WASHINGTON — The centuries-old question about a tree falling in the forest best encapsulates the debate over the latest draft of the "qualified residential mortgage" proposal: If regulators create a risk retention requirement that applies to relatively few loans, does it exist at all?

Under the Dodd-Frank Act, lenders were supposed to retain at least 5% of the risk of any loan they securitized. But the law mandated that regulators also provide an exception to this standard, one that — by all accounts — was supposed to be narrow.

What regulators proposed last week was instead broad, allowing any loan that meets basic underwriting requirements to qualify for QRM status. That is fueling criticism that regulators are undermining a Dodd-Frank mandate in the face of pressure from the Obama administration, the housing lobby and community groups.

"It's the exception that ate the rule," said Edward Pinto, a fellow at the American Enterprise Institute. The new proposal "really turns the whole thing on its head. For single family mortgages, risk retention becomes a non-event."

Even some regulators have had difficulty understanding the intent of the latest plan.

"What is the point of promulgating a risk retention standard and then exempting everything from it?" said Daniel Gallagher, who sits on the Securities and Exchange Commission, in a statement after the SEC and five other agencies released the proposal. (Gallagher dissented from the SEC's decision to back the plan.)

At issue is what former Rep. Barney Frank, the co-author of Dodd-Frank, once called "the single biggest thing in the law." After the financial crisis, many analysts said a core cause was that loan originators lacked "skin in the game" because they usually sold their loans into the secondary market and did not have to be concerned with whether the loan eventually defaulted.

Frank in particular set out to change that situation, pushing a provision in the House bill that was designed to force securitizers to maintain some of the risk. Under pressure from the housing lobby, however, the Senate passed an amendment that created an exception for high-quality mortgages, dubbed "qualified residential mortgages," that met certain criteria. In the original Senate language, lawmakers suggested certain criteria that regulators should use in defining that exception, including a reference to a possible 20% down payment requirement. By the time the bill was finalized, however, that language was dropped, although lawmakers frequently described the QRM as a "narrow" exception to risk retention.

Regulators' initial attempt to implement the provision, unveiled in 2011, also included a proposed 20% down payment requirement. But by then, the suggestion was met with a firestorm of criticism from consumer groups, who worried it would cut off credit to low- and middle-income borrowers, and lenders, who said it would raise mortgage prices. Lenders also raised concerns about how QRM would interact with so-called "qualified mortgages," a separate criteria for loans defined by the Consumer Financial Protection Bureau that were given added legal protections from potential consumer lawsuits.

Last week, regulators eliminated any down payment requirement and instead proposed that QRM criteria match that of QM. As a result, any loan that avoids certain characteristics, such as negative amortization and balloon payments, and carries a debt-to-income ratio no higher than 43%, would qualify as QRM.

Most observers estimate that means the vast majority of single-family mortgages will be QRM compliant.

"The exception of the rule is written in such a way to encompass almost the entirety of the current mortgage market," said Ed Mills, a policy analyst with FBR Capital Markets.

To some, that undermines the original purpose of Dodd-Frank.

"Regulators abandoned the intent of the law," said Mark Calabria, director of financial regulation studies at the Cato Institute, and a former top Senate Republican staffer.

By matching QRM with QM, regulators have "punted any responsibility for this, but that's what they were trying to do," he added.

Many observers said abandoning any down payment requirement was a mistake.

"I don't think it needs to be 20%, but at the same time there needs to be something in there higher than zero," said Kevin Jacques, a finance professor at Baldwin Wallace University.

Jacques said that aligning QRM and QM was also an error. The QM regulation was designed to protect consumers, while QRM was designed to protect investors. The two standards did not have to be the same, he said.

"You've got one agency worried primarily about risk to consumers, and you've got another agency worried about risk to the financial system," said Jacques. "They're effectively looking at whether there is something to be gained by bringing these two together. To me, what that says is the bank regulators are not worried enough about the safety and soundness of the banking system as laid out in Dodd-Frank. They seem a bit too preoccupied with consistency of regulation."

To be sure, the latest proposal won praise from a diverse coalition of consumer, housing and industry advocacy groups that had argued the regulators' first attempt at implementing the risk-retention provision went too far. The magnitude of opposition to the original proposal is a large reason why the agencies — in considering such dramatic revisions — opted to issue a second proposal instead of just finalizing the earlier rule.

Ethan Handelman, vice president for policy and advocacy at the National Housing Conference, noted that the provision in Dodd-Frank applied to many other types of loans, besides mortgages, that do not have an exemption.

"It may look like the exemption is replacing the rule, but really it's just a product of the way Congress lumped a bunch of different asset-backed securities together," he said, adding that aligning QRM with QM "makes a lot of sense in terms of creating some clarity for lenders, borrowers and investors."

Others note that the mortgage market has changed significantly since the crisis — that even though the QRM and QM standards would apply to a significant part of today's market, the risky subprime loans of the real estate boom would not have enjoyed the exemption from risk retention. According to some economic estimates, subprime and alt-A loans between 2004 and 2006 made up 30% of the origination market.

"The more important point is that QM prohibits many of the risky practices that led to the problems during the last crisis," said a source from one of the agencies that issued the proposal , who spoke on condition of anonymity. "You are creating a floor so that as conditions improve you are not regressing to an era of low doc and no doc loans, negative amortization, and only underwriting to teaser rates. Data suggest that many of the Alt-A and subprime loans leading up to the crisis had these features and as such would have been subject to risk retention."

Mills said that even if the exception is now the rule, Dodd-Frank has succeeded in raising underwriting standards overall, a key goal of the law.

"The underwriting requirements are very strong," said Mills. "The underwriting requirements here are very consistent with what QRM rules were supposed to do, which was to have mortgages with characteristics that lowered the risk of default."

Yet others see it as a clear violation of the spirit of Dodd-Frank.

"We have essentially diluted the link between credit quality and bank risk taking," said D. Anthony Plath, a professor at the University of North Carolina in Charlotte. "That goes counter to the intent of Dodd-Frank. We're back-sliding into the way things were in 2006 when banks could originate loans without regard for how risky they were. Dodd-Frank was supposed to prevent that."

Observers said regulators were likely overwhelmed by the political forces aligned against risk retention requirements. Even President Obama, one of the top defenders of Dodd-Frank, appeared to suggest recently that regulators make QRM similar to QM. But very few industry stakeholders spoke in favor of tougher QRM requirements.

Critics point to the law itself, which said the QRM definition should include underwriting characteristics that lower the risk of default. But down payments — or the lack thereof — are one of the best indicators for future default, many have said.

Regulators "just caved into the politics," said Calabria. "You had a combination of Realtors and community activists and lenders hating down payment requirements. There's no voice for safety and soundness. There's no constituency for avoiding calamities."

Joshua Rosner, a managing director at the research firm Graham Fisher & Co, said the incident makes it clear that one of the biggest errors in Dodd-Frank was leaving "so much to regulators to decide."

"As a result, regulators are circumventing or ignoring many of the intentions of Dodd-Frank," he said. "QRM was supposed to create the gold standard of mortgages that would be exempt from risk retention. By removing the down payment requirements of the earlier proposal, they've essentially said that almost any mortgage can be defined as a gold standard."

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