This morning the Federal Deposit Insurance Corporation became the first of six government agencies to adopt for public comment a proposed rule concerning risk retention on mortgage-backed securities, as required by section 941 of the Dodd Frank Act. As several of the FDIC directors noted, the rule could have profound consequences for this country’s financial system, and in particular for its housing finance system. Most at risk, perhaps, is the ability of that system to effectively serve the vast majority of Americans looking to buy their first homes who have no hope of saving a 20 percent down payment plus closing costs, and no access to relatives or a charitable organization or governmental entity that might provide the funds (with no expectation of repayment).
The primary purpose of the Dodd-Frank risk-retention provision is admirable: to ensure that those who transfer credit risk to capital market investors through mortgage-backed securities—which are bundles of individual loans packaged up by mortgage lenders for sale to institutional investors worldwide—retain a sufficient amount of that risk to align their interests with those of the investors. In other words, to put at least a damper on the “originate-to-distribute” model in which neither lenders nor the issuers of securities had a financial interest in making good loans that were likely to be repaid by the borrowers.
Recognizing, however, that it is possible to identify good loans based on product structure and underwriting standards, the statute allows exemptions to risk retention for securities backed entirely by loans meeting such standards, as defined by the regulators. For 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. As described this morning by both FDIC staff and several FDIC directors, the regulators designed the QRM to be “conservative,” in the belief that the exemption should cover only a small part of the market, leaving a “liquid, active market” for securitization of nonexempt loans.
Many parts of the proposed QRM definition, especially those related to loan structure, are commendable, but the underwriting requirements give pause. Footnote 145 in the proposal explicitly recognizes that the proposed QRM definition is likely to exclude many prudently underwritten loans to credit worthy borrowers, and indeed it will. The most severe limitation would make eligible only loans for which a a borrower provides a 20 percent down payment (plus closing costs) in cash. And the maximum loan-to-value ratio of 80 percent for the purchase of mortgages by the issuers of mortgage-backed securities must be calculated without considering private mortgage insurance. Other requirements that are likely to disqualify many borrowers include: the borrower may not have been 60 days past due on any debt within the last 24 months, and tighter debt-to-income ratios than were standard long before the recent housing crisis.
Some of the FDIC directors and staff emphasized their concern about how the rule would affect the availability of mortgages for low- and moderate-income households. This is a critically important question. To its credit, the Department of Housing and Urban Development managed to get a somewhat less onerous alternative into the questions (page 87 for those looking at the FDIC text), but even that option would preclude most first-time homebuyers from a QRM loan. And the fact that this alternative went completely unmentioned at the FDIC meeting suggests how difficult the road ahead is.
Will bank portfolios and the non-QRM securitized markets be interested in and able to serve this part of the population affordably, without gimmicks that will eventually hurt both borrower and lender? Under the proposal, as long as the two mortgage finance giants Fannie and Freddie are in conservatorship, their guarantee will be deemed to have met the risk-retention requirement. But what will be the impact of any reduction in the activities of Fannie Mae and Freddie Mac, as both the Obama administration and House Republicans are now proposing? Will there be successors to Fannie and Freddie, and how will their securitizations be treated? And what will be the impact on the Federal Housing Administration, taxpayers, and communities if in the end all low-down-payment mortgages are insured 100 percent by the government through FHA?
One thing becomes crystal clear in reviewing the proposal. It is hard to analyze the implications of the Dodd-Frank regulatory reforms and its implementation through this and other rules without a clear understanding of what the rest of the housing finance system of the future will look like. If some of the radical privatization schemes under consideration now—including some of the options in the Treasury white paper and this regulatory proposal—both were implemented, then we will be looking at a dramatically different housing market. The pendulum will have swung so far in the other direction that homeownership could be only a dream for many of America’s middle-class families who could be successful borrowers with well underwritten lower downpayment mortgage products.
The irony of this situation should be lost on no one. If the concerns of community-based and civil rights advocates and others about bad lending and securitization had been heeded years ago, we would not be in a position where the ability of much of the population to access the American Dream depends on the uncertain outcome of a highly complex rulemaking process and an uncertain legislative future. But it does.
The rule, which contains 174 multipart questions for comment, is likely to be published next week for 60 days of public comment. It is important to make sure we’re heard this time. We’ve got 60 days.
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.