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Poison Pill: How the "Qualified Mortgage" Exception Killed Risk Retention

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WASHINGTON — What was billed as a relatively small exception to a risk retention rule is now in danger of becoming so big it may render the regulation nearly useless.

It was probably intended that way from the very beginning.

While there has been significant debate since regulators unveiled the criteria for so-called "qualified residential mortgages"- which will be exempt from the retention rule - very little has been said about how the exception ended up in the Dodd-Frank law in the first place.

A look back reveals a banking industry ostensibly fighting for a "gold standard" of mortgages, but also lobbying to make the exception the rule, instead of the other way around.

"First they argue for an exception," said Rep. Barney Frank, one of the reform law's co-authors, said in an interview. "Then they argue that because there's an exception, we shouldn't go ahead with the rule. In that sense, they're trying to play a little bait-and-switch."

Believe it or not, the issue — now one of the biggest financial lobbying fights in Washington — gained little public attention at the time it was first broached.

In May 2010, at the height of the debate over last year's sweeping financial reform bill, the Senate Banking Committee had passed a reform bill that included a requirement that banks that packaged loans and re-sold them to investors had to retain a 5% interest.

The provision was intended to address an uncontroversial lesson of the financial crisis: that securitization rules encouraged the creation of risky mortgages because there was usually a greater fool willing to buy even the shoddiest loans.

Republican Sen. Johnny Isakson, the longtime president of a Georgia-based real estate business, took to the Senate floor to discuss the creation of an exemption from the risk-retention rule for "qualified residential mortgages," which would have to meet certain quality standards to be established later by regulators.

His proposal had support across the aisle from Sen. Kay Hagan of North Carolina, home of Bank of America Corp., which lobbied on the issue, and Sen. Mary Landrieu of Louisiana.

Their basic sales pitch was that risk retention was unnecessary for high-quality mortgages.

"We are not going where we make zero down, interest-only, all-day, stated-income, reversed amortization loans anymore," Isakson said on the Senate floor. "But we are going to make the good-old-days loan, where there is a down payment, where there is skin in the game, where there is an income-to-debt ratio, and where the borrower is qualified to borrow the money they are borrowing."

Although the amendment barely registered with the general public, K Street was paying close attention.

According to lobbying records, major industry players lobbied on behalf of its passage, including Bank of America, the Credit Union National Association, the National Association of Federal Credit Unions, the Independent Community Bankers of America, and the Mortgage Bankers Association.

The Senate amendment — introduced by Hagan, Isakson, and Landrieu — sought to loosen the risk-retention rule by instructing the regulators to carve out a category of residential mortgages that would be exempt altogether.

In determining which loans would qualify, the regulators were told to take into consideration "underwriting and product features that historical loan performance data indicate result in a lower risk of default." This language would later become a focal point of the lobbying effort against the regulators' proposal.

The amendment also listed examples of the kinds of underwriting and product features the regulators should consider when they defined a qualified residential mortgage.

The list, which was not exhaustive, included the ratio between borrowers' monthly mortgage payments and their monthly income, the ratio between all of the borrowers' total monthly debt payments and their monthly income, the potential for a sharp rise in monthly payments as the result of a resetting adjustable rate mortgage, and prohibitions or restrictions on interest-only payments and prepayment penalties.

Lastly, the Senate amendment suggested that the regulators, in defining the exemption, consider whether or not borrowers who made down payments of 20% or less had mortgage insurance on their loans.

The amendment passed in the Senate by a voice vote, becoming part of the bill that went to a conference committee responsible for ironing out the differences between the House and Senate versions.

But when the final bill emerged from the conference committee, the QRM provision contained an important change, one which has not previously been reported.

While the bill still included the reference to mortgage insurance as a way to protect against default, the reference to loans with down payments of 20% or less — and indeed any reference to down payments — had disappeared.

This would turn out to be a harbinger of things to come.

After the law was passed, it took regulators until March to define QRM. The criteria, importantly, included a 20% down payment, along with a debt-to-income ratio for borrowers and restrictions on their payment histories.

Although most of these factors were discussed in the law's language, the high downpayment factor and other criteria sparked a sharp backlash from a diverse array of stakeholders.

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Comments (5)
Any reader of this should consider that Salmon's analysis provided a one-sided perspective since virtually all loans with 5% down payments had either FHA or private mortgage insurance and that lender losses were largely covered by that insurance.
Posted by aschweiger | Friday, August 19 2011 at 6:57AM ET
The risk retention law was poor public policy from the beginning. As Bill Isaac pointed out at a ABA conference in March, in the 1970s some large banks created REITs and sold commercial real estate loans to REITs that they sponsored, and were required to keep 10% of those loans. All the REITs failed in 1973 / 1974.

The people who wrote the Dodd-Frank "Wall Street Reform Act" were so misguided that historians will look back at it and shake their head with disbelief.

@Tony S: We'll see if the mortgage insurance companies will ever be able to pay on all their claims to FHMLC and FNMA. To save themselves, they are routinely rejecting 25% of all claims and their claims paying ability continues to dwindle. I agree with Salmon's analysis, low down payment loans are inherently riskier. People's propensity to walk away increases as they are progressively more underwater on their mortgage versus the value of their home. Oh, and don't forget that FNMA and FHMLC needed a $200 billion ($300 billion?) bail-out because they insured and bought so many of these crappy low down payment loans.

30 year mortgages are NOT appropriate for any other than first time home buyers and why some are trying to reconstruct that system with government backing is beyond me.
Posted by Stephen Lange Ranzini | Friday, August 19 2011 at 7:29AM ET
It's not just that people are less likely to default on a loan with a higher down payment; it also matters that those higher down payments provide the bank with an equity cushion that will reduce losses in the event of a default.
Posted by mrates | Friday, August 19 2011 at 7:39AM ET
Salmon's analysis is bad statistics 101. This is what we get when bloggers do our policy analysis for us. Low downpayments during the boom were HIGHLY correlated with high debt-to-income ratios, high interest rates, high fees, 2-28 structures, prepayment penalites and all of the other junk that increased loan risk. There is ample evidence that low down payments (not zero) that are used in otherwise safely structured loans with DTIs not over 40-45% perform fairly well. No loans perform very well when property values fall by 50%, but low-down payment, by itself is not the problem.

Let's look at the plethora of sound analyses out there not at Salmon's junk.
Posted by danimmer2 | Friday, August 19 2011 at 8:45AM ET
As a Banker, mortgage banker & broker, and someone who has worked for the State of MD running failed S&Ls and then for an FDIC entity doing workouts for the failed $32B Bank of New England, I have seen all sides of the issue/problem.

There is no doubt in my mind, and the minds of all regulators that the higher the stake THE HOMEOWNER CAN LOSE, the lower the default rate. Perhaps 20% down is too much in some circumstances but, as a benchmark, it works; so does the old-fashioned DTI of 28
Posted by riisacoff | Friday, August 19 2011 at 10:07AM ET
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