Mortgage Originators Must Have Skin In the Game
The Dodd-Frank financial regulation reform law passed after the 2008 financial crisis is mostly a misguided over-regulation of the financial sector that punishes financial firms with costs and compliance burdens for little gain. However, one aspect of the law that would have been beneficial was a requirement that mortgage originators retain at least five percent of the risk from all except the safest residential mortgages. The risk retention requirement would give firms an economic incentive to ensure that borrowers are likely to repay the loan. Unfortunately, financial regulators appear ready to bow to industry pressure and effectively remove this positive part of the law.
Prior to Dodd-Frank, mortgage originators could bundle mortgages into securities and sell off all the risk, making their entire profit within the first month or two from a combination of closing fees and a markup on the mortgage backed securities that they sell as soon after closing as possible. This contributed strongly to the real estate bubble and the mortgage market meltdown. Mortgage originators had an incentive to approve borrowers and close loans, but no incentive to worry about the quality of the loans they were making.
Why was anyone surprised that lots of bad loans were made, fraud was allowed, and corners were cut in order to increase closings? The profits on originating mortgages were completely separated from any risk of nonpayment. Profits for banks and other originators were purely a function of the volume, not quality of loans made.
If the government continues to assume risk in the mortgage market through the guarantees offered by the FHA, it has the right to ask originators to share in the risk. In fact, given that taxpayers are on the hook for the amounts guaranteed, the government has an obligation to minimize the risk to taxpayers. A risk retention requirement would be an important step in the right direction.
Yet in the face of fierce lobbying by the banking industry, the federal regulatory agencies involved in issuing the final rules for mortgage origination and risk retention are collapsing in complete surrender. Mortgages were supposed to fall into three categories and banks were supposed to retain a minimum of five percent of the risk for all mortgages except those in the safest category, called qualified residential mortgages.
However, in the latest iteration of the proposed regulations almost all mortgages will be categorized into the safest category. Banks will be able to act exactly as they did before the 2008 financial crisis. The pre-1980s industry standard limited total debt payments to 36 percent of a borrower's income and generally required the mortgage payment to be 28 percent or less. The new rules look set to allow borrowers to stretch to 43 percent of income without banks having to accept any risk.
At this level even small economic setbacks could throw a borrower into financial distress and lead to mortgage nonpayment. If these mortgages count as ultra-safe, one wonders if any mortgages will ever fall into the categories that require risk retention by the mortgage originators. It is hard to imagine circumstances where a mortgage should be made that would place a borrower in a position where total debt payments exceed 43 of pre-tax income except when the borrower actually has very high net worth relative to income and could actually pay the loan off from net worth.
The fact that Rep. Barney Frank and former FDIC Commissioner Sheila Bair oppose this proposed rule in tandem with the conservative American Enterprise Institute is proof of problems with the policy. Liberals are worried that banks and other mortgage originators will again make loans that end up getting borrowers in financial trouble. Conservatives are concerned that the taxpayer will again have to pay for the damage by bailing out the banks. Both see the opportunity for a replay of the 2008 mortgage market meltdown.
In general, government should stay out of markets as much as possible. However, when government does interfere in a market in order to regulate it, the least it can do is establish economic incentives that will tend to lead to a socially desirable outcome in the regulated market. Virtually the only thing Dodd-Frank got right was the risk retention requirement for mortgage originators. That rule gives those approving the mortgages an incentive to be careful and responsible in that approval process. In fact, forcing lenders to retain five percent of a loan's risk is a pretty minor risk sharing requirement.
Credit securitization was a worthwhile development that allowed more funding to flow into many different credit markets, not just mortgage markets. It allowed smaller investors to participate in these asset classes while still benefiting from some level of diversification and the assumed accompanying risk reduction. However, these secondary investors do not have access to sufficient information about the borrowers to accurately assess the quality of the loans.
Only the originators can do that. But without an economic incentive, mortgage originators will care only about approving as many loans as possible rather than the quality of those loans. Requiring originators to share the profits and losses along with the eventual investors in the mortgage backed securities they plan to sell is a reasonable burden to impose. It might even restore enough trust in the market to make mortgage origination more profitable than without the risk retention requirement.
Financial regulators should stand up to the big banks and their lobbying efforts. The final definition of qualified mortgages needs to maintain the intent of Dodd-Frank to force originators to retain a small share of the risk in all but the safest mortgages. If mortgage originators are not willing to have a little skin in the game, they can just sit on the sideline.