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The New FDIC Risk Retention Rules Reject Insurance

Government Regulation
CNBC.com
Government Regulation

One of the more controversial provisions of the new mortgage risk retention rules proposed by financial regulators today is that they don’t allow banks to correct weaknesses in mortgage pools by purchasing credit protection.

Before the financial crisis, banks regularly wrapped mortgage-backed securities with insurance in order to get a higher credit rating. The idea was that the insurance diminished the possible investor losses on the securities, since the insurance company would have to pay if the underlying mortgages defaulted.

Banks argued that the same logic should apply to the risk retention rules. If the risk of losses is taken on by an insurance company, the banks argued that additional risk retention would be redundant. So they wanted to have insured mortgage pools count as "qualified residential mortgages" that would be exempt from the rule that banks retain 5 percent of the risk when they securitize mortgages.

Regulators appear to have rejected this line of argument. They point out that the purpose of the risk retention rule was not merely to diminish losses on mortgage-backed securities but to incentivize banks to police loan quality. Indeed, Dodd-Frank requires regulators to consider whether a provision would reduce defaults on mortgages—rather than just diminish the size of losses.

Insurance may make it less likely that banks or investors will take losses. But it does nothing to make a loan less likely to default. Since one of the goals of Dodd-Frank was to reduce the number of homebuyers who default and lose their homes to foreclosure, regulators made the right choice here.

Regulators were no doubt also cognizant that the insurance that wrapped many mortgage-backed securities did not work as promised during the financial crisis. Many insurers were so severely under-capitalized that they faced insolvency when the bills came due—which meant that investors suffered losses despite being insured. What’s more, the insurers have been arguing that they don’t have to pay many claims because the loan pools underlying the securities did not meet their standards.

Companies that had hoped to offer insurance on mortgage-backed securities are likely to suffer because of this part of the risk retention rules. Before the financial crisis, this was a booming business. It died a swift death when so many insurers went bankrupt. If banks had been allowed to bring mortgages up to snuff through insurance, this would have become a booming business again. Disallowing insurance to make up for loan inadequacies deprives insurers of this subsidy.

Regulators have left the door for insurance slightly open. They are inviting banks to present evidence that insured mortgages are less likely to default than mortgages that are otherwise identical. This is likely to be an impossible task.

The historical data on insured mortgage pools is mixed but—at first glance—it appears to support the contention that insurance decreases the likelihood of defaults. But on anything deeper than a first glance, this statistical illusion does not survive serious scrutiny. It turns out that insurance doesn’t magically make homeowners more likely to remain current on their mortgages. Rather, insured pools of mortgages were sometimes of higher quality than uninsured—perhaps because insurers sometimes required the loans meet higher standards or did their homework on the loans. Once higher quality loans are removed, it’s unlikely that loans in insured pools will default less frequently.

There’s actually reason to suspect that defaults would be more frequent for insured pools if regulators had allowed insurance to automatically make a loan count as a qualified residential mortgage. Banks would be eager to insure the worst loans to avoid carrying a portion of the risk. Investors would have less of an incentive to police loan quality, since the insurance would immunize them from the loss. The incentives for banks and investors to modify loans to avoid foreclosures would be diminished.

Of course, nothing in the rule actually prohibits banks from purchasing credit protection on mortgage securities. If ratings agencies still give credit for insurance wraps, banks are free to take advantage of this. They just won't be able to use the insurance to escape the risk retention requirement.

Given the miserable performance of bond insurers during the financial crisis, the exclusion of an insurance exemption should have been an easy call for regulators. Thanks to intense lobbying from the financial sector, it wasn’t. But—against all odds—regulators are actually doing the right thing here.

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