When the mortgage securitization market collapsed amid a flood of defaults and foreclosures — many of them on loans that should not have been made — the cry arose for lenders to have “skin in the game.” To properly align incentives, the argument went, those who make loans must suffer if the loan goes bad.
Representative Barney Frank wants banks to assume some risk for the loans in mortgage pools.
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That principle was enacted by Congress last year in the Dodd-Frank law, but the mortgage industry managed to persuade legislators to insert an ill-defined loophole that would allow at least some mortgage loans — and perhaps nearly all of them — to escape the requirement that banks retain at least 5 percent of the risk.
Now it is up to an unwieldy council of regulators to set the parameters of that loophole. They will do that by defining the term “qualified residential mortgage.” If a loan is a Q.R.M., as bankers now refer to such loans, then it can be sold to investors without the lender retaining any risk.
Much of the banking industry has been pushing for an expansive definition that would leave few, if any, conventional loans subject to the skin-in-the-game requirement. To hear them tell it, there is virtually no way that any bank would make a mortgage loan at a reasonable rate if it had to share in any losses.
“The potential impact on the availability of credit stemming from the Q.R.M. risk-retention exemption cannot be overestimated,” John A. Courson, the president of the Mortgage Bankers Association, wrote in a letter to regulators.
“Few loans to ordinary customers are likely to be made outside the Q.R.M. construct; the loans that are made will be costlier and likely to be made only to more affluent customers.”
In other words, Congress did not know what it was doing when it mandated the retention of risk, and the regulators should spare us such folly.
If bankers had their way, only loans that were negatively amortizing, or had balloon payments, would be excluded. You could buy a house with no money down, so long as you took out mortgage insurance. Even interest-only loans would be acceptable in some instances, and what few rules there were could be circumvented because bankers would be given discretion when applying the rules.
It now appears the regulators will not go nearly that far. According to people knowledgeable about the discussions, the regulators are likely to propose that the definition allow only loans with a down payment of at least 20 percent. Adjustable-rate loans would be permitted, but there would be limits on how large an adjustment would be allowed. These people spoke on the condition that they not be named.
One provision likely to set off controversy is a limit on how that 20 percent down payment is obtained. The buyer would have to put up at least half of it — 10 percent of the purchase price — from his or her own holdings. The rest could be a gift, from parents, for instance, but it could not come from seller concessions or from borrowing. Mortgage insurance would not enable a nonqualifying loan to become qualifying.
The regulators hope the result of this will be two vibrant mortgage markets, with a substantial share of mortgages in each market. If a qualified mortgage is defined too broadly, there would be few other loans made, and even fewer of them would be able to be packaged in securities, when and if a private-label market for those securities begins to function again. Without enough available loans, no such market would be likely to develop.
The bankers’ solid front on the issue was shattered by Wells Fargo, which suggested that only loans with a 30 percent down payment — a 70 percent loan-to-value ratio — should qualify. Other bankers were horrified.
In an interview, John P. Gibbons, an executive vice president of Wells Fargo Home Mortgage, said he thought “skin in the game” made sense and would make it more likely that private investors would again be willing to invest in mortgage securities that did not have a government guarantee.
“You gain confidence when you go to a restaurant and see an owner is eating his own food,” he said.
That was the view of Barney Frank, the Massachusetts congressman whose name is attached to the law. “We’re basically saying now, ‘You’ve got to keep 5 percent of that,’ ” he said after the law was passed. “That way we’ll just get better-quality loans made in the future.”
One reason some lenders oppose skin in the game is that they do not have enough capital to cushion the additional risk. Those not affiliated with depository institutions are not used to keeping loans on their books, and a requirement that they do so could reduce the amount of competition. That could help well-capitalized banks, like Wells Fargo, the largest mortgage lender in the country. According to Mortgage Daily, a trade publication, Wells Fargo had a 25 percent market share for mortgage loans made in 2010.
The group of regulators, which includes the Securities and Exchange Commission and bank regulatory agencies, as well as the agency that supervises Fannie Mae and Freddie Mac, must also decide just what constitutes “skin in the game.” The law says banks should keep a 5 percent stake, but it does not say how that should be calculated.
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