May 27, 2024

DealBook: F.D.I.C. Advances New Rules for Mortgage Securities

Federal regulators voted Tuesday to propose new rules that would prohibit Wall Street banks from unloading packages of risky mortgages on investors without keeping some of the risk on their own books, a leading cause of the financial crisis.

The proposed rule would require banks to retain 5 percent of the credit risk on certain securities backed by mortgages, leaving the banks with so-called “skin in the game” on all but the safest loans.

Wall Street banks, which lobbied to temper the rules, won some limited concessions from regulators. The rules do not apply to so-called “qualified residential mortgages,” conservative loans that meet strict underwriting criteria set by regulators. Banks, under the proposal, also would enjoy leeway in deciding how to retain the risk.

The Federal Deposit Insurance Corporation’s board voted unanimously in favor of the proposal, opening it up to public comment. The proposal was mandated by the Dodd-Frank Act, the financial regulatory law signed by President Obama in July.

The law aimed to prevent Wall Street from returning to its old tricks. During the mortgage bubble, lenders churned out bad loans and Wall Street eagerly sold the loans to investors. None of those players had a stake in how the assets ultimately performed.

“This will encourage better underwriting by assuring that originators and securitizers can not escape the consequences of their own lending practices,” Sheila C. Bair, the F.D.I.C.’s chairwoman, said at a public hearing on Tuesday.

But for now, the rules are unlikely to cause much of a shakeup in the mortgage business, as regulators crafted a gaping exemption: Mortgage-backed securities sold or guaranteed by Fannie Mae and Freddie Mac. As long as the government owns Fannie Mae and Freddie Mac, the mortgage giants will not have to retain any risk associated with their mortgage-backed securities.

The two mortgage finance companies, along with several other government agencies that are exempt under the proposal, collectively cover more than 90 percent of the market. The private securitization market dried up during the financial crisis and is only now making a gradual comeback.

The new proposal “pretty much preserves the status quo in the mortgage market,” Jaret Seiberg, an analyst at MF Global’s Washington Research Group, said in a note on Tuesday. “That means few changes in how things work today for mortgage insurers and originators.”

But the rules are not yet complete — and bank lobbyists are only getting started. Banks contend that the new restrictions will cause the private mortgage market to shrink even further, making it harder for consumers to obtain loans.

Ms. Bair contends that will not happen. “The intent of this rule-making is not to kill private mortgage securitization — the financial crisis has already done that,” she said. “Our intent is to restore sound practices in lending, securitization and loan servicing, and bring this market back better than before.”

Still, banks are sure to push for a broader definition of “qualified residential mortgages,” the safer loans exempt from the 5 percent retention requirement.

“I don’t think they’ll go bananas,” said Jason Kravitt, a partner at Mayer Brown and founder of the law firm’s securitization practice. “But the industry will have to work very hard indeed to broaden the definition of qualified mortgages.”

Under the proposal, borrowers must put a 20 percent down payment on their home purchases for a bank to securitize the loan without keeping a stake. The proposal also requires borrowers to be current on other loans and to earn a certain income if a bank wants the exemption.

The proposal would not exempt notoriously risky loans, like interest-only mortgages and adjustable-rate mortgages that feature potentially huge interest rate increases.

Regulators reassured lenders that the government is open to tweaking the requirements or scrapping them in favor of an alternative approach. The proposal includes nearly 150 questions for the industry to address.

But Mr. Kravitt said Wall Street was unlikely to force an overhaul of the proposal.

“Unless the industry makes a strong case that the proposal will prevent the capital markets from having the capacity to finance mortgages, I think it will roughly stay the same,” he said.

Wall Street already won some leeway with regulators. Banks are allowed to pick and choose how they will keep the 5 percent stake. The risk-retention “menu of options,” for instance, features a “vertical” stake, which would allow banks to retain 5 percent of every tranche of a given securitization, according to a summary of the proposal. The industry also can choose a “horizontal” stake, where banks would bear the first 5 percent of losses on the securitization. An additional option is an “L-shaped interest,” which would combine the two other approaches. Yet another alternative allows banks to keep a representative sample of loans from a securitization deal.

The retention requirements fall not on the banks that originate loans, but the firms that package the loans and sold them to investors.

Although the firms, typically big Wall Street banks, would not be able to hedge against the retention risk, under certain circumstances they would be able to pass it on the liability loan originators.

The transfer must be voluntary, and the originator must have contributed at least 20 percent of the loans in a securitization to share in the risk retention.

The proposal was drafted as a joint effort by the F.D.I.C. and five other federal agencies: the Office of the Comptroller of the Currency, the Federal Reserve, the Securities and Exchange Commission, the Federal Housing Finance Agency and the Department of Housing and Urban Development.

The S.E.C. will vote on the proposal on Wednesday before it begins a public comment period. The F.D.I.C.’s public comment period ends on June 10.

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