By Rob Garver
September 15, 2011
Of the many financial reforms in Dodd-Frank, a requirement that lenders retain a share of the risk in mortgages they sell to investors seemed like a no-brainer. If lenders were on the hook, too, the thinking went, they would tighten standards and avoid the kind of defaults that contributed to the collapse of the housing market and the financial crisis.
But now that a rule to implement this provision has been written, critics say the requirement will make it so hard to get a mortgage that it will further depress the housing market and undercut a struggling economy. “I’ve been in this business 32 years and I have never seen guidelines as tight as they are now,” said Scott Eggen, senior vice president for capital markets with PrimeLending, a mortgage lending subsidiary of Dallas-based Plains Capital Corp.
Even frequent critics of lender practices, such as the National Community Reinvestment Coalition and the National Consumer Law Center, have joined bankers and bank lobbyists in calling for regulators to rethink the rule.
“The proposal as introduced will literally erase a decade of accomplishment in defining what is a responsible loan,” said David Berenbaum, chief program officer with the Coalition, an advocacy group for community organizations that support affordable housing and equal access to credit. “It is going to narrow the range of loans that lenders are willing to originate to the point that only consumers with the best credit scores—meaning white and affluent consumers—are going to get loans.”
During the housing bubble of the last decade, lenders to marginal borrowers could quickly offload the risk of default by selling the loans to third parties that packaged mortgages into securities. When those borrowers couldn’t make their payments, the value of the securities tanked. To create an incentive for more prudent underwriting, the Dodd-Frank financial-reform act directed regulators to issue rules requiring mortgage lenders to retain no less than five percent of the risk associated with loans they sell.
Critics claim that the proposed rule, as written by six federal agencies, ignores exemptions Congress intended to put in place. Their concern is how regulators interpreted the provision in the law exempting “qualifying residential mortgages” from the risk retention requirement.
Regulators defined qualifying residential mortgages very conservatively, requiring a 20 percent down payment, caps on a borrower’s debt-to-income ratio, restrictions on loan terms, and other limits designed to restrict the number of loans that would qualify for the exemption.
The rule “will encourage better underwriting … assuring that originators and securitizers cannot escape the consequences of their own lending practices,” Sheila Bair, then chairwoman of the Federal Deposit Insurance Corp., one of the agencies involved in writing the rule, told the FDIC board when it was announced.
Loans considered qualifying will be easiest to securitize—increasing banks’ liquidity and lowering their costs. Loans that fall outside the guidelines, by contrast, will be much harder to move off a bank’s books, reducing liquidity and increasing costs. Some say banks could stop underwriting non-qualifying loans altogether or would charge higher interest rates to offset their increased costs.
“If the stated policy goal here is to have a default rate of one percent or less on qualifying residential mortgages, I am sure they will get to that goal,” said Bruce Schultz, vice president at Spirit Bank in Bristow, Okla. “But you could also get to a default rate of zero by making no loans.”
Bob Davis, executive vice president for government relations at the American Bankers Association, estimated that somewhere between one half and two-thirds of mortgages currently being securitized by Fannie and Freddie would fail the new test. “The narrowness is really sort of absurd,” he said. The National Community Reinvestment Coalition, in a comment letter to regulators, estimated that just 10 to 20 percent of residential mortgages would be considered qualifying under the proposed standard.
There were similar requirements in the past for loans sold to government-sponsored enterprises Fannie Mae and Freddie Mac. But individuals who couldn’t meet those requirements often could get loans at favorable terms by purchasing mortgage insurance. The mortgage-default rate, near historic lows of between one and two percent before the financial crisis, according to Standard & Poor’s/Experian Credit Default Indices, peaked at about 5.5 percent in 2009. It fell back to around 2.5 percent this spring after the rash of foreclosures as the housing market tanked. New-home sales are down more than 70 percent from their peak in 2006.
Tom Feltner, vice president of the Woodstock Institute, a fair housing advocacy organization in Chicago, said the size of borrowers’ down payments and their debt-to-income ratios had little to do with the wave of mortgage defaults that sent the economy into decline in 2007.
The real problem, he said, was the proliferation of “exotic” loans that allowed borrowers to defer principal payments, such as interest-only loans, and others that were structured to allow lower payments but the principal balance increased over time. “About half of those exotic loans went into default during the economic crisis,” said Feltner.
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