The 20% Solution: Risk Retention Will Help Reprivatize Mortgages
By Thomas J. White
I was dismayed to learn that an alliance of banks, real estate agents and consumer housing advocates has formed to oppose the proposed 20% minimum down payment for “Qualified Residential Mortgages.”
http://www.americanbanker.com/issues/176_106/consumers-united-qrm-criteria-1038368-1.html
It is a national policy goal that mortgage financing should migrate from the government sponsored enterprises back to the private markets, which remain mostly closed because of investor resistance. Providing standards that promote investor confidence is the key to accomplishing this goal. 
 
http://www.americanbanker.com/issues/176_28/gses-1032715-1.html
Under a provision of the Dodd-Frank financial reform law enacted last year, originators must retain at least 5% of the credit risk in home mortgages they sell unless the loans meet the standards for QRM. Congress left it to regulators to write those standards, and in March they released a proposal including the 20% equity requirement.
Those in opposition say down payment alone does not determine creditworthiness and that other factors should be allowed into the determination of what is a safe loan. However, the purpose of risk retention is not to prohibit the granting of certain loans. Rather, the purpose is to create an environment that will allow the securitization markets to resume financing a substantial percentage of home purchases.
Investors are rightly distrustful of mortgage pools without substantial down payments. There is no coupon high enough to compensate investors for credit losses when those losses arise from systemic risks, and a lack of standards in mortgage lending is a systemic risk. So if the market for residential mortgage securitization is going to be revived, there must be standards that investors can believe in.
Investors do not trust purchasers of homes to buy what they can afford.  Investors do not trust mortgage originators to verify income and (non-real estate) assets across a large pool of mortgages. Investors do not trust the rating agencies to perform due diligence to ensure that mortgage originators are doing what they say they will do. Investors do not trust that the regulators will do anything to protect them. The only things that investors can trust are down payments that are meaningful or risk retention by the mortgage originators.
Many years ago, when banks starting buying receivables from companies, twenty times the expected loss was a rough standard for risk retention.  Twenty percent down payments were the norm when the local bank held mortgages. There is something about the number 20 when conservative bankers are thinking about credit enhancement to protect against loss.  Why should the securities markets deserve anything less?
As for the ability to originate loans that do not meet the “qualified” standard, risk retention does nothing to prohibit such lending. “Non-qualified” loans can be held on a balance sheet or sold into the market with risk retention.  
National policy should be that loan originators accept the risk that they deem prudent and the securitizations should be protected from all but a remote probability loss scenario.  That is the definition of a triple-A security.  An environment like this will keep the cost of home financing at the lowest possible price for those who put up substantial down payments.  That is as it should be. 

To restore balance between GSE and private market activity in the mortgage market, there must be substantial risk retention or substantial down paymentsI was dismayed to learn recently that an alliance of banks, real estate agents and consumer housing advocates has formed to oppose the proposed 20% minimum down payment for “Qualified Residential Mortgages.”

It is a national policy goal that mortgage financing should migrate from the government-sponsored enterprises back to the private markets, which remain mostly closed because of investor resistance. Providing standards that promote investor confidence is the key to accomplishing this goal. 

Under a provision of the Dodd-Frank financial reform law enacted last year, originators must retain at least 5% of the credit risk in home mortgages they sell unless the loans meet the standards for QRM. Congress left it to regulators to write those standards, and in March they released a proposal including the 20% equity requirement.

Those in opposition say the down payment alone does not determine creditworthiness and that other factors should be allowed into the determination of what is a safe loan. However, the purpose of risk retention is not to prohibit the granting of certain loans. Rather, the purpose is to create an environment that will allow the securitization markets to resume financing a substantial percentage of home purchases.

Investors are rightly distrustful of mortgage pools without substantial down payments. There is no coupon high enough to compensate investors for credit losses when those losses arise from systemic risks, and a lack of standards in mortgage lending is a systemic risk. So if the market for residential mortgage securitization is going to be revived, there must be standards that investors can believe in.

Investors do not trust purchasers of homes to buy what they can afford. Investors do not trust mortgage originators to verify income and (non-real estate) assets across a large pool of mortgages. Investors do not trust the rating agencies to perform due diligence to ensure that mortgage originators are doing what they say they will do. Investors do not trust that the regulators will do anything to protect them. The only things that investors can trust are down payments that are meaningful or risk retention by the mortgage originators.

Many years ago, when banks starting buying receivables from companies, twenty times the expected loss was a rough standard for risk retention. Twenty percent down payments were the norm when the local bank held mortgages. There is something about the number 20 when conservative bankers are thinking about credit enhancement to protect against loss. Why should the securities markets deserve anything less?

As for the ability to originate loans that do not meet the “qualified” standard, risk retention does nothing to prohibit such lending. “Non-qualified” loans can be held on a balance sheet or sold into the market with risk retention.  

Securitizations should be protected from all but a remote-probability loss scenario. That is the definition of a triple-A security. An environment like this would keep the cost of home financing at the lowest possible price for those who put up substantial down payments. 

To restore a balance between GSE and private activity in the mortgage market, there must be substantial risk retention or substantial down payments.

Thomas J. White is a former executive vice president and head of credit at Dwight Asset Management and has held senior portfolio and risk management positions at MetLife and J.P. Morgan & Co.