Today's debate about financial services reform has been infected by a puzzling confusion — the failure to distinguish between exotic mortgages and traditionally underwritten mortgage products. It's an essential distinction, one that goes to the heart of the problem Congress seeks to fix.
A one-size-fits-all approach to reforming the securitization process has been driving the debate so far. Legislation passed by the House, and a similar provision expected to come before the Senate Banking Committee this month, would require lenders and securitizers to retain up to 10% of the credit risk on every loan sold or securitized.
But a study conducted for Genworth Financial Inc., in collaboration with the Community Mortgage Banking Project, highlights how across-the-board risk retention is the wrong approach.
The study analyzed more than 20 million loans originated between 2002 and 2008 and found that traditional underwriting standards, such as full income documentation and straightforward loan features, yielded dramatically fewer defaults. Riskier, "nontraditional" mortgages defaulted at a rate nearly three times greater than those underwritten to time-tested, traditional standards.
"Qualified mortgages" — mortgages underwritten using back-to-basics standards — performed 2.6 times better before the housing boom in 2002, and 3.25 times better at the peak in 2005. The conclusion is inescapable: traditionally underwritten mortgages did not cause this crisis.
While I understand the arguments for risk retention, the one-size-fits-all approach being considered by Congress poses significant risks to borrowers and to the prospects for a housing market recovery:
Liquidity for responsible lending will be sharply reduced. The mortgage-backed securities market benefits consumers and helps reduce overall risk in the financial system by matching investors desiring long-term investments with consumers' product of choice – the 30-year fixed-rate mortgage. Without a robust securitization market, the availability of fixed-rate loans will be sharply curtailed. Simply put, bank deposits alone cannot support the demand for fixed-rate loans.
Consumers will face higher costs. — One estimate from JP MorganSecurities indicates the cost of funding through securitization could increase mortgage rates by up to 300 basis points. Although intended to curb risky lending, across-the-board risk retention will impose higher costs on consumers with responsible credit histories who are seeking safe, stable mortgage products — people and products that had nothing to do with the current crisis.
Systemic risk in the mortgage market will increase. Across-the-board risk-retention requirements would hit community-based lenders particularly hard. Companies like mine that not only meet but significantly exceed the minimum-net-worth guidelines of the FHA, Fannie Mae and Ginnie Mae simply are not structured to retain a piece of every loan we originate — that's not how mortgage banking works. Yet we stand behind the representations and warranties on every loan we originate. That is risk retention! Community banks and credit unions also would face severe liquidity constraints and would be forced to curtail their lending. A poorly designed risk-retention standard will eliminate local market competitors and accelerate the consolidation of the market into a few megalenders — an ironic result in a bill intended to mitigate systemic risk.
While the nation is struggling to emerge from the worst economic crisis of a generation, we all want effective safeguards to prevent history from repeating itself. Risk retention should target real risk. As financial reform moves forward, Congress should focus risk retention on securities and high-risk assets that have been proven to generate high defaults, market imbalances and disruptions.
But reform efforts also need to protect what works; traditionally underwritten loans to creditworthy consumers should be exempt from risk-retention requirements.