Thursday, August 29, 2013

Regulators Soften on Credit Risk Retention Rule

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Yesterday financial regulators proposed a revised rule addressing the retention of credit risk for sponsors of securitizations -- the proposed rule can be found here (PDF).1  The thought is that by removing the separation between the origination and securitization of loans, lenders will focus more on the quality of loans rather than the quantity, as they would have to keep some 'skin in the game' when structuring asset-backed securities.

The original March 2011 proposal (PDF) required securitizers to retain at least 5% of the credit risk for any risky assets that do not satisfy the requirements of a "qualified residential mortgage" (QRM).  One of the main differences between the original proposal and the new proposal is the QRM definition.

In the original proposed rule, a QRM is "closed-end credit transaction to purchase or refinance a one-to-four family property at least one unit of which is the principal dwelling of a borrower". The mortgage must have a term of at most 30 years and must be secured by a first-lien.  In addition, the borrower must satisfy certain credit requirements including a relatively clean credit report (e.g. no currently past due obligations, etc.), income requirements (debt-to-income ratio not to exceed 28%) and the borrower must put down a 20% down payment (loan-to-value ratio of at most 80%).

Both banks and consumer advocates criticized the original proposal since the overly restrictive requirements on the mortgages would "drastically limit affordable mortgage financing options".  In addition, policymakers criticized the rule fearing that limiting financing options would likely stifle the recovery in the housing market.  The collected comments on the original proposal can be found here.

The proposal's latest incarnation broadens the definition of a QRM and makes the definition consistent with the Consumer Financial Protection Bureau's (CFPB) Qualified Mortgage (QM) Standard (PDF).2  According to the President of the American Banker's Association, the broader definition of a QRM will let lenders issue relatively high-quality mortgages and possibly make loans cheaper since they could sell them in the secondary market.

Of course, by broadening the definition of a QRM, the proposed rule also weakens investor protections by allowing lenders to originate lower quality mortgages and then effectively remove any credit risk from their books through securitization.  As SEC Commissioner Gallagher put it, "What is the point of promulgating a risk retention standard and then exempting everything from it?"
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1 The proposed rule was required by Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (PDF).
2 For more information, see the SEC white paper (PDF) "Qualified Residential Mortgage: Background Data Analysis on Credit Risk Retention."

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