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October 23, 2014

Weakening reforms in the securitization market to protect mortgage financing from an uncertain threat is a bad trade.

By Stephen Hall, Securities Specialist at Better Markets

The final risk retention rule mandated under the Dodd-Frank law and released this week by federal regulators represents a step forward, but it still falls short of what we need to reform the securitization markets and prevent another financial crisis and devastating economic collapse.  The rule includes a huge loophole for “qualified residential mortgages” that threatens to gut the new risk retention requirement for mortgage-backed securities.

Without any doubt, mortgage-backed securities loaded with subprime loans were the nuclear fuel for the financial crisis of 2008 and the following economic disaster that still haunts millions of Americans with unemployment, lost retirement, and underwater mortgages.  Because the banks and other market participants could make huge up-front profits but off-load all of the risk when they batched up millions of subpar home loans and sold them as securities, they had no incentive to care about the quality of the loans that were packaged and sold.  When the housing market crashed, those securities plummeted in value, many becoming worthless, igniting the financial crisis.

In the aftermath of the 2008 crash, Congress saw that one of the best ways to prevent similar reckless behavior in the future was to impose a meaningful risk retention requirement on the banks and other institutions that package and sell asset-backed securities.  If they have to hold some of the investment risk they are selling, they will have some ‘skin in the game’ and an incentive to take greater care when assembling their asset-backed securities.  And if increased investor confidence revitalizes these markets, then consumers, businesses and local governments can benefit, since they ultimately depend on a healthy securitization market for access to affordable credit, as Better Markets argued in public comments to the federal regulatory agencies in October of last year.

So, “job one” for this rule was to help reform the securitization market, not to protect mortgage financing from the uncertain impact of a strong risk retention rule.

Unfortunately, today’s rule includes a massive loophole that will exempt the vast majority of residential mortgages from the risk retention requirement.  The so-called “qualified residential mortgage” or “QRM” is defined so broadly that most mortgages will be considered good enough to bypass the risk retention requirement.  In addition, the rule exempts securitizations issued by the GSEs (Fannie Mae and Freddie Mac), which represent an estimated 80% of the home mortgage market—even though Congress clearly didn’t intend that result.

As a result, almost all of the residential mortgage-backed securities subject to the rule will not require the lender/packager to retain meaningful risk.  They will have no skin in the game just as before the crisis, effectively defeating a core purpose of the rule.  The resulted, in part, from housing advocates arguing that the risk retention requirement might cause some lenders to reduce their mortgage lending, especially to people of modest means, or increase the cost of those loans.  Thus, housing policy was mixed in with the effort to reduce systemic risk and prevent financial crashes and crises.   Even if those concerns have some merit (and advocates did not produce concrete, reliable evidence that would be the case), those concerns don’t justify a de facto repeal of the risk retention requirement through a huge QRM loophole that could put the entire U.S. economy at risk.  If another mortgage securitization bubble triggers another financial crisis, the damage to the housing market will far exceed whatever marginal costs a strong risk retention rule might create for those who want mortgage financing.

More importantly, this is not, as it was unfortunately portrayed by some, an either/or situation.  We don’t have to choose between a more stable, risk-reducing securitization markets and fair access to home ownership.  First, a strong securitization market that has the confidence of investors should reduce credit costs and expand credit availability to all Americans.  Second, if a strong risk retention rule really does hamper access to mortgage financing for some Americans, then that can be addressed with other targeted housing policy solutions.   However, sacrificing a safer securitization market purportedly to protect the mortgage financing market from a vague and unproven threat is unwise and bad policy that may result in both a riskier securitization market and less credit availability.

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