The risk retention standards under the Dodd-Frank Act being voted on this week by federal regulators are an important part of revitalizing our housing finance system, but they will only work well if we get the rest of housing finance reform right.
CNBC.com
The securitization market blew itself up during the financial crisis and it won’t be rebuilt until investors can have confidence that securitization sponsors’ interests are better aligned with their own. The risk retention standards, which require securitization sponsors to retain a 5 percent interest in the loans they securitize and to hold capital adequate to cover that risk, will help to do that, as will rules on transparency being promulgated by the SEC under the Dodd-Frank Act.
Risk retention and transparency are good for the securitization markets, and strong securitization markets are important for liquidity, pricing, diversity of funding, and reducing the government’s exposure to risk in the whole mortgage market.
Under the proposed risk retention rule, certain “qualified residential mortgages,” or QRM, will be exempt from risk retention. The proposal takes a very conservative approach to these mortgages, for example, by requiring a 20 percent down payment by individual borrowers to qualify.
Mortgages insured by the Federal Housing Administration are exempt from risk-retention. Moreover, Fannie Mae and Freddie Mac satisfy the risk retention requirement for the mortgage-backed securities they guarantee, as long as they are in conservatorship and backed by the United States government.
The risk retention rules, however, only work to ensure mortgage market resiliency and access to responsible homeownership for the long-term, if one imagines a continued role for “conforming” mortgages—mainstream mortgages that today are guaranteed by Fannie and Freddie but don’t involve a blanket rule of 20 percent down payment.
As Fannie and Freddie are wound down, if the future involves new regulated entities or other mechanisms for guaranteeing conforming loans, and whose capital would back a risk retention requirement, then the proposal for a broad risk retention requirement with a narrow exception for QRM, would not preclude access to homeownership for middle class Americans. The private sector would take first loss on such loans, with the government providing explicit back-stop guarantees, paid-for in advance, on the mortgage securities.
The regulators’ proposal, coupled with a sensible approach to the secondary market, would increase confidence in QRM securitizations at the high end of the market, use risk retention to better align interests in the non-QRM securitization market, and leave a broad market in conforming and FHA loans to meet the demand for quality mortgages with lower down payments but sound underwriting and straightforward terms for a broad section of American families. This approach would increase the resiliency of the system while not significantly decreasing access to sustainable mortgages for those who can afford them.
But the proposal runs the risk of shutting off access to homeownership for most families if the QRM standard, which is intended to apply to a narrow segment of the market, instead becomes the de facto “gold standard” for mortgages and morphs into a requirement for conforming mortgages as well.
While borrowers should have “skin in the game,” a 20 percent requirement applied to the whole market is well beyond what is required for prudent risk management and could not be met by most borrowers. Already, the Obama Administration’s proposal for a blanket 10 percent down payment requirement for conforming mortgages goes too far; instead, the required down payment should also be a function of other risk factors, such as debt-to-income ratios and credit score.
Moreover, if the housing finance system is privatized, with no role for government-insured mortgages beyond FHA, and there’s a blanket requirement for high down payments for all mortgages, then access to mortgage credit for most borrowers would be severely constrained. The 30-year fixed rate mortgage would not be available for most American households; the mortgage market would be severely concentrated in the top four of the biggest banks; and rates would go up significantly for everyone.
So the risk retention rules being voted on this week are an important—and positive—development for a revitalized housing finance system, but only if a robust market is maintained in conforming and FHA mortgages, with more flexible—but still prudent—underwriting and straightforward terms.
Michael S. Barr is Professor of Law at the University of Michigan Law School and a Senior Fellow at the Center for American Progress and a CNBC Contributor. He served as Assistant Secretary of the Treasury for Financial Institutions 2009-2010.
