Banks lobby to underwrite bad loans with no risk retention

Lenders prefer to underwrite loans and pass the risk to others thus avoiding consequences for shoddy work. Housing advocates want unqualified borrowers to receive loans even if many borrowers won’t repay them. Both lenders and housing advocates agree that the Dodd-Frank financial reform law blocks their agenda, so they formed a coalition to lobby the agencies responsible for implementing this law. These responsible agencies capitulated to the coalition in an example regulatory capture.

Wikipedia defines Regulatory Capture this way:

Regulatory capture is a form of political corruption that occurs when a regulatory agency, created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure; it creates an opening for firms to behave in ways injurious to the public

The standards set forth in Dodd-Frank protect the public good. Lower loan standards lead to more foreclosures destabilizing neighborhoods and exposing taxpayers to losses. Lower loan standards benefit narrow special interests at the expense of the public good, and concerned citizens should oppose efforts to roll back these standards.

Mortgages Without Risk, at Least for the Banks


Published: November 28, 2013 [dfads params=’groups=165&limit=1′]

There was no single cause of the financial crisis, but a chief one was surely the way mortgage loans were made by people who believed they had no reason to care if the loan was repaid.

That was why the Dodd-Frank financial overhaul law included risk retention — called “skin in the game” — as a major reform. For all but the safest loans, someone connected to the loan had to keep a stake in it. If such a loan went bad, then that lender would suffer along with those who bought securities containing it.

“To me,” said Barney Frank, the former chairman of the House Financial Services Committee and co-author of the law, “the single most important part of the bill was risk retention.”

Obviously, lenders want to pass off risk to others. Riskless profits are always preferred to profit with potential for loss. However, when lenders have no risk, they also have no incentive to follow sound underwrting guidelines, which is why this provision was so important to legislators when this law as drafted.

I am not alarmed about this as much as others because lenders subsume some risk in a securitization scenario. If lenders underwrite loans that later go bad, the servicers of the mortgage-backed security pools force lenders to buy back these bad loans, particularly if these pools are insured by Freddie or Fannie. Lenders retain put-back risk for some period after origination whether they want it or not. Further, if the borrower defaults on a loan with an obvious defect in underwriting, the lender retains put-back risk for the life of the loan. Put-back risk is a workable substitute for Dodd-Frank risk retention; however, I would prefer to see both.

But it now appears that section will be rendered moot as multiple regulators give in to pressure brought by an odd coalition to classify virtually every mortgage as exempt from the risk retention law.

That coalition includes large parts of the banking industry, which seems to have no desire to stand behind its loans,

This assessment is correct. Lenders oppose risk retention because they want to avoid all consequences for bad loans.

as well as consumer advocates and the housing industry. The latter groups say they are worried that poorer people will be unable to obtain loans if all loans cannot be securitized.

The housing industry opposition is expected. People who make a living from real estate transactions oppose any law which hinders more transactions, even if such changes are for the public good.

When Barney Frank was in Congress, he championed those who wanted unqualified borrowers get loans due to their ethnicity. Now he decries their efforts as against the public good. He was wrong when he was in Congress, but he is right now.

On the other side, asking regulators not to gut the law is an equally unusual, if smaller, coalition. It includes Mr. Frank; Sheila C. Bair, the former chairwoman of the Federal Deposit Insurance Corporation; and the American Enterprise Institute, a conservative research group that has rarely, if ever, found itself in agreement with Mr. Frank on a regulatory issue.

Shelia Bair was one of the finest bureaucrats in Washington. She opposes relaxing risk retention laws because she knows it will embolden banks to make more bad loans. The only reason Barney Frank and the American Enterprise Institute agree is because Barney Frank changed his mind. I suppose witnessing the complete and utter failure of your policies will do that.

The Dodd-Frank law told regulators to effectively set up three categories of mortgages. At the top were “qualified residential mortgages,” called Q.R.M. Those were to be the only mortgages that did not require skin in the game if they were pooled and sliced up into securities.

Under that were “qualified mortgages,” called Q.M. The Consumer Financial Protection Bureau was to establish standards for those, which it has done.

(See: New mortgage regulations will prevent future housing bubbles)

Those rules, to take effect Jan. 10, were supposed to protect consumers, not the financial system. The bottom category was to include mortgages that met neither of those standards. They would require risk retention, as did the Q.M. mortgages.

The rules on qualified mortgages are meant to assure that consumers can afford them, and the requirements are rather low. Lenders must go to the trouble of verifying a borrower’s income, and the total monthly debt obligation must be no more than 43 percent of pretax income. There are no requirements for down payments, or limits on how much is lent relative to the value of the property.

Before the lending excesses that led to the crash, Ms. Bair said in an interview this week, banks generally refused to make loans on which repayments would be more than 35 percent of income, and often had lower limits. “There is,” she said, “a lot of room under Q.M. to make mortgages that should not be made.”

I hoped the new qualified residential mortgages would close some of the obvious loopholes. Unfortunately, the new rules leave open these loopholes despite the dangers. For example, the new qualified mortgage rules establish no down payment requirement despite evidence that low down payments cause excessive delinquencies and loan losses.

That brings us to Q.R.M. — the qualified residential mortgage. The six regulators that are supposed to agree on rules for that put out a proposal in 2011 that gave in to the banks on many issues, but not all. The banks reacted with anger, and the latest proposal is a virtual complete surrender. It essentially says that any mortgage that meets qualified mortgage standards will meet the higher ones as well.

The result,” Mr. Frank wrote in a comment letter, “would be two categories, those that fall below standards and probably shouldn’t be made, and those that could be made and would not be subject to risk retention.”

Let us pray that put-back requirements on securitizations are enough incentive for lenders to underwrite responsibly within the qualified mortgage standard.

“I am not surprised,” Mr. Frank added, that “the overwhelming majority of commenters who are interested in building, selling or promoting the sale of housing to lower-income people support effectively abolishing risk retention. I should note that if all of these people were correct in their collective judgment, we would not have had the crisis that we had.

Three fellows of the American Enterprise Institute — Edward J. Pinto, Peter J. Wallison and Alex J. Pollock — agree. “With the demise of an independent Q.R.M.,” they wrote in a comment letter, “the credit quality objective of the Dodd-Frank law has been lost.”

Essentially, many of those who want to effectively abolish the Q.R.M. category fear that if lenders are forced to retain some risk, such loans will either not be made or will be prohibitively costly.

Let’s stop and consider that idea. It carries the assumption that future investors in mortgage-backed securities will underprice this risk and repeat the mistakes of the housing bubble. I believe investors who assume the greater risk of certain types of loans will also drive up the cost. It doesn’t matter who carries the risk if it’s priced properly.

They seem to take for granted that no bank will be willing to retain risk.

Not if they can avoid it.

[Barney Frank] noted that until the 1980s risk retention was common for home mortgages. Banks made loans and kept them on their balance sheets, just as they did other types of loans. The securitization revolution changed that, and now the banks like the idea of collecting fees without risking their own capital.

Understandable though reprehensible.

To those who would defend the status quo, other reforms in the Dodd-Frank law mean there is no need for risk retention. The requirement that banks evaluate a customer’s ability to repay, along with new appraisal rules, “will help to discourage inaccurate or fraudulent appraisal practices,” wrote the Center for American Progress, a liberal research group. “Together, these restrictions will prevent the securitization of the type of predatory and unsustainable loans that inflated the housing bubble and led to the subsequent foreclosure crisis.” …

Legislators succeeded in eliminating toxic loan programs including interest-only and Option ARMs. Legislators enacted more stringent qualified residential mortgage rules to further protect the public good.

Advocates for extending loans to unqualified borrowers blind themselves to the harm they do to underprivileged communities. Providing better loan products is not sufficient to sustain home ownership: The borrowers must consistently make payments. Most of these borrowers don’t qualify because they don’t demonstrate the fiscal responsibility necessary to sustain ownership. People who can’t save 3.5% for a down payment or who can’t get their FICO scores above 640 simply aren’t ready for home ownership. Potential borrowers need education and self-discipline. Lenders shouldn’t give them a loan then hope the borrower spontaneously develops the fiscal responsibility to make payments, particularly when the US taxpayer is insuring against the loss.

Most of the regulators appear to have been convinced that there is too much risk that a nascent housing recovery would be threatened if banks had to be responsible for the lending decisions they made. The question is whether others will give in and agree. The banks lost their fight to avoid “skin in the game” in Congress, but they may well win it in the regulatory agencies.

When house prices were falling, the real estate industrial complex opposed reform because the market was too weak to restrict credit. Now that prices are rising, the usual suspects oppose reform because it might harm the recovery. In the future, these same groups will oppose reform because it might weaken prices. No matter the market conditions, special interests will oppose anything that might cause them to make less money. At some point, legislators and bureaucrats must courageously defend the public good and tell the real estate industry to pound sand. Let’s hope this happens before we inflate another damaging housing bubble by caving in to the demands of those who want to make riskless profits in real estate.

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Borrowers like these demonstrate the need for risk retention

If lenders had to retain some of the long-term risk on the loans they underwrite, they would look at borrower history in determining eligibility. Ponzis are easy to spot. Imagine you are an underwriter looking over this borrower’s history, and ask yourself if you would underwrite the loan if you were responsible for the loss.

  • This property was purchased on 5/19/1995 for $230,000. The former owners used a $218,500 first mortgage and a $11,500 down payment.
  • On 12/22/1997 they obtained a $49,500 stand-alone second. Two and one-half years after purchase, they already had all their money out plus an extra $38,000 to blow.
  • On 8/26/1999 they refinanced with a $240,000 first mortgage and obtained a $30,000 stand-alone second.
  • On 9/28/1999 they opened a $60,000 HELOC.
  • On 1/29/2002 they refinanced with a $297,000 first mortgage.
  • On 4/16/2002 they obtained a $48,000 HELOC.
  • On 3/18/2003 they refinanced with a $316,000 first mortgage and opened a $35,000 HELOC.
  • On 7/15/2003 they opened a $79,000 HELOC.
  • On 2/24/2005 they got a $153,000 stand-alone second.
  • On 9/29/2005 they refinanced with a $472,000 first mortgage and opened a $94,950 HELOC.
  • Assuming they maxed out the final HELOC, and given their past history, we can surmise they did, the total property debt was $566,950.
  • Total mortgage equity withdrawal was $348,450 including their $11,500 down payment.

So would you give them a loan? I suppose you could gamble that another lender will be more foolish than you and refinance you out, but nobody wants to be the last lender when a Ponzi implodes.

You see, any rational person can spot a Ponzi. If lenders retained risk, they would not underwrite loans to Ponzis like these. So unless you think giving loans to people like this is a good idea, you should oppose efforts to soften risk retention standards.

18831 BARRY Ln Santa Ana, CA 92705

$474,900 …….. Asking Price
$230,000 ………. Purchase Price
5/19/1995 ………. Purchase Date

$244,900 ………. Gross Gain (Loss)
($37,992) ………… Commissions and Costs at 8%
$206,908 ………. Net Gain (Loss)
106.5% ………. Gross Percent Change
90.0% ………. Net Percent Change
3.9% ………… Annual Appreciation

Cost of Home Ownership
$474,900 …….. Asking Price
$16,622 ………… 3.5% Down FHA Financing
4.38% …………. Mortgage Interest Rate
30 ……………… Number of Years
$458,279 …….. Mortgage
$128,344 ………. Income Requirement

$2,289 ………… Monthly Mortgage Payment
$412 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$99 ………… Homeowners Insurance at 0.25%
$516 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,316 ………. Monthly Cash Outlays

($578) ………. Tax Savings
($617) ………. Principal Amortization
$27 ………….. Opportunity Cost of Down Payment
$139 ………….. Maintenance and Replacement Reserves
$2,286 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$6,249 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,249 ………… Closing Costs at 1% + $1,500
$4,583 ………… Interest Points at 1%
$16,622 ………… Down Payment
$33,702 ………. Total Cash Costs
$35,000 ………. Emergency Cash Reserves
$68,702 ………. Total Savings Needed
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