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.
Posted in Capital Markets, Dodd-Frank, Housing, Real Estate, Securities Regulation
Tagged Section 15G, securitization, skin-in -the-game
5 Comments
- Fordham Corporate Center
FHA, VA and conventional loans — the overwhelming bulk of all financing — will not require 20 percent or a 5 percent reserve.
You’re right for the short term. The rules exempt mortgages backed by the FHA from risk retention. Until the gov’t backs out of Fannie and Freddie, the credit risk retention rules will have a limited effect on the market, considering only 5 % of mortgages originated today are private label.
While I believe your efforts at undertanding what happened in the housing sector – and your subsequent desire to try and ensure it does not happen again – are both well intended, you need to research your topic to a far greater degree. First, I would recommend you look at the entire history of Fannie Mae/Freddie Mac/FHA. Though great problems (clearly) occured over the last 8 years, the decades long history represents a very stable, safe, impressive, cost effective mortgage finance strategy. The problems that occured were NOT a result of traditional private-label financing issues. Nor were they necessarily a problem of deception in the up-front origination channel (though that was a contributing factor). Ultimately greed – in the desire for greater and greater amounts of mortgage securities – resulting in the steady deterioration of underwritig quality to fill that desire (and loan officers/mortgage companies all too unfortunate willingness to exploit that desire) – led to the downfall. To entirely throw out decades of effective mortgage lending because of the practices of the last 10 years, without effctively identifying which practices led to the problems, is a major mistake. To then say “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.” is truly a poorly rationalized statement.
Eliminating a substantial number of (legitimate) borrowers is bad enough – and should not be taken in such a haphazard way- but is still not the end of the world, just a shame. Creating policies that will only lead to the drastic increase in size of the “Already too big to fail” big banks, eliminating much of the smaller to mid-size origination channels (with that volume funneling to the big banks, relatively dramatically increasing the cost of home ownership, and increasing the length of time it takes for the US (and the rest of the world) to get back on more sound financial footing are ALL highly probable results of what you call for. Is that worth making draconian changes that don’t address what the real problems of the last 8 years were? Changes were necessary. Requirements that don’t allow the craziness that occured in the last 8 years are necessary. Swinging the pendulum wildly back to far side of risk is detrimental, dangerous and unnecessary. Freeway deaths occur to a far greater degree when the speed limit is 75 verses 55. Does that mean, to avoid freeway deaths we should lower the speed limit to 30MPH? That is an equivelant to what you are calling for.
in 2009, only 30% of all loans originated would have met the QRM definition…..even less for QM…. Here is a question for you… What would the economy look like if the auto industry lost the ability to finance 70% (or more) of their product?
Thanks for the comments but your analyses are misguided.
First of all, that 70% of loans originated today are not QRM does not mean that the private label industry has lost 70% of the ability to finance homes—it means that originators and securitizers actually have an incentive to monitor 70% of the loans that they had previously dumped off to investors.
Second, what is to protect consumer borrowers and investors in a world where securitizers and originators operate under an originate-to-distribute model of lending? It is evident that the prior model failed spectacularly and that diversification alone did not make securitized lending safe.
In the pre crisis RMBS market, the parties in the securitization chain, namely mortgage originators, sponsors and credit rating agencies, all acted in their best financial interests, to the detriment of investors. These parties all generated large fees for their role in the securitization chain, retaining little—if any—exposure to the loans they distributed. The proposed credit risk retention rules are a rebuke of the originate-to-distribute model of lending that seek to encourage better loan underwriting by giving securitizers and originators a financial incentive to monitor carefully the loans that they pass off to investors. Further, risk retention places default risk where it is best internalized—by the individuals who create and best understand the RMBS (and related re-securitizations).
Empirical research suggests that the expansion in mortgage credit to subprime borrowers was caused by an outward shift in the supply of mortgage credit by lenders (i.e., lax lending standards, abuses of intermediaries, demand from investors) rather than borrower’s demonstrating greater income potential (See Atif R. Mian and Amir Sufi 2007). Because there is a nearly insatiable demand for triple AAA rated debt on the market, securitization was used as a tool to create artificial supply (See Gorton and Metrick 2010). This was made possible because mortgage brokers cut as many loans as they could—even to individuals with no income job or assets—and distributed these loans to sponsors. Sponsors then turned the loans into ABSs and made increasingly complex re-securitization products, such as CDOs, CDO-squared, and CDO-cubed (not to mention purchased CDSs to eliminate any residual exposure on loans), which enabled them to pass any risk they retained in an ABS to investors.
Sophisticated investors in RMBS products (and related re-securitizations), such as pension fund and hedge managers, were unable to properly price risk nor understand how the structured finance worked. Without originators or securitizers monitoring loan quality, sophisticated investors were reliant on credit ratings agencies to reveal the loan quality in securitization pools. Contrary to their better judgment, however, credit ratings agencies gave risky ABSs and re-securitization products—that they knew were prone to high default rates—investment grade ratings in order to generate future business from sponsors.
To put it simply, all of the players best able to monitor loan quality failed to do so pre-Crisis because they had no financial interest in the long term performance of the mortgage loan. Financial incentives are the best way to ensure that loans are properly monitored. In fact, studies have shown that default rates in the RMBS market were lower when originators and sponsors were affiliated entities, whose financial incentives were aligned (Demiroglu and C. James 2009).
The Proposed Rules do not put decades long private label lending to an end (as you critics suggest)— they simply make the system more akin to what it was prior to modern securitization when community mortgage originators actually retained some of the risk on the loans they gave to consumer borrowers. Further, the QRM rule does not eliminate fee collection from the securitization picture; instead, it simply aligns the interests of those who collect fees with the interests of investors whose returns are tied to the performance of the mortgage loan. As critics to the QRM point out: a narrow QRM means that many safe loans will be non-QRM. This in turn means that there should be sufficient investor demand in these products to make non-QRM lending safe for investors and affordable to consumers.