By: Vishal M. Mahadkar
Securitization of residential mortgage loans increases credit availability and liquidity as capital market funders from around the world are linked with consumer borrowers. The distance created between consumer borrower and ultimate bondholder, however, results in an originate-to-distribute model of lending that misaligns incentives and encourages shady—and even predatory—lending practices. As we all know, underwriting standards deteriorated, subprime mortgages defaulted, and investors all over the world doubted the underwriting quality of all securities products, which inhibited banks from financing their short-term borrowing needs, leading to outright insolvency for some and a life-line of bail-out funds for others. The flaws in residential mortgage securitization also meant an end to private label lending, as the federal government, through the Federal Housing Agency, originates over 95% of all residential home loans today.
Section 941 of the Dodd Frank Act (the “Act”), or the “skin-in-the-game” provision, is an integral solution to the flaws in the securitization process that seeks to ensure sound underwriting standards and boost investor confidence for all asset backed securities. Representative Barney Frank, the Act’s co-name sake, considers the section the single most important component of the Act’s 2000-odd pages. The Act adds a new Section 15G to the Securities Exchange Act that generally requires originators and securitizers to retain not less than 5 percent of any asset backed security unless all of the assets that collateralize the security are Qualified Residential Mortgages (“QRMs”) or meet other safe harbor exemptions. The Office of the Comptroller of the Currency (“OCC”), Board of Governors of the Federal Reserve System (“Board”), Federal Deposit Insurance Corporation (“FDIC”), U.S. Securities and Exchange Commission (“Commission”), Federal Housing Finance Agency (“FHFA”) and the Department of Housing and Urban Development (“HUD”) (the OCC, Board, FDIC, Commission, FHFA, and HUD, collectively, the “Agencies”) proposed rules to implement the credit risk retention requirements of section 15G of the Exchange Act on April 29, 2011 (the “Proposed Rules”) that were open to public comment until August 1.
The Agencies defined the QRM exemption narrowly, hoping that the QRM will be the exception, not the rule—that is, the Agencies forecast that most home loans in the private label market will be non-QRM loans where securitizers would be required to keep some “skin-in-the-game.” Some of the QRM provisions are easily understandable, such as no-balloon payments, caps on interest rate shocks on adjustable rate mortgages, and verification of a borrowers credit history. Other aspects are stringent and controversial: a 20 percent down payment from the borrower not including closing costs, a loan to value ratio of 80% (or as low as 70% for a refinancing loan), a front end debt-to-income (“DTI”) ratio (the ratio of the borrower’s monthly housing debt to the borrower’s monthly gross income) of no more than 28 percent and a back-end DTI (the ratio of the borrower’s total monthly debt to the borrower’s monthly gross income) of no more than 36 percent. Rule makers forecast that the additional costs of skin-in-the-game should only increase the interest rates on non-QRM loans by 10 to 15 basis points.
The Proposed Rules have ironically united mortgage originators, consumer advocates and financiers alike in fierce opposition to the QRM. “The arguments are divided into two camps: those who think that the rules will make homeownership too costly for some and those who want their business incorporated into the rule.” The better argument generally assumes that the additional costs of skin-in-the-game in non-QRM loans will ultimately be passed on to consumers in the form of high interest rates. There is wide divergence in how great the interest rate premium on non-QRM loans will be, but some reports forecast that the rates could increase by as much as 100 basis points. Consequently, commentators worry that borrowers who have the ability to repay, but who would not meet the stringent QRM standards, would be stuck with prohibitively costly non-QRM loans.
Despite the broad push back to the proposed QRM rule, rule makers should stay firm and adopt a narrow QRM. Investor confidence is the most important factor in restoring liquidity to the private label mortgage market. Both rule makers and critics admit that many borrowers who pose a low default risk will be denied QRM loans under the Proposed Rules. This knowledge will certainly boost investor confidence in the non-QRM market, and allow securitizers to create investment grade quality non-QRM loans. Without risk retention, intermediaries fraudulently passed off subprime mortgages as investment grade to investors. Under the Proposed Rules, the structure should incentivize maximizing both loan quantity and quality, as intermediaries will not want to retain interest in low quality loans. Further, fee generation still provides the economic impetus for securitizing home loans, which should ensure that there is some level of competition in the market for non-QRM loans, which in turn should keep non-QRM interest rates from being excessively expensive.
Pundits fail to understand that investor demand for prudently underwritten home loans, the quality of which is confirmed by securitizers retaining risk, will satisfy the demand for housing for those who can actually afford a home loan. Sure, interest rates of non-QRM loans will be higher than that of QRM loans, but the narrower the definition of the QRM, the smaller the premium will be. Further, credit is a privilege, not a right. If preventing another housing bubble and financial crisis means increasing private label mortgage interest rates by as much as 100 basis points (1 percentage point) to the detriment of some borrowers, so be it.
Should it turn out that a narrow QRM makes mortgage lending prohibitively expensive, then the rules should be amended ex post. In the words of Sheila Bair, former chairman of the FDIC and one of chief promulgators of the QRM, “[t]he intent of this rulemaking is not to kill private mortgage securitization – the financial crisis has already done that. Our intent is to restore sound practices in lending, securitization and loan servicing, and bring this market back better than before.” If we allow regulators to do their jobs—before attacking Dodd-Frank piece-by-piece—perhaps they will succeed.