks,” McMahon recalls. “FASB went and modified the mark-to-market rules such that changes in fair value that were believed to be temporary did not have to be permanently impaired,” he explains.

Exemption for Fannie and Freddie

The exemption of Fannie and Freddie loans adds another troublesome wrinkle, according to Pinto. He finds unpersuasive the claim by regulators that Fannie and Freddie are already retaining 100 percent risk by guaranteeing the securities. “What burden does it impose on Fannie to retain 100 percent, when Fannie has no capital?” he asks.

Ed DeMarco, acting director of the Federal Housing Finance Agency, the regulator for Fannie and Freddie, explained in testimony on March 31 why it would be problematical to impose the 5 percent requirement on the two government-sponsored enterprises. While noting that loans securitized by Fannie and Freddie are not classified as QRMs under the proposed risk-retention rule, DeMarco said that 100 percent backing for securities guaranteed by the GSEs is “obviously the maximum possible and far beyond the 5 percent risk retention required by Section 941.”

“Furthermore, since the risk retention by the [GSEs] is itself backed by the Treasury [and] not by private capital, it is unique from any other 100 percent risk-retention structure that might some day exist,” DeMarco testified.

If Fannie and Freddie were subject to the risk-retention requirement for non-QRM loans, “they would be forced to hold on their balance sheet 5 percent of the securities they issued backed by non-QRM loans,” DeMarco suggested.

“To impose such a requirement would add nothing further to the [GSEs’] skin in the game or credit-risk exposure,” he added. If they had to add to their portfolios to retain the risk, it would be “inconsistent” with the goal of reducing their portfolios by 10 percent a year. “It also is not clear how having the [GSEs] meet the risk-retention requirement . . . would encourage private capital to enter the market,” he said.

Pinto found DeMarco’s arguments unconvincing. “That reminds me of Br’er Rabbit saying ‘Don’t throw me in the briar patch,’” Pinto says. “Not only does the 5 percent retention not impose a burden, it gives them a benefit. They now have more in their portfolio,” making it harder to wind them down and improving profitability. Thus, the risk-retention rule, if imposed on Fannie and Freddie, would strengthen them, he maintains. “It would make it more difficult for the private-sector market to revive itself,” he says.

In Pinto’s opinion, Washington “got everything pretty much wrong” when Congress included the 5 percent risk-retention rule in Dodd-Frank and the regulators proposed a regime to implement it. “The goal was x. They have accomplished y, which is nothing like x,” Pinto says. Having proposed rule y instead of x, the regulators had an opportunity to limit the damage; but instead they compounded their original mistake by issuing a “QRM definition that has come a cropper,” he says.

Coalition of Opponents to QRM

The opposition to the proposed narrow definition of a QRM gained strength June 2 when the Mortgage Bankers Association joined forces with four consumer and affordable lending advocate organizations to oppose key features the proposed QRM. The formation of the coalition was announced at the National Press Club.

Coalition members including MBA, the Center for Responsible Lending, the National Housing Conference, the National Community Reinvestment Coalition, and Consumer Federation of America.

Representatives from the five organizations were in agreement that the proposed rules low loan-to-value (LTV) and low debt-to-income (DTI) requirements for the QRM would restrict access to mortgage for qualified borrowers.

“This is an issue obviously of great importance to the housing finance system for a broad, wide variety of stakeholders who care deeply about the future of housing in this country,” stated David Stevens, president and chief executive officer of MBA.

There is agreement among the coalition on the fundamental assumption underlying the proposed risk-retention rule in Dodd-Frank, Stevens noted, but not as it has been proposed.

“All of us here in this room agree that safe and sound underwriting practices, fully documented mortgages, fully amortized mortgages – the variables that were fundamental to the proposed QRM rule – make absolute sense as we look forward to the market to show that there are safe and sound underwriting practices,” Stevens said. 

Stevens pointed out that Dodd-Frank has two measures for mortgages. One is the Qualified Mortgage or QM, which is the outer boundary defining what loans can be originated by institutions regulated by the six regulatory authorities that proposed the rule. Within that QM box, which regulators have defined, is the QRM.

“Knowing what will or will not exist outside QRM in the mortgage market [could have] an extraordinary impact potentially on the accessibility to home ownership,” Stevens said.

Kenneth Edwards, policy counsel at the Center for Responsible Lending, Washington, D.C., said that the risk retention was not just an economic issue, but also a civil rights issue.

“We strongly agree that mortgages that are exempt from the risk retention rule should be responsible and sustainable,” Edwards said. “But, we strongly disagree [with the assumption] that Draconian requirements for down payment, credit and debt-to-income ratios are necessary to produce responsible and sustainable mortgages.”

Edwards calculated it would take 10 years for the average U.S. household to save enough for a 10 percent down payment, and 2 percent closing cost. For the average Latino family, it would take 12 years, and for African-Americans it would take 15 years.

Ethan Handelman, vice president for policy and advocacy for the National Housing Conference, Washington D.C., said the boundaries in the definition of a QRM could determine who will have access to affordable lending in the future.

“We want to make sure QRM doesn’t become an underwriting standard,” Handelman said. If the underwriting pendulum swings too far and restricts access to mortgage credits. There’s a risk the QRMs will come to seen as “good loans,” while everything is not, he added.

“What we want to make sure is that we are not creating a barrier by artificially defining a rule that shapes in unintended ways the mortgage space,” Handelman said. “It would be much less deleterious to focus on the product-type restrictions,” such as limiting the QRM to the 30-year fixed rate, pre-payable, fully amortizing mortgage.

John Taylor, president and chief executive officer of the National Community Reinvestment Coalition (NCRC), Washington, D.C., warned of the dire consequences for society if a narrow QRM definition prevails.

“Coming from the very agencies that had the job and responsibility to prevent the kind of predatory lending, the kind of abusive-lending products that got us into this of mess, we now have a solution that will restrict access to housing in a way since we haven’t seen since the Jim Crow era,” Taylor said.

Taylor said research down by NCRC has found there is “no evidence” to support the notion that a 20 percent down payment will affect the performance of the loan.

NCRC looked at a million loans done in 2006 and overlaid the QRM as currently defined to see what the default rate would be. Out of the million loans, those that meet the QRM definition would end up with 0.14 percent default rate, according to Taylor.

NCRC also looked at 3 percent down payment, the default rate rises to 0.26 percent – “a default rate that anybody in the industry would embrace,” Taylor said.

Barry Zigas, director of housing policy at the Consumer Federation of America, Washington, D.C., said the QRM debate matters because the access to homeownership matters to households and to the larger society.

“Homeownership remains, in spite of all the upsets we’ve had over the last five years, the surest path to accumulation to wealth accumulation and asset building for most American families,” Zigas said.

According to the Federal Reserve’s 2007 Survey of Consumer Finances, Zigas said, among households in the lowest quintile of income, 41 percent are homeowners, three times the number of households with retirement income. “And the value of their homes was far in excess of what those who did have retirement accounts had been able to save,” he added.

Zigas pointed out that homeownership rate for minorities, which never got above 50 percent, is “sinking faster” for minorities, while the homeownership rate for whites remains high at 70 percent.

Stevens pointed out the Dodd-Frank did not specify that LTV and DTI be part of any definition of the QRM.

“We believe that the regulators, while being very thoughtful in this process, have over-reached by adding loan-to-value and DTI which will create societal boundaries which we believe were unintended by those who drafted the law in the first place,” Stevens said.

According to the Federal Housing Finance Agency data, 70 percent to 90 percent of all mortgages loans approved between 1997 and 2009 would have been excluded under the proposed QRM definition, Stevens said.

Deal economics

Industry insiders find further fault with another provision in the proposed risk-retention rule--the requirement that sponsors of securitizations set up a premium capture reserve account. “This account is designed to serve as ‘first-loss’ credit enhancement for the transaction,” according to an April 8 explanation of the provisions in the proposed rule by Mayer Brown LLP, a law firm headquartered in Chicago, Illinois. In that sense, the accounts appear to be intended to compensate for the porousness of the five options for risk retention the regulators propose to offer to securitizers.

Such accounts were “not contemplated” in the original Dodd-Frank legislation, according to Tom Deutsch, executive director of the American Securitization Forum (ASF), New York. Unless this requirement is limited from its present form, Deutsch testified on April 14, “the issuer will not be able to earn any profit or return on residential mortgage-backed securities until 30 years down the road.”

Apparently the regulators proposed the premium capture reserve account “to prevent the upfront monetization of excess spread by the sponsor,” Deutsch testified,” under the theory that allowing such monetization would effectively negate the economic exposure that a sponsor is required to retain”--that is, the 5 percent risk retention.

In the initial proposed rule, premium capture was “based on proceeds in excess of 95 percent of the par value of the securities issue,” Deutsch said. That requirement goes beyond the 5 percent risk retention in most cases and set asides “the entire value of interests issued in the securitization over par.”

Deutsch testified that representatives of some of the regulators have told him they are willing to listen to suggestions to scale back the premium capture reserve so that it represents only a 5 percent risk retention and not any retention above that level.

Next steps

It is not clear how responsive regulators will be to the chorus of criticisms that have greeted the proposed risk-retention rule. In testimony before the House Financial Services Committee on April 14, representatives from the regulatory agencies strongly defended their proposals while also promising to read carefully the comment letters that were originally due by June 10.

The fact that regulators extended the deadline to August 1 a few days before the time ran out on the original deadline suggests that they are intent on getting a full hearing of all objections to the proposed rule.

The tangled web of proposed rules is now so complex and so likely to undermine the chances for a rebirth of the private-sector residential mortgage securitization market that it is not clear how it can be untangled in a way that would work in the real world.

Arguably, the best way to proceed would be to start all over and try to engage with financial institutions in a more constructive rather than adversarial way. Yet regulators are more likely to stick to revising their current rule.

In any effort to find common ground, it remains to be seen how far the regulators will go to address the complaints filed against the proposed rule. Stay tuned. MB

Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

Copyright© 2011 Mortgage Bankers Association. Reprinted with Permission.



Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

Visit Mind over Market:

Mind Over Market

Click Here>>