Will the Eliminating Risk Retention Provision of the Dodd-Frank Act Bring Back Risky Mortgages?

Will the Eliminating Risk Retention

 

The Wall Street Journal headline reads “More Risky Loans Allowed.” It is a non­ subtle “shot” at Washington for eliminating the risk retention provision, once a primary component of the Dodd­-Frank Act, forcing mortgage lenders to retain, at least, a small percentage of every mortgage sold into the secondary market. The focus was to effectively prevent another housing bubble, replete with its unfortunate “boom and bust” features.

The Federal Housing Finance Agency, in its attempts to expand credit and lending, supports lowering down payment minimums back to three percent. Late October 2014 also saw the Federal Reserve (and other regulators) approve rules that permit private mortgage­-backed securities with no down payments of any level. Dissenters note that bureaucrats should never be allowed to dictate terms of private contracts of any type.

New Congress Reforms?

Since the midterm elections are now a fait accompli, it appears the new Congress is charged with creating significant reforms in the housing market financing arena. Until or unless that happens, Fannie Mae, Freddie Mac and the FHA (Federal Housing Administration) will still dominate the housing finance market, as they have in the past.

The original Dodd­-Frank Act (2010) referenced “qualified mortgages,” as those eligible for sale or securitization in the government­ related mortgage financing market. Qualified mortgage sales included a provision that forced lenders to retain a percentage, originally at least five percent, of the mortgages they sold.

The theory: Instead of selling 100 percent of their mortgages, leaving zero risk for banks and other direct lenders, they would retain some risk of default, unlike the unbridled lending in the residential market during the first decade of the 21st century. After passage of the Dodd­-Frank Act, the common phrase became “everyone has skin in the game,” noting that all participants had some risk for losses.

Skin in the Game—Or Not?

The Wall Street Journal calls the new rules, the “no ­skins game,” since borrowers need not have any deposit and lenders need not retain risk. The regulators continued to use the phrase “risk retention rules,” even as they waived the original minimum retained ownership regulations.

When the new Congress debates mortgage reforms, it will face mounting pressure to eliminate the no risk modification before a new housing bubble rears its dangerous head. Reforms that stimulate safer lending are welcome; another housing bubble and the inevitable meltdown that follows are not.

Another “feature” of the new rules may be even more damaging to the business community. Regulators mandated lender risk retention for “leveraged loans.” This financing involves bank loans to companies already carrying heavy debt loads.However, regulators placed the five percent risk retention rule on the buyers, not sellers, of these contracts.

Opponents rail that there is neither logic nor accountability on the banks or lenders making these risky loans.

Regulator Motivation

Whatever the regulators’ motivation, an unintended consequence may potentially surface. This initiative may well discourage lending to commercial organizations. Should investors rebel at the percentage of leveraged loans in collateralized loan obligations (CLOs), the market for loan purchases may dry up. Lenders would then be forced to keep business loans in their portfolio, while assuming all of the risk of default. Since the Fed has now ceased its massive investment in mortgage securities and CLOs, the potential problem could quickly escalate. With low credit spreads already squeezing profit margins, adding further risk to questionable loan packages could turn off the secondary market faucet. Christopher Dodd (Senate Banking Committee) and Barney Frank (House Financial Services Committee) had envisioned a much different outcome for their Wall Street Reform and Consumer Protection Act. Intended to consolidate regulatory agencies, better safeguard financial markets and create tools for managing financial crises. The Dodd-­Frank Act objectives appear to be sidestepped in the latest regulatory action.

Profitability and Asset Preservation

Although profitability remains a primary goal of banking institutions, the lessons learned during the housing and mortgage crisis taught many about the equal importance of asset protection. It appears that, before the housing bubble burst, even experienced lenders may have downplayed the asset preservation factor. The recent regulator actions may give Congress stronger incentives to modify, if not rewrite, the Dodd­-Frank Act, including addressing the repeal of the well­-intentioned “risk retention” provisions. While some of those new to the banking industry may welcome the lack of “risk retention” regulations, seasoned bankers who lived through the Great Recession understand the major role asset preservation plays in keeping financial institutions strong, stable and viable.