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More "Safe" Toxic Mortgages, Coming Soon From A Bank Near You

Tuesday, 18 Dec 2012 | 3:51 PM ET
Photodisc | Getty Images

Regulators are close to finalizing rules on mortgages that will be especially appealing to lenders because they will carry with them some degree of immunity from borrower litigation.

As Peter Eavis of the New York Times reports, both consumer groups and bankers agree that the category of loans that will be known as "qualified mortgages" should be very broad. All that's left is a fight over exactly how much legal immunity banks will get from making the loans.

In writing the proposed rules, the Federal Reserve suggested two approaches, and it is up to the consumer agency to define the safeguard for lenders.

One option, called a "safe harbor," raises the threshold for litigation. In that case, a borrower may win a lawsuit only by showing that the disputed mortgage lacked the precise features required for a qualified mortgage, like a defined amount for points and fees.

A second option would increase borrowers' ability to challenge a mortgage in court. A loan might appear to comply with the requirements for a qualified mortgage, but the borrower might be able to introduce other evidence that shows the underwriting fell short of the standards.

The entire idea of a "qualified mortgage" deserves revisiting. It essentially amounts to a government stamp of approval for mortgages that meet criteria regulators view as making loans less risky. By offering legal protections for making such loans, regulators hope that banks will be incentivized to make more of them. And no doubt they will.

But what if the regulatory view of risk is wrong?

If regulators are not particularly good at assessing risk, we might doubt the wisdom of encouraging banks from making more and more of these loans. If the regulators get the criteria wrong, if the loans wind up being riskier than regulators anticipated, we'll have strong-armed the entire banking sector into taking on not only more risk than expected but the same exact risks. This is a recipe for systemic failure cooked right up in the code of Dodd-Frank.

This is not a far-fetched possibility. One of the reasons our entire financial system became so exposed to highly-rated mortgage securities in the years before the financial crisis was that regulators took the view that ratings reflected risk and the capital adequacy requirements rewarded banks that also adopted this view.

I described this regulatory induced herding of commercial banks and investment banks back in March:

The original Basel financial regulations had a built-in mortgage bias that was intended to encourage banks to acquire mortgage-related assets. The German delegation to the original Basel meetings had urged a tilt toward mortgages in hopes of stimulating their domestic mortgage market. The Federal Reserve reluctantly agreed to accept that mortgages would get a 50 percent risk weighting.

What this meant was that a well-capitalized U.S. bank required to hold 10 cents of capital on for every $1 of commercial loans it made—representing a 10 percent capital requirement—would only have to hold 5 cents for each mortgage it made or bought. The deal was even better for mortgage bonds backed by Fannie Mae or Freddie Mac. They required regulatory capital of just 2 cents on the dollar.

The rules for US commercial banks were changed in 2001 to apply developing Basel II concepts. In order to encourage banks to hold more liquid assets, regulators wanted to encourage securitization and the holding of securities. The new banking rules applied a 200 percent capital requirement—or 20 cents on the dollar—to mortgage bonds rated B or lower; 100 percent—10 cents on the dollar—to mortgage bonds rated BB or BBB; 50 percent—5 cents on the dollar—to bonds rated A; and AA or AAA mortgage bonds got 20 percent—2 cents on the dollar.

The effect of this change on the mortgage-backed security market and commercial banks is told in "Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation," by Jeffrey Friedman and Wladmir Kraus. As they explain, this change in capital requirements led to an explosion of issuance of private-label mortgage securities and a huge buildup of mortgage-related risk on the balance sheet of commercial banks.

So guess what happened when the SEC decided to supervise the Wall Street CSEs using the same Basel criteria beginning in 2004? The Wall Street firms dramatically increased their exposure to the very same kinds of loans that the commercial banks had been gobbling up.

This chart, from a 2009 Federal Reserve Bank of New York staff report by Tobias Adrian and Hyun Song Shin, shows both the steepening curve of the commercial bank acquisition of mortgages following the 2001 change and the parabolic rise of "ABS Issuers"—which means, for the most part, investment banks—acquiring mortgages following the 2004 change.

What the 2004 amendments accomplished, then, was not a dramatic unleashing of leverage but a reorientation of the balance sheets of the Wall Street investment banks toward mortgage-backed securities. Instead of "originating to distribute," the investment banks now had a regulatory incentive to hold mortgage-securities instead of other assets.

The Qualified Mortgage regulations will create a new class of highly desirable mortgages that will likely once again rise to dominate the financial sector.

Making matters worse, regulators are also implementing a similar set of mortgage privileges for something called a "Qualified Residential Mortgage." I know that sounds a lot like a "Qualified Morgage" but the two things aren't exactly the same. The QRM's will be exempt from the risk-retention rules aimed at encouraging banks to make better quality mortgages by forcing them to hold five percent of the risk on their books. Banks are expected to load up on QRMs because they are free from this balance sheet constraint. And this is again based on the conceit that regulators can develop rules that will properly assess which mortgages are less risky.

Banks and self-styled consumer advocacy groups, at least those that want banks to stay loosey-goosey with mortgages, have been pushing to expand the definition of QRMs, just as they have been pushing for the expansion of litigation-resistant Qualified Mortgages. In fact, banks want to merge these two categories into one broad exemption available to loans for a broad array of borrowers, not just those with pristine credit.

The details don't matter so much as the process. The concept of "qualified" in both cases will be decided not on some technical grounds but on the basis of politics and lobbying. Even if the government were staffed with experts knowledgeable enough to determine what should count as "qualified," the end result would likely include too many risky mortgages. And since the government is not omniscient about risk, what we have is the self-interested guiding the semi-ignorant in the creation of rules that will determine a huge part of the balance sheet of the financial system.

I feel safer already. Don't you?

Follow me on Twitter @Carney

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