Effective mortgage reform that works in favor of consumers and preserves a healthy market structure will depend on an accurate diagnosis of the industry's ailments and a strong but measured cure.

Most reform proposals floated so far address issues related to products, "sales practice" standards and stronger risk management, but do not look ahead to the post-reform structure of the mortgage market. Reforms that accelerate consolidation into the hands of a few large megalenders would not be healthy for consumers or regulators.

Consumers benefit most from a diversity of origination sources. Today, those benefits are delivered by hundreds of community-based mortgage banks that bring to the market increased competition, "best execution" secondary market pricing, local market knowledge and high-touch customer service. Preserving a healthy market structure will require reforms that embrace three key principles:

  • A level playing field: Of course, this term means different things to different institutions, and every industry group will be invoking it. The best solution, although politically difficult, is to establish uniform national lending standards. This would ensure that consumers are never in a position of having to know what charter their lender holds in order to know what protections they have. With or without preemption, financial reform must ensure that consumer protections apply equally to all lenders, regardless of charter.
  • "Skin in the game": In the broadest sense, this means putting capital at risk. Proper allocation of risks throughout the housing finance chain is critical to restoring underwriting and risk management discipline. However, if the rules on "skin in the game" overreach, significant damage could be done to market competition, access and product choice. Skin in the game can take numerous forms — retained ownership interests, retention of servicing rights, representations and warranties, and mortgage insurance all serve to put capital at risk by those originating and securitizing mortgages. Multiple forms of risk retention should be recognized and permitted in order to ensure that both balance sheet lenders and secondary market sellers can compete head to head.
  • "Plain vanilla" product standards: This concept is a centerpiece of the Obama administration's new approach to financial regulation. Any such rules must apply to all lenders, regardless of charter, and must be sufficiently flexible to encourage innovation and reasonable choices for consumers. There should be a clear and robust safe harbor for standard products, and measured additional standards for products outside the safe harbor. Making an "alternative" or nonstandard mortgage should not expose lenders or securitizers to draconian sanctions.

Unfortunately, as the reform debate has unfolded in Washington over the past few months, some in the industry have cleverly constructed a narrative that blames the "shadow banking system" for the mortgage crisis. In these pages and elsewhere, commentators and policymakers have argued that competition from nonbank mortgage lenders started a "race to the bottom," forcing "heavily regulated banks" to lower their product design and credit standards. As a result, these pundits argue, any new consumer protection standards should focus on the unregulated and underregulated nonbank lenders, with banks retaining their current regulators and their federal charter preemption.
This is a dangerous misdiagnosis of the problem. The risk in following this conventional prescription is a mortgage market that will be dominated by an oligopoly of megalenders.

Independent mortgage bankers did not — in fact, could not — create the exotic products and loose credit standards that are blamed for the race to the bottom. By definition, no mortgage banker can make a loan without an investor commitment to buy it pursuant to specific product and underwriting standards.

Historically, mortgage bankers originated and sold loans directly to the government-sponsored enterprises, or issued securities through Ginnie Mae. This was largely a "plain vanilla" lending operation with a limited product menu tilted toward fixed-rate loans and traditional underwriting and documentation standards.

In the past decade, however, loans were increasingly sold to "aggregators" — predominantly large banks and thrifts that negotiated their own deals with the GSEs and developed alternative products and flexible underwriting guidelines that the government-backed sector could not — or would not — match.

Wall Street firms, with the assistance of the rating agencies, contributed to the rapid expansion of products and guidelines by working with the banks and monoline subprime lenders to develop securitization vehicles for these new mortgages.

Later these Wall Street firms jumped in with both feet by establishing origination and correspondent lending divisions that could feed the securitization beast.

Many lenders that sold to the aggregators followed this race for market share, originating and selling huge volumes of loans pursuant to the guidelines and product standards of the aggregators and securitizers.

In the process, mandated mortgage disclosures did not keep pace with product innovation, the industry failed to take the initiative to upgrade sales practices and risk management to address the increased complexity.

The aggregation process was efficient, perhaps, but it resulted in a significant concentration of market power in a handful of megalenders that were driving product development and the erosion of underwriting standards in the market.

Today, the two largest mortgage lenders account for 44% of originations. The top four — all of them banks — capture almost 60% of the market. Fortunately, however, hundreds of independent mortgage bankers survived the meltdown by sticking to their core business — the "plain vanilla" FHA, VA and GSE products from more than a decade ago.

As Congress transitions from talking about financial reform to executing on it, it would be a mistake to place the blame for the meltdown — and the brunt of reform regulations — on the traditional mortgage banking business model.

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