U.S. bank regulators on Tuesday unveiled a proposal to overhaul the market for securities backed by mortgages and other assets, a piece of the financial system battered by the recession and financial crisis.
The proposal approved for public comment by the Federal Deposit Insurance Corp. and Federal Reserve Board is designed to encourage safer lending practices by mandating that issuers of mortgage-backed securities follow conservative principles, such as requiring 20 percent down payments for mortgages, or hold a portion of the loans on their books. Companies that package loans into securities would have to hold at least 5 percent of the credit risk, unless the loans meet an exemption for high-quality loans.
The proposed exemption would apply to loans with a minimum 20 percent down payment, but the agencies also requested public comment on an alternative that would allow for a 10 percent down payment and mortgage insurance.
It also recommends that homeowners spend only 28 percent of their pretax income on their primary mortgage and 36 percent on total debt, including home equity, car and student loans plus credit card debt, a limit that’s far more restrictive than what lenders allowed during the housing boom.
The proposed rules wouldn’t apply to the vast majority of loans made today. For example, loans backed by Fannie Mae, Freddie Mac and the Federal Housing Administration, which back about 90 percent of new loans, are exempt as long as the companies remain under federal control, which they have since September 2008. Fannie and Freddie package loans into securities and sell them to investors with a guarantee against default. Regulators decided that this guarantee would satisfy the risk retention requirement.
Mortgage lenders and consumer advocates, however, argue that the proposal will constrain credit.
John Taylor, chief executive of the National Community Reinvestment Coalition, argued that requiring 20 percent down payments will “ensure broad swaths of working and middle class people will not be able to get a loan.”
The Federal Reserve approved the proposal on Monday, the FDIC did so on Tuesday and the Securities and Exchange Commission will consider it Wednesday. The proposal also needs the approval of the Department of Housing and Urban Development, Office of the Comptroller of the Currency and Federal Housing Finance Agency.
The six federal regulators haggled over the standards for months and are unlikely to make changes until they receive comments from industry and consumer advocacy groups. Finishing the regulations could take several more months, as comments aren’t due until June 10.
Treasury Secretary Timothy Geithner called the proposal “an important next step in our ongoing efforts to fundamentally reform America’s housing finance market and our nation’s broader financial system.”
But FDIC Chairman Sheila Bair said the rule doesn’t mean that “all home buyers would have to meet these high standards to qualify for a mortgage.” The exemption, she said, will apply to “a small slice of the market.” Providing too broad of an exemption “could cause credit availability outside the exempt category to evaporate,” said Acting Comptroller of the Currency John Walsh.
That decision on Fannie and Freddie is likely to be opposed on Capitol Hill. Rep. Scott Garrett (R-N.J.) will introduce a bill Tuesday requiring them to comply with the risk-retention rules. Sen. David Vitter (R-La.) said the rule “would not make (Fannie and Freddie) or their loans safe.”
The rules were required by the Dodd-Frank financial overhaul law passed last summer, which required issuers of securities backed by mortgages and other loans to hold 5 percent of the credit risk. The goal is to require banks to have more “skin in the game” and avoid a repeat of the lax lending practices that led to the financial crisis.
The market for mortgage-backed securities issued without the government’s guarantee has been virtually dormant since the housing market went bust. The new rules are meant to lay out which loans can be included in those securities.
In 2003 more than $3 trillion in asset-backed securities were issued. That number, which includes Fannie and Freddie securities, fell to just over $1.9 trillion in 2009, according to Asset Backed Alert, a trade publication.
The rules also give issuers of mortgage-backed and other asset-backed securities a choice over what portion of loans they must keep, meaning they could decide to take less risky pieces. They also include a set of standards for mortgage servicers, which collect mortgage payments and distribute them to investors.
Including them in the rules for gold-standard loans was a key priority for Bair, and a source of behind-the-scenes contention for regulators. Regulators are also working on a broader proposal that would apply to all loans.