May 19, 2024

High & Low Finance: A Flaw in New Rules for Mortgages

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.

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