The “Skin in the Game” Game
Under proposed mortgage-lending regulations announced on Tuesday by the Federal Deposit Insurance Corporation and the Federal Reserve Board, there basically would be three paths a home loan could take toward securitization, in which it is bundled into an investment offering backed by other mortgage loans and real estate assets.
The most common of the three paths is for the loan to qualify for backing by one of the government-controlled mortgage guarantors: Fannie Mae, Freddie Mac, or by the Federal Housing Administration. At this point, that path covers more than 85% of the loans currently being written.
Path number two, under the proposed regulations, would require a minimum down payment of 20%, bringing the loan in compliance with the regulations’ conservative “qualified residential mortgage” criteria. As a recent Wall Street Journal article explains, the regulation proposal also recommends that homeowners given these loans spend only 28% of their pretax income on their primary mortgage and 36% on total debt, including home-equity loans, car and student loans, and credit card debt. (The Journal also notes that the proposal requests public comment on an alternative approach that would allow for a 10% down payment and mortgage insurance.)
Path number three would require lenders to hold at least 5% of the loans on their books as a way of assuring investors that the lenders have a stake – “skin in the game” – in the mortgages they write and therefore would, at least in theory, be attentive to the quality of the loans they back. The proposed regulations would allow banks a few ways to retain the risk: by holding onto 5% of mortgages whose risk is declared identical, by taking the first 5% of losses, or by holding 5% of every class of mortgage-backed security.
Tougher than expected
The 5% risk-retention regulation is mandated by the Dodd-Frank Act, although the details of the regulation proposal released this week seemed to be more stringent than the banking industry hoped.
“It is quite draconian,” Ellen Marshall, a lawyer who represents banks as a partner in Manatt, Phelps & Phillips, told the New York Times. “It is requiring the 5 percent of risk retention on a huge swath of the market. It is permitting securitization without the retention of 5 percent only in the case of very old-fashioned mortgages.”
The National Association of Home Builders said it pushed for regulation proposals that would avoid slowing the recovery of the housing market. Raising credit standards too high, the association said in a press release early this month, would bump many creditworthy borrowers into the high-risk category, and prompt many lenders – particularly community banks – to simply abandon the residential market, which would dilute competition and make loans even more expensive and difficult to obtain.
On the other hand, reverting to anything that approaches the lending and securities-rating standards that prevailed during the boom years wouldn’t be such a hot idea either. Mortgage lenders are as motivated to move housing into recovery as anyone, and they’re unlikely to be deterred by having to keep a little skin in the game. The FDIC and Fed are soliciting comments from industry and consumer-advocacy groups until June 10; after that, finalizing the regulations is expected to take at least a few more months.