Bank regulators are set to hold an open meeting on Tuesday to discuss a controversial risk-retention rule for mortgages—and its even more controversial carve-out.
Under the Dodd-Frank financial reforms, banks are required to retain at least five percent of the risk on mortgages they securitize.
The idea was that banks would be more careful about making loans and structuring mortgage-backed securities if they were required to keep a part of the credit risk. From the start, that has had banks griping that this will choke off the mortgage market and raise borrowing costs of home-buyers.
But now financial companies are trying to get around the law by manipulating a carve-out for "qualified residential mortgages." Lawmakers punted on the definition of a qualified residential mortgage when the law was written, charging regulators with deciding what mortgages are safe enough to avoid the risk-retention rules. Obviously, many financial firms would like to see an expansive definition that would reduce their need to retain risk.
On Tuesday, the board of the Federal Deposit Insurance Corporation will hold a open meeting to discuss the rule and the carve-out.
The very first companies to begin agitating for an exemption from risk-retention were Fannie Mae and Freddie Mac. Lobbyists argued that mortgages that mortgages backed by either Fannie or Freddie should automatically be included as qualified mortgages.
That should have been a bit shocking. Fannie and Freddie have demonstrated complete incompetence when it comes to risk management. There is only one possible reason to exempt mortgages they back from the risk-retention rule: because if the mortgages they back go sour, the tax-payers are on the hook. Got that? The argument isn't that the mortgages are actually safer--it's just that the risks don't hit investors because Fannie and Freddie are backed by the government.
The precedent for exempting Fannie and Freddie is something that is actually included in Dodd-Frank. The law said that mortgages backed by the Federal Housing Administration are exempt from the risk-retention rules. The logic for this exemption, as far as anyone can tell, was the same thing: all of the credit risk is borne by the tax-payers, so why require banks to retain any risk.
When I wrote about this last August, it was clear there was a ratchet effect occurring. Exempting the FHA would result in banks crowding into FHA loans, possibly crowding out lending to the broader markets served by Fannie and Freddie. In order to keep that part of the market robust, the exemption needed to be expanded to include them.
That created its own risk. Banks would find it far cheaper to create mortgages that could run through the FHA, Fannie, and Freddie than purely private markets. This would set back attempts to reinvigorate private lending and remove taxpayer backing from the market. Purely private lending would wither.
The answer should have been: let's just get rid of the qualified mortgage exemption for the FHA and refuse to extend it to Fannie and Freddie.
But Wall Street came up with another approach: let's expand the exemption even further to include qualified private insurers as well.
Gretchen Morgenson of theNew York Times explainedwhat's wrong with this approach.
The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured.
But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans. Lengthy litigation between the parties is under way but has by no means concluded.
Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington.
I'd go even further. If we cannot trust the banks, the FHA, Fannie, Freddie or private insurers to evaluate risk properly—why have a qualified residential mortgage exemption at all?
The exemption exists on the assumption that financial regulators can properly evaluate which mortgages are of sufficiently higher quality that they do not require risk-retention. But financial regulators have no way of determining the factors that should be used, the weight given to each factor, and the appropriate levels of each factor.
They can build models, make guesses, consult experts—but we have no reason to believe that these models will be any more effective than the ones that led regulators ignore the perils that led to the financial crisis. More realistically, the factors will be decided politically, under the influence of lobbyists, as a compromise between the interest of regulators and the interests of lenders.
The lobbying we're seeing now will not stop once the definition is set. There will be on-going lobbying to raise or lower a down-payment requirement, an income requirement, a verification rule. Studies will be produced to show that this rule is unnecessary, or that rule is discriminatory.
It wasn't so long ago that everyone from George Bush to Barney Frank to Angelo Mozillo believed down-payment requirements were simply a discriminatory hold-over from the dark ages of red-lining. How long till we're back there?
Perhaps most importantly, the qualified residential mortgage exemption will make the market more homogenous. Banks will crowd into the mortgage markets that count as qualified. This means that if the regulators' view of risk is mistaken—as it almost surely will be—that mistake will be repeated across every major financial institution in the country. It's a recipe for another disaster.
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