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.