A Flaw in New Rules for Mortgages
By FLOYD NORRIS
That fact was central to the Obama administration’s proposals to fix the housing finance market a couple of months ago, but it seems to have been forgotten by a collection of regulators that proposed rules this week on when banks will not have to retain risks for loans they make.
Perhaps inadvertently, they gave Fannie Mae and Freddie Mac, the government-run housing finance agencies, another competitive advantage. That is exactly the opposite of what needs to be done.
The proposals are generally good. They force lenders to shoulder some of the risk when they securitize all but the safest mortgages. That is what the Dodd-Frank law required, and for good reason. One of the big problems we had leading up to the crisis was that many lenders believed they could profit by making loans while leaving others to suffer if the loans went bad.
But where is that risk to be retained? The law says it should be retained by lenders or securitizers; an unwieldy group of regulators is left to fill in the details. The regulators are also supposed to determine what constitutes a “qualified residential mortgage” — one that is so safe that the lender need not retain any of the risk.
It was those issues that the regulators addressed this week. They decided that “Q.R.M.’s,” as they are called, had to be very conservative, with 20 percent down payments and strict limits on leverage. That is good. If mortgage loans do not meet the highest standards, somebody involved in making the loans should be responsible if they blow up.
Much of the criticism of the proposed new rules seems to assume that no mortgage loans will be made at all if lenders have to keep some of the risk.
“By mandating a 20 percent down payment on qualified residential mortgages, the administration and federal regulators are excluding those without huge cash reserves — which constitutes most first-time home buyers and many middle-class households — from a chance to buy a home,” said Bob Nielsen, a home builder from Nevada and chairman of the National Association of Home Builders.
Regrettably, some consumer advocates have joined in that chorus.
What should happen, said Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation and one of the regulators involved in the proposal, is that “Q.R.M. loans will be a small part of the market,” and other loans will be made by lenders who do have “skin in the game.” The proposal asks for discussion of ways that can be accomplished without forcing banks to tie up excessive amounts of capital.
“Economic incentives,” she said, “are the best check against lax underwriting standards.”
Consider how absurd this debate would have seemed a few decades ago. Then you got a mortgage loan from a bank, which stood to profit if you made your payments and risked loss if you did not. Imagine arguing that no bank would lend if it had to take a risk. What business, people would have asked, did banks think they were in?
Over the decades, banks got out of the habit of actually owning loans. Instead, the loans were securitized, with investors putting up the money. Some loans went to Fannie Mae and Freddie Mac, so-called government-sponsored enterprises, whose securities were widely viewed as backed by the federal government. Others were securitized by Wall Street firms.
Investors should have monitored the quality of the loans — just as Fannie and Freddie should have — but they did not. Lower rungs of those securities would take losses if there were a lot of defaults, but senior tranches were deemed completely safe by bond rating agencies, who assumed that losses would never rise to those levels.
You know what happened. Easy money led to excessive lending and soaring home prices. That led to overbuilding. Mortgages were written on terms that lenders knew home buyers could not really afford. The borrower would pay less than the interest owed for a while, and then payments would soar. It was assumed that a homeowner facing those high payments would either sell the home or refinance the mortgage, creating more fees and more mortgages to securitize.
Then it all collapsed. It turned out that people who could not afford payments did not make them. House prices began to fall, and refinancing or selling at a profit became impossible. Investors wanted no part of private-label mortgages, and banks wanted to lend to only the safest borrowers. Fannie and Freddie would have gone bankrupt without the government stepping in to rescue them.
Now the government is responsible for something like 95 percent of all new mortgages issued. The exceptions are “jumbo” mortgages that are too large to be guaranteed by Fannie or Freddie and that banks are keeping on their books.
The banking system is unlikely to want to keep enough loans to allow the government market share to shrink as much as it needs to, so it will be necessary to re-establish a private securitization market. That market has recovered for many things, like credit card and auto loans, but not for residential mortgages.
What will it take to get a private securitization market going?
First you need investors who are willing to believe that this time is different. The skin-in-the-game rules, plus additional disclosure being mandated by regulators, should help.
Second, you need to make Fannie and Freddie less competitive, without destroying the market. The Obama administration has supported gradually raising the fees they charge for their guarantees and reducing the size of the mortgages they can guarantee. The idea is to develop what some regulators call an exit strategy for Fannie and Freddie.
We don’t know how much fees would have to go up to provide enough for investors to step up, but we do know that the housing market is so weak that rapid radical action would be risky.
In looking to the skin-in-the-game rules, however, the regulators forgot about what seemed important when they were thinking about Fannie and Freddie. Community banks were insistent that they be able to sell loans to Fannie and Freddie without having to set aside any capital. Since the rules say it is the securitizer who is to take the risk — and Fannie and Freddie shoulder the entire risk when they guarantee securities — that seemed to make sense.
But it also gives the government lenders another advantage. Say you are with the First National Bank of Smalltown. You can sell your non-Q.R.M. loans to Bank of America to securitize, and it may try to find a way to make you keep some of the risk. In any case, since it will have to keep some risk itself, it has a stake in carefully monitoring your loan underwriting standards.
If Fannie or Freddie buys your non-Q.R.M. loan, there will be no private sector money at risk. Will they carefully control risks? We can hope. But they sure did not do that before. On the margin, it makes dealing with Fannie or Freddie more attractive to banks, and it makes a private market less likely to develop.
The proposed new rules are open for comment, and there will be intense lobbying to relax the Q.R.M. rules as a way of completely getting around forcing banks to take risks when they make loans. Small banks especially seem to think it is a birthright for them to make money on mortgages without suffering any ill effects if the loans go bad. They argue that they did not cause the last crisis, so they should not have to suffer now.
The founders of many of those little banks — now long dead — would never have thought it possible that such a right could exist. Now it is defended as critical to saving the housing market.
To get a private securitization market going, we need both to make that market more attractive to investors and to make Fannie and Freddie less attractive to banks trying to dispose of loans. This proposal does one, but unfortunately not the other.
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