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.

Not only did lenders, Realtors, and home builders object, but so did consumer groups and others that advocate on behalf of low-income and minority borrowers.

A lobbying group calling itself the Coalition for Sensible Housing Policy formed in opposition to the 20% down payment proposal. Its 46 member organizations include not only industry groups, but also non-profit organizations like the Center for Responsible Lending, the National Fair Housing Alliance, and the NAACP.

Ultimately, 320 members of Congress — both Republicans and Democrats, including Isakson, Hagan and Landrieu — have urged regulators to ease QRM standards. One of their key arguments is that the regulators ignored the intent of Congress.

But that argument doesn't wash with Mark Calabria, a former Republican staffer on the Senate Banking Committee staffer who is now director of financial regulation studies at the Cato Institute. He said that the regulators followed the direction they were given in the law.

"I'm not a fan of what they came up with, but what they came up with is absolutely consistent with what they were directed to come up with in the statute," Calabria said.

These days, lawmakers like Isakson aren't so focused on the need for down payments — something he once suggested should be mandatory on the Senate floor.

"We don't have a down payment problem in this country, but rather an underwriting problem," Isakson said in June.

Hagan made a similar argument in a recent interview.

"I think that by just putting this 20% down payment rule and narrowly defining the qualified residential mortgage, it would be harmful to the economy," Hagan said. "I think that too many middle-class families would not be able to purchase a house if it was a very, very narrow exception."

The lawmakers and groups supporting them argue that QRM loans will face a much lower interest rate, while all other loans will carry a higher cost.

But it is not at all clear how large the gap in mortgage rates will actually be.

In June, then-Federal Deposit Insurance Corp. Chairman Sheila Bair said that she believed that QRM borrowers will receive savings on their interest rates of only about 1 to 15 basis points. The coalition of industry and consumer groups cites a much larger estimate — a spread of 80 to 185 basis points.

Susan Wachter, a professor of real estate finance at the Wharton School, University of Pennsylvania, expressed skepticism about any claims of certainty regarding the likely market impact of the QRM rule, given that so many other parts of mortgage-finance reform are still to be decided.

For example, the future of Fannie Mae and Freddie Mac remains up in the air. Also undecided are a broader set of mortgage rules that will likely contribute the contours of whatever private securitization market eventually re-emerges from today's housing bust.

So the lobbying fight over QRM is shaping up as the opening round in a broader, multi-year debate over the future of the U.S. mortgage finance system, she said. "It is problematic to be building it without a larger frame," Wachter said.

Another central argument of the industry's lobbying is on shaky ground.

Because last year's reform law calls on the regulators to incorporate loan features that are linked to lower default rates, the coalition of industry and consumer groups has sought to show that a high down payment should not be considered such a feature.

"High down payment and equity requirements will not have a meaningful impact on default rates," the lobbying coalition argued in a report issued in April.

That report included data showing that well-underwritten, bubble-era loans with a down payment of at least 5% had default rates that were not a great deal higher than for loans that met the same underwriting standards and had a down payment of at least 20% percent.

But when the numbers are sliced differently, they tell a different story.

Reuters blogger Felix Salmon dug into the same source data, and found that overall, loans with low down payments have substantially higher default rates than loans with higher down payments.

Looking at loans from 2002 to 2008, Salmon found that mortgages with down payments of 20% or more had default rates of less than 5%, while mortgages with down payments of 5% or less had default rates of around 16%.

Salmon even concluded that it made a significant difference to have a down payment of 15% to 20%, versus 20% or higher.

"The lower the downpayment, the more likely a loan is to become delinquent. By far," Salmon wrote. "That's a simple fact which the mortgage lobby will go to astonishing lengths to hide."

Ironically, risk retention was once seen as one of the least controversial items in Dodd-Frank. Yet it appears unclear whether anyone is fighting to maintain the tough QRM requirements that would leave the retention rule for residential mortgages mostly intact.

Frank and Bair, who left the FDIC in July, have both said they would prefer that the exemption from risk retention didn't exist. Frank noted that the House version of reform never included a QRM exemption, and said he only accepted it because he needed the Senate on board.

"It became important to get the bill through, particularly in the Senate, to have one. And that's what we did," he said.

But Frank appears outnumbered in Congress, and Bair is no longer with the FDIC. Facing significant political pressure from virtually every major player in the market, FDIC Acting Chairman Martin Gruenberg, who has been nominated to succeed Bair, hinted recently that regulators are rethinking their position.

At his July 26 confirmation hearing, Gruenberg said there is a need to strike a balance between the securitization problems demonstrated by the financial crisis and the need to provide access to mortgages for creditworthy borrowers.

"I think that is the challenge of this rule," Gruenberg said. "I think we understand close review of this rule is going to be necessary."

Which raises another question: If the regulatory reform law creates a risk retention standard that does not apply to most residential mortgages, will the regulation even matter?

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