Law-makers must get real about risk

Paul Muolo
Paul Muolo is executive editor of National Mortgage News

Never before in the history of the US has Congress (pictured) attempted to undertake the sort of massive regulatory reforms that are now under consideration for the financial services industry. Actually, I shouldn’t say that. Back in 1982 Congress and President Reagan decided to deregulate the sleepy but money-losing savings and loan industry, an idea that seven years later cost the Treasury – read taxpayers – $150bn.

The lesson learnt was that maybe the savings and loans sector only needed a tweak after all, not a fundamental overhaul.

But here we are again with a huge re-jig ahead of us and this time the crisis is much larger in scope – $2trillion or so depending on how you do the math and figure out the end point of the mess.

Just bailing out US mortgage investing giants Fannie Mae and Freddie Mac will cost $200bn, maybe more. Anyway, I guess the intentions of Congress are honourable – make sure such a regulatory failure never happens again while making it financially impossible for banks, non-banks and Wall Street firms to be so stupid again with regard to lending, securitising, leverage and hedging.

Our elected officials are trying to prevent the ’too big to fail’ scenario but are not sure how to do it. In theory, the idea is to prevent financial firms from gobbling up too much of a market and borrowing so much that if they fail they wreak havoc far and wide.

This is effectively what happened when American International Group, a writer of credit default swap contracts on sub-prime mortgage bonds and other instruments, almost crashed and burnt after it was discovered way too late that it didn’t have enough cash to pay off on all the CDS bets it had written. AIG was saved by $80bn in federal aid and for our trouble, we the people now own most of the company.

But surely if our elected officials were serious about preventing ’too big to fail’ they would write a law that put a 5% cap on how many deposits one US bank could gather. Or cap how many loans – mortgage or otherwise – a single institution can own. Or how many CDS contracts a firm can write.

Of course, none of these ideas are on the table, which tells me that politicians are either clueless about finance or comfortable taking donations from the banks they technically oversee.

Non-banks are starting to breathe easier concerning the 5% risk retention rule in the proposed legislation

I could go on for hours about pending legislation but it’s probably best to zero in on what might be the most important aspect for residential originators – risk retention.

The way the law is at the moment any lender that securitises home mortgages, risky or otherwise, must retain 5% of the loans to show they have skin in the game. The intention behind such legislation is sound – no lender in its right mind would originate crappy loans if it too would take a hit on the mortgages underlying the mortgage-backed securities created. Sounds reasonable, right?

Well, yes and no. It has been argued – and there’s plenty of research to back this up – that there’s nothing wrong with funding and securitising A paper mortgages as long as they are soundly underwritten. Let’s not forget that this crisis was caused by poorly underwritten sub-prime loans – mortgages that were made with virtually no employment or income verification checks. If the borrower had a pulse, they got a loan.

If you believe that A paper mortgages are still safe, as I do, you can argue that a 5% risk retention rule would be onerous and financially crippling for small or medium-sized lenders trying to use the securitisation market. Think about it – for each $100,000 mortgage they write and securitise there would be a $5,000 set-aside. Multiply that by millions or billions and it adds up.

Yes, I know 5% doesn’t sound much but the fear is that such capital requirements will force smaller players to close or sell out to bigger fish in the industry.

It should also be pointed out that many of these smaller players retain the servicing rights to the loans they fund. In other words, these organisations already have risk retention. If the loans they fund go south their servicing income disappears.

And a 5% risk retention requirement would be particularly harmful to non-bank residential funders, of which there are roughly 3,000 still in existence – half the number of three years ago. Non-banks tend to have small balance sheets, and they face a tough time getting credit these days.

Now some may say so what if smaller players disappear? Well, if they did it would run counter to preventing ’too big to fail’ wouldn’t it? Having fewer lenders would mean less competition and consumers would have fewer options.

As we go to press non-bank lenders are starting to breathe easier concerning the 5% risk retention rule for MBS issuers contained in proposed legislation.

Lobbyists working the issue say Senators Chris Dodd and Richard Shelby – the committee chairmen in charge of the show – now understand that without exemptions for Fannie Mae, Freddie Mac and Federal Housing Administration-backed mortgages – in other words, A paper loans – many non-bank lenders could disappear leading to further consolidation and yes, more worries about ’too big to fail’.

For non-banks with little or no balance sheet capacity holding 5% of MBS risk could prove expensive, notes one lobbyist working for the mortgage insurance industry.

“If the 5% language stays in you will see this business roll up,” he tells me, requesting his name not be used.

Community bankers are worried about the issue too and are seeking legislative relief. The amendment process began last week and continues for at least another. The non-bank sector is pushing for language that creates a qualified mortgage test with an exemption from the 5% risk retention requirement.

Qualified mortgages would be safe and fully documented loans that do not have interest-only payments, balloon payments or negative amortisation, as Senator Johnny Isakson said recently. It’s hard to predict how the issue of risk retention will play out but at least it seems that

Congress is finally starting to get the picture. Let’s hope.

Paul Muolo is executive editor of National Mortgage News