May 19, 2024

DealBook: F.D.I.C. Proposes Rule to Tie Banks to Mortgage Risk

Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation.Andrew Harrer/Bloomberg News Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation.

8:17 p.m. | Updated

Federal regulators, seeking to outlaw a leading cause of the financial crisis, voted on Tuesday to propose new rules that would prohibit Wall Street banks from selling packages of risky mortgages to investors without holding onto a stake in the loans.

The proposed rule would require banks to retain at least 5 percent of the credit risk on securities backed by mortgages on all but the safest loans, leaving the banks with “skin in the game.” So-called qualified residential mortgages, conservative loans that meet strict underwriting criteria, are eligible for an exemption.

Months of contentious debate, most of it focused on the definition of qualified residential mortgage, led up to the vote. Some banks lobbied hard to broaden the definition, but without much luck. Banks did win leeway for choosing how to retain the risk.

The Federal Deposit Insurance Corporation’s board voted unanimously in favor of the proposal on Tuesday, 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.

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

But for now, the proposal is unlikely to cause much of a shake-up in the mortgage business. It does not apply to securities carrying a government guarantee, which represent more than 90 percent of the market.

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 report on Tuesday.

The rules are not yet complete — and industry lobbyists are only getting started. Banks, home builders and other industry groups argue that the new restrictions will cause the private mortgage market to shrink even further, making it harder for consumers to obtain loans.

Ms. Bair says 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.

Still, banks are sure to push for a more flexible definition of qualified residential mortgages.

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

Under the proposal, a bank can securitize a loan without retaining a stake if a borrower puts a 20 percent down payment on a home purchase. Some industry insiders complain that 20 percent is excessive.

“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,” Bob Nielsen, chairman of the National Association of Home Builders, said in a statement.

The proposal also requires borrowers to be current on other loans and to meet an income threshold 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 was open to tweaking the requirements or scrapping them in favor of an alternative.

But some banks are at odds on the best approach. And Wall Street, Mr. Kravitt said, is unlikely to force an overhaul of the proposal, which does allow banks to have some choices about how they will keep the 5 percent stake.

The proposal was drafted as a joint effort by the F.D.I.C. and several other federal agencies, including the Securities and Exchange Commission and the Department of Housing and Urban Development.

As the lending industry scrutinized the proposal, some securities experts praised the regulators.

“There’s nothing wrong with securitization, but it won’t work if you don’t have an honest assessment of the risk of the loans,” said D. Anthony Plath, an associate professor of finance at the University of North Carolina, Charlotte. “Without skin in the game, you’re playing musical chairs with mortgages.”

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