New US rules to cut mortgage risk, improve underwriting

Adam Jeffery | CNBC

U.S. federal regulators on Wednesday will unveil a reworked proposal aimed at reducing risk in the mortgage market and limiting the type of shoddy underwriting practices that fueled the housing bubble.

The Federal Deposit Insurance Corp (FDIC) will vote on whether to release for public comment rules requiring lenders and bond issuers to keep a stake in loans that they bundle and sell as securities, with the exception of mortgages that are labeled low-risk.

Five other agencies, including the Federal Reserve and the Department of Housing and Urban Development, were required by the 2010 Dodd-Frank law to work on the rules and are expected to put forth similar proposals shortly.

The plan, which is being re-proposed after an initial version drew wide criticism, is expected to loosen the definition of "qualified residential mortgages" that are exempted from the regulations.

Regulators originally said banks and bond issuers would have to keep "skin in the game," or hold part of securitized loans on their books, unless the mortgage included a 20 percent down payment.

That proposal in 2011 caused alarm across the housing industry and among consumer groups. They feared the rules, as originally set out, could restrict access to credit for some low-income borrowers.

In the new proposal for public comment, the agencies are expected to eliminate the downpayment requirement for qualified residential mortgages.

Instead, mortgages that meet a minimum standard already approved by another regulatory agency will be considered exempt from the risk retention rules.

"It's very important that they're making this re-submission," said Barry Zigas, director of housing policy for the Consumer Federation of America. "I think it's a reflection of the fact that there was a very, very broad range of unified comment on the difficulties the proposed rule might create."

Future mortgage finance framework

The new proposal comes amid a slew of changes inspired by the 2007-2009 financial crisis. Regulators have cracked down on mortgage underwriting, the way banks deal with borrowers with outstanding loans, and other aspects of lending.

Lawmakers also intend to overhaul U.S. housing finance in response to the market collapse that forced the 2008 takeover of Fannie Mae and Freddie Mac, a process that could take years.

The risk retention rules are aimed at preventing banks from writing risky loans with impunity. In the years leading up to the crisis, banks used shoddy underwriting standards under the assumption that they could sell loans off to securitizers and avoid harm if the borrowers defaulted.

Dodd-Frank called for lenders and bond issuers to hold 5 percent of those loans on their books, giving them more incentive to make better loans.

The law called for some mortgages to be exempt but did not require a downpayment. When regulators decided "qualified residential mortgages" would need a 20 percent downpayment, critics said that could hamper credit and hurt the economy.

"The reaction was fairly extraordinary and unanimous from consumer advocates, industry experts and housing stakeholders - all aligned around the fact that the rule as proposed could have had an adverse impact on the housing recovery," said David Stevens, chief executive of the Mortgage Bankers Association.

Regulators instead plan to scrap the downpayment and match the "qualified residential mortgage" exemption to the Consumer Financial Protection Bureau's standards for good mortgage underwriting.

The consumer bureau's standard, which is part of rules requiring banks to make sure borrowers can repay loans, includes mortgages that have low fees and that go to consumers who do not have big debt loads already.

The six agencies also plan to ask for public comment on a number of additional questions, including whether or not a downpayment requirement should be added for exempt loans.

Regulators hope to complete the risk retention rules by the end of the year, before a series of unrelated mortgage rules takes effect in early 2014.