Wednesday, March 30, 2011

Lawler: The “Shrill Cry” from Lobbyists on QRM

by Bill McBride on 3/30/2011 04:11:00 PM

Earlier on Shadow Inventory:
CoreLogic: Shadow Inventory Declines Slightly

In the following long post, housing economist Tom Lawler clears up some misunderstandings and misinformation regarding the new proposed mortgage rules: The “Shrill Cry” from Lobbyists on QRM

Yesterday the Office of the Comptroller of the Currency, Treasury (OCC); Board of Governors of the Federal Reserve System (Board); Federal Deposit Insurance Corporation (FDIC); U.S. Securities and Exchange Commission (Commission); Federal Housing Finance Agency (FHFA); and Department of Housing and Urban Development (HUD) jointly issued their proposed rule on “credit risk retention” for assets collateralizing asset-backed securities pursuant to the Dodd-Frank Act, and the proposed rule included a proposed definition of a “qualified residential mortgage (QRM)” For ABS backed by QRMs, the DFA provides for an exemption of the risk-retention rule. For folks who don’t remember, the “inclusion” of an exemption for QRMs was in the act because of heavy lobbying by financial institutions and housing-related trade groups, and it put regulators in the uncomfortable position of trying to decide what types of mortgages were so inherently “low risk” that they should/could be excluded from the rule designed to ensure that ABS issuers had “skin in the game.”

Regulators yesterday proposed defining “QRM” much more restrictively than the lobbyists who had successfully gotten the concept of a “QRM” into the legislation, including a LTV restriction of 80% (and no piggybacks), front/back end DTIs of 28% and 36%, respectively, and other “borrower credit history” restrictions. Industry lobbyists quickly commented negatively.

From the National Association of Realtors:

The definition of QRM is important because it will determine the types of mortgages that will generally be available to borrowers in the future. Borrowers with less than 20 percent down could be forced to pay higher fees and interest rates, up to 3 percentage points more, for safe loans that otherwise do not meet too narrow QRM criteria.
From the PMI Group:
"While we are disappointed that the regulators chose a very narrow and restrictive definition of QRM, we are encouraged that they are seeking comment on an alternative QRM definition that would involve a 10 percent down payment and more reliance on private mortgage insurance. Additionally, we believe that prudentially underwritten mortgages with less than a 10 percent down payment and private mortgage insurance should also be included in the definition," said David Katkov, PMI's Executive Vice President and Chief Business Officer.
From the NAHB:
A plan unveiled today by the Federal Deposit Insurance Corp. that would require a minimum 20 percent down payment for "qualified residential mortgages" would disrupt the housing market and jeopardize the economic recovery, according to the National Association of Home Builders (NAHB).
"By mandating a 20 percent down payment on qualified residential mortgages, the Administration and federal regulators are excluding those without huge cash reserves – which constitutes most first-time home buyers and many middle-class households – from a chance to buy a home," said NAHB Chairman Bob Nielsen, a home builder from Reno, Nev. "Just do the math. First-time home buyers historically average 40 percent of home-buying activity. It would take an average family 12 years to scrape together a 20 percent down payment. This plan is nothing short of an assault on homeownership that could have a long-lasting negative impact on housing for generations to come."
From the American Securitization Forum:
“For residential mortgages, however, the extremely rigid proposals for a qualified residential mortgage (QRM), combined with explicit exemptions for the mortgages guaranteed by the U.S. taxpayer through the government sponsored enterprises (GSEs), will further prolong the U.S. government’s 95% market share of the credit risk of newly originated mortgages. The QRM proposals will keep a significant amount of private capital on the sidelines, while pressuring the Federal Housing Administration (FHA) to continue to fill this role with American taxpayers as the backstop for mortgage credit risk. Drawing private capital out of the mortgage finance system, rather than encouraging its entry, will only serve to further depress home prices nationwide and keep first-time home buyers out of a housing market suffering from a severe oversupply of available homes. As part of detailed proposals sent to the joint regulators in November 2010, ASF members, including institutional investors and RMBS issuers, developed a series of standards, such as income and asset verification, minimum borrower equity and debt-to-income ratios, that would better balance the need to promote prudent loan underwriting with the need to restore an appropriate credit supply to American homebuyers.”
The legislation specifically exempts ABS/MBS that “are insured or guaranteed as to the payment of principal and interest by the United States or an agency of the United States and that are collateralized solely (excluding cash and cash equivalents) by residential, multifamily, or health care facility mortgage loan assets, or interests in such assets,” and for mortgages Ginnie Mae securities are exempt. Contrary to some media stories and lobbyist statements, securities issued by Fannie Mae and Freddie Mac are NOT exempt; rather, the regulators noted that because the GSEs already retain the credit risk of the mortgages backing their MBS/PCs, the GSEs already satisfy the risk-retention rule. Of course, both GSEs are under conservatorship, and “taxpayers” are in fact taking on this risk, but technically the GSEs are not “exempt.”

Contrary to what various lobbyists seem to imply, the proposed QRM rule does NOT “mandate” 20% down payments, or preclude originators from making loans with lower down payments and/or other “riskier” features unless those loans are sold to/guaranteed by FHA/VA/GSEs. Also, originators that sell non-QRM loans to entities who plan to package the loans into “private-label” ABS/RMBS are NOT necessarily required to “retain” 5% of the risk of such loans. Rather, the ISSUER would be required to retain 5% of the “risk,” though the issuer COULD “allocate” the risk retention back to the originator – though that would require ongoing tracking for compliance. Here is an excerpt from the risk retention proposal.
“Importantly, the proposal does not mandate allocation to an originator. Therefore, it does not raise the types of concerns about credit availability that might arise if certain originators, such as mortgage brokers or small community banks (that may experience difficulty obtaining funding to retain risk positions), were required to do so. Mandatory allocation of risk retention to the originator of the securitized assets also could pose significant operational and compliance problems, as a loan may be sold or transferred several times between origination and securitization and, accordingly, an originator may not know when a loan it has originated is included in a securitization transaction.”
Now let’s look at some “math.” The NAR purported that the QRM definition combined with the risk retention rule, which ONLY effects mortgages backing certain ABS/RMBS, would be “forced to pay higher fees and interest rates, up to 3 percentage points more,” even if the loan was “safe.”

Hmm? Let’s first assume that without the QRM/risk retention rule, the rate charged to a borrower for a loan destined to back a private label RMBS was, say, 6%. Now let’s assume that the issuer of a RMBS backed by non-QRMs had to retain 5% of the risk, and for simplicity’s sake let’s assume the risk-retention is in a “vertical” form – meaning a pro-rata (5%) retention of all tranches in the RMBS. Clearly for the 95% of the RMBS “sold” to other investors, those investors would not require a HIGHER yield because the issuer retained some of the risk. If anything, it might be a tad lower – but will assume it’s still 6%.

Now … what yield would the issuer “require” to “hold” that 5%? Well, for accounting, regulatory, or “other” reasons, perhaps that issuer might require a yield higher than 6%. So let’s just assume that the issuer “required” a yield of 10% -- which seems way too high. How would that impact the borrower? Well, we’ll use the complex formula “95% of 6% plus 5% of 10%,” which equals …. gosh, 20 basis points! So … where’d the NAR get 3 percentage points? Well, I THINK they may be using “Gross” estimates of what investors would require to purchase mortgage-backed securities not guaranteed by “the government” (explicitly or implicitly). But wait! That estimate HAD NOTHING TO DO WITH QRM or the risk-retention rule!

Of course, banks, thrifts, or any other investors who wished to hold mortgages on THEIR balance sheets are not at all impacted by the QRM definition, which ONLY applies to mortgages backed by private-label ABS/RMBS!!!!

So ... why the “hue and cry?” Well, to some at least partly it is more of a “stigma” issue than an “economic” issue – having the government sorta/kinda say that loans with less than a 20% down payment, or greater than 28/36 front/back-end DTIs, are not “qualified” residential mortgages seems to some to suggest that they therefore are “excessively” risky, and perhaps even not “worthy” enough to be called “prime.” That, of course, is silly – the industry is not going to shift its definition of “prime” based on the “QRM” definition – which again is the regulators’ difficult/foolhardy attempt to define the type of loan that is so “inherently” low-risk that it warrants an exemption from the “risk retention/skin-in-the-game” rule dictated by legislation. And for the securitization industry, adding a 5% retention rule just adds a little more cost of doing business in the private-label RMBS market, which is already “broken” and where no real progress has been made to “fix” the old “built to fail” model filled with multiple “conflicts of interest” most of which are not “fixed” by risk retention.

It woulda just been better if the whole concept of “qualified residential mortgage” had not been in the legislation at all.

Of course, yesterday’s risk retention proposal was just that – a proposal that is now out there for comment.

In re “fixing” the private-label market, it would have been nice if the legislation banned structures that created conflicts of interest across tranches; banned servicers advancing principal and interest (instead making the asset-backed security backed by the cash flow from the assets!); addressed other servicer practices that act to the detriment of investors; and mandated the credit rating agencies use a completely different credit rating structure than the “binary” corporate debt credit rating grades, which almost by definition can’t appropriately be used for asset-backed securities. Limiting senior/sub structures to “true” senior/sub structures – where ALL cash flows first go to the senior holder, then to the next-most senior holder, etc. – would also have been a “good idea.”

However, with or without a QRM definition, and with or without a “fixing” of the private-label RMBS market, that private label market can’t really compete effectively for loans that are eligible for purchase/guarantee by FHA/VA/USDA/Fannie/Freddie in the current market environment.

The private-label RMBS market, by the way, played an extremely minor role in the overall US market until last decade, and even before last decade it was subject to some serious “perturbations” – the subprime market in the latter part of the 90’s (less credit risk than prepayment risk, which precipitated the increased use of excessive prepayment penalties) and the manufactured housing debacle just a few years later (the catalysts for which were eerily like those of the subprime implosion last decade).

Growth in ABS Market Click on graph for larger image.

The growth in that market surged last decade, with explosive growth from 2003 to 2006. Of the $4.0 trillion increase in total 1-4 family mortgage debt outstanding in the US from the end of 2002 to the end of 2006, almost 40% of that increase ($1.6 trillion) was in mortgages backing private-label ABS. Needless to say, an astonishing number of loans that have gone bad were loans that were backing private label RMBS. There is little doubt the country would have been better off if that market had not existed, and no competent housing/mortgage analyst wants that market to come back in its old, built-to-fail form.

It can, of course, be “fixed,” but conflicting incentives and excessively complicated structures – more often than not designed to “game” the credit rating agency models and “arb” credit rating agency ratings – as well as the “old” credit rating “model” and scale, need to go.

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