The Dodd-Frank Act ignores the political origins of the subprime lending debacle, including the massive regulatory failures, by blaming Wall Street for victimizing mortgage borrowers. By following the pattern of the Depression-era financial legislation that Dodd-Frank replaces, this political diversion has set the stage for a return to the status quo ante.
Its securitization requirement "to have skin in the game" may well exacerbate "regulatory arbitrage" among funding choices. It maintains and arguably doubles down on all of the conflicting social goals imposed on erstwhile "prudential" regulators.
Capital market funding: Policymakers are off to an auspicious start implementing a new framework for capital market financing. Basel III capital rules, covered bond rules and securitization rules have all deteriorated into independent political negotiations within the same framework of SEC-sanctioned reliance on credit rating organization ratings. Dodd-Frank required securitizations to retain the "riskiest" 5% retained interest. There is now a political battle over which mortgages will be exempt from this requirement and which tranche is the "riskiest." Based on the past experience with subprime loans, the securitizations of the worst predatory loan pools with the highest promised coupons can produce relatively worthless residual interests of 5% of the underlying pool — interests that can subsequently be written off — with reported securitization profits from stripping out illusory future yield exceeding the subsequent loss.
Private mortgage securitization is easily repaired so long as strict regulatory principles are established to prevent arbitrage. Regulators have long been aware of the generic problem of regulatory arbitrage in securitization, but remain unfamiliar with the details. The solution requires not only formulating and implementing Basel III correctly with capital requirements appropriate to the risk, but full coordination with capital market regulators for comparability of mortgage-backed securities with covered bonds and portfolio lending. Either risk-based capital rules should not refer to the rating agencies regarding MBS, or the regulators will also have to regulate the raters.
There is no need to ban senior/subordinated securitization structures, but all securitizations done by banks should be treated under generally accepted accounting principles as a financing — rather than asset sale — comparable to deposit or covered bond funded financing. In addition, the risk-based capital requirement should be based on the risk of the underlying mortgages rather than the financing technique chosen. The lowest requirement — 50% under Basel I — should be reserved for loans with verified 20% cash down payments — or with private mortgage insurance — that meet strict underwriting criteria. The requirement for other loans should be much higher, and high-risk loans — including, where appropriate, those underwritten to meet social goals — higher still.
Nonbank mortgage banks (or independent subsidiaries of bank holding companies) should still be able to securitize with asset-sale treatment. But primary mortgage insurance should be required for all loans with an initial loan-to-value ratio above 80% to mitigate moral hazard of loan originators, and excess servicing revenue should not be reported as income unless and until the servicing contract is sold as well. Nonbank finance companies could be allowed to finance riskier uninsured mortgages with senior/subordinate securitization structures, but these should be recorded as financings under GAAP to avoid the illusion of excess profitability caused by "present value" accounting.
Separating subsidy from prudential regulation: The Federal Deposit Insurance Corp. should be stripped of all enforcement responsibility for social lending goals and have final say in all bank prudential regulatory matters. The regulation of capital markets should also be consolidated in a purely prudential regulator, the Federal Housing Finance Agency being the most likely candidate once stripped of enforcing social goals. Oversight of the Federal Housing Administration (and Ginnie Mae) should be shifted from the Department of Housing and Urban Development to an exclusively prudential regulator, the FHFA again being a good candidate. State insurance regulators should retain primary responsibility for private mortgage insurance oversight.
The U.S. has a long history of transparently budgeting and targeting direct homeowner subsidies, delivered separate from finance in nondistorting ways. HUD is already responsible for managing funded subsidy programs, enforcing social lending goals and enforcing home-borrower protections.
