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Provision in Sweeping Bank Reform Law to Affect Mortgage Availability

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By Ronald D. Orol

RISMEDIA, January 3, 2011—(MCT)—A behind-the-scenes battle is forming over a provision to the sweeping bank reform law that will affect mortgage availability. At issue is a provision in the sweeping Dodd-Frank Act that requires banks to have “skin in the game” by retaining some of the risk of loans they package and sell.

The goal of the measure is to eliminate a problem leading to the financial crisis where lenders packaged and sold subprime mortgages they knew would fail. Lawmakers drafting the legislation also included a measure that would exempt certain mortgages from the risk retention rule if their loans met certain high underwriting standards.

But reaching an agreement on what the criteria will be for these high-standard loans dubbed “qualified residential mortgages” (QRM) is expected to be difficult and, depending on how regulators rule, a huge slice of the mortgage market could be exempted from risk retention—or only a small piece of the market.

That could have a major impact on what kinds of mortgages are available, and for what price. Mortgage rates have remained near historic lows but mortgage activity is near decade depths.

Reuters reported last week that a group of prominent investors and academics urged top U.S. officials to move quickly to enact the provision, citing the “chaotic situation in the mortgage market today.”

Ernest Patrikis, a partner at White & Case LLP in New York, said regulators must balance how conservative they want underwriting standards to be against how much lending they want to see. What they decide will have a major impact on the kinds of interest rates borrowers with different capabilities will receive. “The borrower that passes the test for a zero-risk retention mortgage will likely get a lower rate on their mortgage than someone that must buy a mortgage that doesn’t get exempted because banks will have to retain some risk there,” he said.

Bank regulators and the Treasury Department are required to work together to draft rules under the watchful eye of a newly formed Financial Stability Oversight Council made up of the heads of bank and securities regulators. A soon-to-be-formed Consumer Financial Protection Bureau, which will write rules for mortgages and other consumer-credit products, will want to be involved as well. Regulators aren’t expected to introduce a proposal for this measure until January.

Washington observers say that regulators, consumer groups and bankers generally already agree to prohibit more exotic or problematic loans from qualifying for the risk retention provision. Specifically, those with negative amortization loans, pre-payment penalties or balloon payments—many of the problematic structures that helped drive the financial crisis—won’t be permitted. Strong credit scores will also be a must as well as effective verification of borrower income.

However, squabbles are already taking place among banks, investors and consumer groups over whether the loans approved under the exemption should have down payments, and if so, how much money down is necessary. Other points of dispute: How many months of verification should be required for a borrower’s income (12 months? 24 months?) and how much debt can a borrower handle. The Mortgage Bankers Association is seeking to include interest-only loans in the definition but consumer groups are passionately opposed.

Big banks are seeking some sort of significant down payment, perhaps as much as a 30% stake by borrowers, arguing that it means homeowners have some skin in the game and would be less likely to abandon the mortgage.

Alternatively, consumer groups are either opposed to having any down-payment requirement or prefer a small down-payment condition.

Finally, smaller banks would like to see a 5% or a similarly small down-payment requirement if borrowers obtain private mortgage insurance and have high credit scores.

Kathleen Day, spokeswoman at the Center for Responsible Lending in Washington said having a high down-payment requirement for the QRM, in the realm of 30% money down, would limit a lot of responsible lending. “Non-standard, non-traditional and predatory products would become part of the universe of the common loan, and it would mean we have the status quo where bad loans are sold as legitimate products,” Day said.

Lisa Rice, president of the National Fair Housing Alliance, a consumer advocacy organization, said a small down payment doesn’t mean the borrower will be more likely to default on the loan. “There are many things that impact a mortgage,” said Rice. “You could take a person who only puts 3 percent down but got their loan at a safe deposit institution or credit union and that loan is better performing than someone who put 20 percent down, got a payment option (adjustable-rate mortgage) and the appraisal was over-inflated.”

Jaret Seiberg, analyst at MF Global Inc. in Washington said he believes regulators will agree to a down payment of 5% for fully documented loans with private mortgage insurance. “Yet this is a real fight, and we continue to worry that the market has ruled out an adverse outcome,” he said.

Wells Fargo & Co. suggested a 30% down-payment requirement, according to a letter the mega-bank sent to the Treasury. The bank argues that a qualified residential mortgage definition that encompasses a large portion of the mortgage market, such as one with a low down-payment obligation, would be ill-advised because it would hike costs for serving credit-worthy borrowers who seek mortgages outside of that definition.

MF Global’s Seiberg reports that some big banks seek a high down payment for the exemption so they can develop products for mortgages that don’t qualify. “A definition of QRM that encompasses a large portion of the mortgage market will produce a tendency to avoid lending to credit-worthy borrowers falling outside that definition,” Wells Fargo stated.

Tom Deutsch, executive director for the American Securitization Forum, which represents mid-sized and large financial institutions and mortgage investors said his members are generally seeking anywhere from a 5-20% down-payment requirement. He contends that a significantly higher down-payment QRM requirement would result in less credit availability for mortgages outside of that definition. “If you are a securitizer, you will have to hold some capital for every mortgage securitized outside of the QRM definition, which means banks will have less capital available to lend for non-QRM borrowers,” Deutsch said.

Seiberg adds that a high down-payment requirement for a QRM loan will mean that most banks and smaller independent mortgage lenders will drive a lot of their lending to Federal Housing Administration mortgages, which are also exempted from the risk-retention requirement.

“The rest of the market will likely reside with the biggest banks, which have the ability to house the mortgages on the balance sheet until the risk retention expires. Yet a low down-payment requirement keeps the door open to competition and should keep mortgage rates low,” Seiberg said.

Consumer groups are worried about access to credit in a scenario where FHA is the only lender for borrowers who can’t afford a 20% down payment.

(c) 2010, MarketWatch.com Inc.

Distributed by McClatchy-Tribune Information Services.

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