ItÕ the Mortgage, Stupid

I don’t know about you, but I found the announcement, last week, that the Federal Deposit Insurance Corp. (FDIC) had approved a notice of proposed rulemaking (NPR) regarding safe harbor protection for bank-issued ABS, really depressing. I was privately thinking that the FDIC would hold off, given internal opposition from two FDIC board members, who also are heads of bank regulatory agencies.On top of that, the Security and Exchange Commission (SEC) is now taking comments on a revamp of its securitization rules. Perhaps most important, Congress is pushing toward securitization reforms in its massive overhaul of financial regulation. I anticipated that the FDIC would back off because it doesn’t have the legislative prerogative, the hands-on experience or human resources to devise and promulgate securitization guidelines. The SEC does. I wasn’t alone in this thought – a couple of veteran bank analysts of my acquaintance thought the momentum would shift away from the FDIC once the chairman and staff had taken their opportunity to rattle their sabers intra-agency. I wished the FDIC would hold off because its lack of experience with securities law and ABS markets really showed in the first version of the rule, attached as an appendix to January’s Advanced Notice of Public Rulemaking (ANPR). In particular, the ANPR, as well as its modestly altered successor, the NPR, promote untruths about the actual extent and quality of disclosure that is currently provided, both under the SEC’s Reg AB and in the form of voluntary monthly loan level performance, prepayment and descriptive data. The NPR calls for disclosure practices that have been standard in private mortgage-backed securities (MBS) for years. (Disclosure realities versus FDIC distortions and misunderstandings are the subject of my column in the May HousingWire Magazine, “ABS Disclosure Debate Is a Whale of a Red Herring.“) Another reason to wish the FDIC would relent is that its securitization campaign reinforces the very sloppy generalizations that have come to replace objective analysis in public discussion and policy formation. The sloppiest by far is the use of the word “bank” and the term “Wall Street.” The media, the press – in straight up reporting or commentary and columns – blog-mouths and twit-heads all have abandoned the distinction between commercial bank, investment bank, mortgage bank, merchant bank, etc. Bank is now a pejorative term, the name of the enemy. “Bank” is used interchangeably with “Wall Street” or the new highly charged generalization, “Wall Street banks” is flung mightily about. The thing we should be calling a commercial bank – is not the main culprit of the originate to securitize model. A predominance of these loans were made and securitized by non-depository institutions, mortgage banking institutions and consumer finance companies that were not subject to federal banking supervision. That’s not to say that big banks and thrifts – subject to Federal banking supervision – were not major players. Wells Fargo, Wachovia, Citigroup, and Chase make the lists of top subprime, alt-A or high interest, mortgage lenders. Also on the lists are the mortgage banks dressed up as thrifts (and subject to Federal supervision) Countrywide, IndyMac, as well as Washington Mutual, until the FDIC seized it, one of the 10 largest depositories in the country. Nonetheless, the lists are dominated by mortgage banking and consumer finance companies as well as mortgage conduits owned and operated by Wall Street investment banks. In other words, all the other kinds of banks, the entities that perform just a small set of what the man on the street thinks of as banking activities, the ones that will rise again to lay off risky loans on yield hungry investors whenever it becomes profitable again to do so. This isn’t simply a semantic point. It’s very practical — an unregulated industry has twice risen to make and securitize subprime loans — and pave the way for dodgy lending, both to prime borrowers and at regulated institutions. The first wave began in the early 1990s and was choked off by the Asian liquidity crisis in the late 1990s (the same forces that brought Long Term Capital down). At the time, a number of the most prominent lender/issuers filed for bankruptcy or were closed down by parents. A second, far larger wave of non-bank mortgage lenders and finance companies blossomed in the 2000s. It is impossible to imagine that a third wave will not appear just as soon as it again becomes profitable to securitize weakly underwritten loans and sell them to yield hungry investors. The Direct Solution More than anything, I was hoping the FDIC would step back and use its pulpit to attack the root problem: lending standards. Fiddling with securitization rules is like slapping a ragged bandage on the wound, instead of forbidding lenders to play with knives. A far more direct use of its authority to make standards for safety and soundness relating, among other things to loan documentation and credit underwriting. John Dugan, Comptroller of the Currency, and one of two FDIC Board members who voted against publishing the NPR on May 11, complained that “the NPR does not embrace the concept of directly improving underwriting standards for mortgages by establishing minimum standards by regulation – a concept that I strongly support”. Dugan has been pressing the case for uniform minimum underwriting standards for some time now in various speeches and in the process of disagreeing with the FDIC’s proposed securitization rule. On March 19, 2009, Dugan testified before the House banking committee that the lack of consistent regulation for mortgage providers was a fundamental reason why the shoddy loans that brought on the current financial crisis were able to be written. In that testimony, he called on Congress to establish national mortgage standards that would apply to all types of originators and to ensure they are applied and enforced in a comparable manner regardless of originator. In November 2009, at a Special Seminar on International Banking and Finance in Tokyo, Dugan outlined minimum requirements: (1) underwriters should verify income and assets; (2) borrowers should be required to make meaningful down payments (“real equity or real-skin-in-the-game”); (3) borrowers on nontraditional mortgages with lower initial payments should be qualified at the higher, permanent payment. Again, on February 2, 2010, Dugan spoke to a conference of the American Securitization Forum on “Securitization, ‘Skin-in-the-Game’ Proposals and Minimum Mortgage Underwriting Standards.” Referencing his Tokyo speech the previous autumn, Dugan argued that skin-in-the-game requirements were an imprecise and uncertain means of improving underwriting practices. Instead, why not do so directly, and establish minimum rules that apply to all mortgages, held or sold. “We could do this,” he said. “Bank and thrift regulators could establish minimum underwriting standards for all mortgages originated, purchased, or sold by banks, thrifts, and, most importantly, by all of their affiliates.” Congress in turn, in the context of financial reform, could set standards for the part of the mortgage market not subject to direct federal regulation and it could establish an effective enforcement mechanism. Where There’s a Will, Is There a Way? True, the bank and thrift regulators could do that. They have the power under the Federal Deposit Insurance Act, both individually and collectively with the other Federal banking agencies, to make safety and soundness regulations for the institutions they supervise. If Dugan feels strongly about it, why hasn’t the OCC taken the lead on this? It is the regulator responsible for banks with national charters? Or has it? I assume that, if it had, Dugan would be including this fact in his statements on the shortcomings of the FDIC’s NPR. Well then, shouldn’t the FDIC, federal regulator of state banks with deposit insurance? Or the Fed, regulator of bank holding companies, financial holding companies and state chartered banks that are members of the Federal Reserve System. (The possibility of regulatory overlap makes bank regulation sound like a short and tedious version of “Who’s on first?” Have the regulators stopped working together while Congress redesigns the US financial regulatory system? Waiting to see whose job gets bigger, whose smaller, who gets pitched out for letting a few giant thrifts and the derivatives shop of a big insurer burn themselves down? Or are the regulators reluctant to put curbs on lenders when in their hearts all they want is to stabilize home prices and stop the credit losses in portfolios, the high cost of servicing bad securities. That’s a trick that requires more, not less housing credit. Congress Tries Congress has not been deaf to calls for stiffer, universal mortgage underwriting standards. The regulatory reform bill passed by the House (H.R. 4173, last December) contains as an amendment, the Mortgage Reform and Anti-Predatory Lending Act (originally passed as H.R. 1728 in May 2009). It would establish as minimum mortgage standards under the Truth in Lending Act (TILA) that the lender (1) must make a good faith determination based on verified documentation that the consumer has a reasonable ability to repay the loan and related fees, taxes, insurance and assessments, and (2) use a fully amortizing payment schedule to qualify borrowers for loans that defer repayment of principal or interest. The House standards also require that a refinancing demonstrate a net tangible benefit to the borrower. There is also a risk retention requirement when non-qualified mortgages are transferred or sold to third parties. In the Senate, Dodd’s regulatory reform bill originally did not include minimum mortgage provisions, but last week, the Senate added a mortgage underwriting standard to the regulatory reform bill currently being debated. The amendment would effectively ban yield-spread premiums and require lenders to verify borrowers’ income and assets. Rules to guarantee a borrower has the ability to repay a mortgage are left to a consumer protection bureau proposed under the bill. Assuming the Senate can pull together and pass a reform bill (they’re set to vote next week or even as early as tomorrow) the differences between House and Senate versions would have to be resolved in conference. Inertia Creeps Not deaf, but Congress hasn’t been bold either. Neither the House nor the Senate bill embodies the Comptroller of the Currency’s recommendations. Neither requires borrowers be qualified at a fully-indexed and fully-amortizing payment of principal and interest or that borrowers make a meaningful downpayment out of their own pockets. It’s disappointing. All Dugan is saying, really, is let’s reinstate the common sense credit standards that underpinned generations of stability in U.S. housing markets. However, a return to the old ways has natural enemies. Opposing lobbies would include the real estate agents and home builders who want housing demand shifted high enough to suck down listed and shadow housing inventories and to revive new home construction. They’ve seen how easy money feeds demand, they won’t relinquish the hope it can return. The mortgage banking lobby would resist as well: the more stringent the minimum, the fewer loans to be made. Then too the home ownership lobby would resist – a significant down payment is a big obstacle to home ownership for low and moderate income buyers. And who knows, perhaps the FDIC is privately cautioning lawmakers that if they tighten housing credit, insured banks will just see more losses for more years. NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.