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The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which Obama administration regulators are now in the process of implementing, includes many new rules that will protect our financial system from the systemic risks that led to the financial crisis of 2008 as well as new ways to protect consumers from the financial abuses of that era while retaining access to quality financial services. Six regulatory agencies have just issued their proposal to implement one of the most important of these rules: the risk-retention requirements of Section 941 of the Dodd-Frank Act. The proposed rule will have profound consequences for current and prospective homeowners across our nation.
At risk in the rulemaking is the ability of the vast majority of Americans to buy their first homes, and the ability of millions more whose home equity has been eroded during the Great Recession to refinance or buy a new home. Under the proposed rule those buying homes will have to come up with a cash down payment of 20 percent of the home value, plus closing costs. Those looking to refinance will need to come up with even more. Not only could this proposed rule make it virtually impossible for renters to become homeowners; it could clog the entire housing market, putting at risk the already uncertain recovery of house prices and the economy.
This result is entirely unnecessary. Well-structured, well-underwritten, fully documented low-down-payment home loans have performed almost as well as loans with much higher down payments throughout this entire crisis. Congress knew what it was doing when it did not include down payment (or the loan-to-value ratio) in the list of factors to be considered under Section 941. It is essential that the regulators follow suit.
The primary purpose of the Dodd-Frank risk-retention provision is admirable and important: to ensure financial institutions that transfer mortgage credit risk to capital market investors through mortgage-backed securities—which are bundles of individual loans packaged for sale to institutional investors worldwide—retain a sufficient amount of that risk to align their interests with those of the investors. The goal is to put at least a damper on the “originate-to-distribute” model in which neither lenders nor the issuers of mortgage-backed securities had a financial interest in how likely borrowers were to repay their loans.
The Dodd-Frank Act, however, recognizes that it is possible to identify loans likely to perform well based on product structure and underwriting standards, which is why the statute allows exemptions to risk retention for securities backed entirely by loans meeting such standards, as defined by the regulators. For single-family residential mortgages, such loans will be known as “qualified residential mortgages,” or QRMs.
The challenge, of course, is in the details, in particular the details of both the risk-retention standards and of the definition of QRMs that are exempt from risk retention. What makes the current rulemaking so challenging is not only its inherent complexity—balancing consumer, investor, lender, and systemic risk issues—but also its timing in the context of the broader debate about the future of housing finance. For the “correct” answer with respect to risk retention has a lot to do with what one thinks the appropriate future should be, and will be, for the programs of the Federal Housing Administration; for Fannie Mae, Freddie Mac, and their possible successors; for the ever-more-concentrated banking industry; and for the currently moribund market for private mortgage-backed securities. The answer will determine much about the shape of housing in the United States for years to come.
In January, the Mortgage Finance Working Group, sponsored by the Center for American Progress, published its analysis of the history and current state of the U.S. housing finance market, and its proposal for the future shape of housing finance in this country. The paper states that any future housing market must be characterized by liquidity, stability, transparency and standardization, affordability, and consumer protection. The paper emphasizes the importance to households, communities, and the economy of the broad availability of affordable long-term, fixed-rate mortgages for owned and rental housing, and of fair and equitable access to capital markets for lenders of all sizes.
So a first question is how the proposed risk-retention rules would impact these goals in the current structure of the housing market. As I suggest below, there is good reason to be concerned, especially with respect to liquidity, stability, and affordability. The Working Group recommended a structure in which well-capitalized Chartered Mortgage Institutions, or CMIs (that cannot be owned by originators of mortgages except under a broad-based cooperative structure), would guarantee securities backed by well-structured, well-underwritten, fully documented mortgages, primarily long-term, fixed-rate instruments. In turn, these securities would receive a paid-for government guarantee against catastrophic loss. Premiums would be held in a fund similar to the federal Deposit Insurance Fund.
How would securities issued by these new CMIs be treated under the risk-retention proposal? Would these CMIs be regarded as “securitizers”? Would their 100 percent guarantee, together with government-backed catastrophic insurance, be deemed to meet the risk-retention rules? If not, would the CMIs be able to provide both housing market liquidity and stability and broad and consistent access to long-term, fixed-rate finance, even for creditworthy borrowers who do not have the upfront resources to put 20 percent down? This issue brief presents some answers to these questions and posits some guidelines for answering others. Our goal is to ensure the broadest array of responsible American homebuyers and owners have access to long-term, fixed-rate mortgages so they can become long-term homeowners and the housing market can begin and sustain the recovery that has so far eluded it.
Defining a qualified residential mortgage
The intersection between rulemaking under Section 941 of the Dodd-Frank Act and broader housing finance policy arises most clearly with respect to the definition in the proposed rule of the “qualified residential mortgage,” or QRM. Under Section 941, mortgage-backed securities that are collateralized solely by QRMs are exempt from the requirement that “securitizers” retain 5 percent of the credit risk of the securities. The theory is that this will align the interests of borrowers, lenders, and investors, and prevent lenders and securitizers from making bad loans.
The fact that many portfolio lenders, who kept 100 percent of the risk of loans, also made bad loans during the boom suggests this theory may not be all it’s cracked up to be. Nonetheless, risk retention is in the statute. Because risk retention is likely to cost something— how much is unclear—and because there is a danger that non-QRM securities will be labeled “unsafe” by bank examiners and others (whether explicitly or informally), there is reason to be concerned that non-QRM mortgages will be hard to come by, will carry significant price premiums, or both. If that is the case, people will usually need to qualify for a QRM if they are to get a loan. That makes the definition a critical determinant of access to housing finance in the future.
The proposed definition is highly restrictive. Most importantly, it defines a home purchase QRM to require a down payment, in cash, of closing costs plus 20 percent of the value of the home. (Refinance QRMs have even larger down-payment requirements.) And this down payment must be in cash with no strings attached; even the highly subordinated, delayed payment soft seconds that many municipalities and nonprofit organizations long used in successful homeownership programs would not be allowed. This is likely to be a substantial bar to receiving a QRM for virtually any prospective first-time homebuyer. In 2007 the median white, non-Hispanic renter had cash savings of about $1,000 and the median minority renter about one-quarter that amount. The median renter net worth was about $7,500 for whites and $2,500 for minority households (see chart).
In comparison, even after massive house-price declines, the median house price in the country is still around $170,000, putting even a 10 percent down payment out of reach for these households. And this isn’t just speculation based on arithmetic. Consider these numbers: In 2009 62 percent of the population nationally put down less than 20 percent to buy a home, and in the D.C. region, in Prince George’s and Prince William counties, both of which have significant minority populations, more than 60 percent put down less than 10 percent.
Far more is at issue than equity across differences in wealth, race, and geography. If new homeowners cannot get on the housing ladder, house prices will remain under stress, and present homeowners who want to move—up or down, to another owned home or rental—will find a much smaller market for their current home. These potential effects will be exacerbated in the credit-starved communities, especially communities of color, which have been hardest hit by the recent economic downturn. As we’ve been discovering for the past several years, an economy without a viable housing market doesn’t work very well.
Down payment and loan-to-value ratio are not even in the statute as something the rulemakers were to consider (a point the Federal Reserve, in its just-published proposal defining a qualified mortgage, seems to have understood). This is because down payment—at least beyond a small amount—is not a particularly powerful indicator of default. Far more important are the loan structure and full documentation underwriting. Even according to the statistics and graphs in the proposed rule, any serious increase in defaults of purchase money mortgages is related to down payments of less than 5 percent. The tables in Appendix A of the preamble to the proposed rule show that the loan-to-value ratio is the least powerful predictor of default of the proposed key characteristics of a QRM.
There is a temptation to believe the QRM definition is no big deal because federally guaranteed mortgages will fill the need for low-down-payment loans. By statute, mortgages guaranteed by an agency of the United States, such as the Federal Housing Administration, are exempt from risk retention. And as long as Fannie Mae and Freddie Mac are in conservatorship, guaranteeing all the credit risk of their securities (not just 5 percent) and with government backing of their capital, the proposal says securities backed by the two companies will be deemed to have met the risk-retention requirement.
But that doesn’t mean low-down-payment mortgages will always be available. The reason: In the ongoing housing finance debate, all the following financing factors are in play:
- Whether the FHA will move to higher down-payment requirements, as hinted in the Obama administration’s housing policy white paper
- Whether having the FHA be the sole source of low-down-payment mortgages is a good thing given the 100 percent government guarantee that makes the taxpayer the backstop of all FHA mortgages, the FHA’s limited capacity to effectively police its origination system when its share of the market climbs to high levels, and the abuses that in the past have appeared in some communities when the FHA was effectively the only mortgage provider
- Whether, even if Fannie Mae and Freddie Mac continue to exist in precisely their current form, they will make low-down-payment mortgages, given the demands of the conservator, the Obama administration’s position that the two companies should be moving to 10 percent down payments and the requirements of mortgage insurers
- Whether if Fannie Mae and Freddie Mac cease to exist, there will be any successor entity or system, such as the system in the MFWG proposal,that is also deemed to meet the risk-retention requirements for non-QRM mortgages.
The result: The effect of a restrictive QRM definition on the lives of millions of American families and their communities is tied up in a housing finance future that is unlikely to become clear for several years after the QRM definition takes effect.
Ensuring qualified residential mortgages can find buyers
But the QRM definition is not the only issue whose resolution is complicated by interaction with issues that will be addressed at a later date. The proposed allowable forms of risk retention are also implicated. Like the proposed QRM definition, the risk-retention portion of the rules will both be influenced by and have a significant influence on the future of any revived private-label mortgage-backed securities market, a critical element of the broader housing finance debate.
Calls for complete privatization of the housing finance market assume the Dodd-Frank reforms, including risk retention, will lead to the creation of a more safe and robust private mortgage-backed securities market than this country has even seen—one that will, without any government backing, broadly provide long-term, fixed-rate mortgages at affordable interest rates.
Does this assumption have any validity? Are the proposed risk-retention requirements tough enough to give investors the confidence they need to restart the market? And if the risk-retention rules are not tough—and banks are already fighting one of the toughest parts, the “premium capture fund”—will the private mortgage-backed securities market come back at all? Some critical questions in this arena are:
- Whether any private-label, non-QRM mortgage-backed securities market will be so dominated by the largest banks because of their greater ability to hold sufficient capital to meet risk-retention requirements that a small group of lenders will define the entire non-QRM market, with smaller lenders, including community banks, credit unions, and community development financial institutions unable to respond to local market needs, or even continue as mortgage lenders
- Whether the proposal to allow securitizers to push the risk-retention requirement back on originators will further disadvantage smaller lenders
- Whether a private-label, non-QRM mortgage-backed securities market, with or without a government guarantee, will provide broadly available, affordable, long-term, fixed-rate mortgages
- Whether a private-label, non-QRM market will have the depth and liquidity that are essential for a vibrant To-Be-Announced market, which enables lenders to provide borrowers with locked-in interest rates and gives holders of mortgage-backed securities confidence of an always-available market in which to trade those securities
- Whether a private-label, mortgage-backed securities market will reemerge as long as securities issued by Fannie Mae and Freddie Mac, as well as Ginnie Mae, can meet the risk-retention requirements through their cost-free access to unlimited government backing, with the advantage this provides over any privately capitalized entity that must retain risk
Both finance and public policy demand the ability to solve complex interrelated problems under conditions of uncertainty. In this case a 243-page, six-agency rulemaking has met up with a multitrillion-dollar financial market and the future of broader housing finance policy. What makes this situation so fraught is that housing is not only a huge part of the economy but hits home for each of us every day.
This is why it is essential that regulators take a step back and refocus where the statute tells them to: on loan characteristics that are determinative in distinguishing a low-risk mortgage from a high-risk one, and then on risk-retention standards that keep the secondary market open on a fair and equitable basis to lenders of all sizes. If they do that, then the risk-retention rules will serve our country well, no matter what the outcome of the broader housing finance debate.
Download this issue brief (pdf)
Read the full brief in your web browser
Ellen Seidman, former director of the Office of Thrift Supervision, is a member of the Mortgage Finance Working Group sponsored by the Center for American Progress.