FDIC and Fed Proposal to Exempt GSEs from Qualified Residential Mortgages is Backwards

Earlier this week the FDIC and OCC agreed to terms for defining “qualified residential mortgages” and have agreed on new rules for risk-retention in mortgage banking. Dodd-Frank directed all federal bank regulators—the Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, Federal Reserve Board, Securities and Exchange Commission, Housing and Urban Development Department and Federal Housing Finance Agency—to work together in a joint process to define underwriting standards for what would be a safe mortgage, the so-called QRM, and then directed that banks be required to hold 5% of the value of any mortgage that was originated with terms outside the QRM definition to cover the risk involved.

Mortgage Servicing News has the story:

Under the agreement, which still must be ratified by other agencies involved with the issue, servicers would be required to offer a loan modification when the value of a borrower’s home is greater than its value in a foreclosure. Loss mitigation activities would have to be initiated within 90 days after a borrower was delinquent, and such procedures would have to be disclosed to borrowers prior to a mortgage closing.

The servicing rules come as part of risk retention standards, which were required by the Dodd-Frank Act enacted last year. As part of the deal, borrowers would have to make at least a 20% downpayment to meet criteria that exempts lenders from retaining a portion of the loan when selling it into the secondary market. […]

But the banking agencies have fought for months over whether servicing standards should be included as part of the QRM exemption, with FDIC Chairman Sheila Bair arguing it was the best way to fix ongoing problems in the servicing arena. The OCC, however, favored separate servicing standards, saying the risk retention rule was not the appropriate place to handle the topic.

The Fed has been working for weeks to broker an agreement between the FDIC and OCC. Under the deal, both sides get what they want. Servicing standards will become part of the QRM, but the agencies will also continue work on separate servicing standards.

An additional—but not trifle—issue here is news that loans sold to Fannie Mae and Freddie Mac will be exempted from the risk-retention rules. This is completely backwards. The GSEs should not support more risky mortgages, that is terrible public policy. Rather, while we still have GSEs—Treasury and GOP are committed to finding a path to shut them down—they should be limited to only QRMs.

If the government is going to say, “This over here is a safe mortgage, and if loan money on more risky terms you will have to hold 5 percent,” then why would it also be okay to say, “But if you sell to Fannie and Freddie you can make loans more risky than our definition of safe and you don’t have to hold the 5 percent either.” Why should the taxpayers have to take on that risk?

(Even the GSEs might find this ridiculous, as Freddie Mac recent announced it will require a minimum 5 percent downpayment on all mortgages it purchases.)

Also at play here is the validity of the servicing standard rules. Originally the servicing standards portion in this agreement was not directed to be a part of the rules for risk-retention. And there is some question about whether regulators have the authority to establish mortgage servicing standards. Fed Chairman Bernanke was not certain about the extent of Fed authority at today’s hearing before the House Financial Services Committee.

If these rules hold it could mean serious changes for the securitization market. The large banks would be able to absorb the 5% rules, but for originators that operate with little capital in reserve, this could be a death blow. Some industry experts suggest this could spark the rise in a covered bonds market, but only if Congress creates a legal framework for the mortgage investment tool later this year. FDIC Chair Bair has suggested, though, that the final rules will not be damaging to community banks.

While the FDIC, OCC, and Fed are on board with these terms, the SEC, HUD, and FHFA still need to sign their consent.