Statement of Patrick J. Lawler, Chief Economist
Federal Housing Finance Agency
Before the U.S. House of Representatives
Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises
April 14, 2011
Chairman Garrett, Ranking Member Waters and members of the Subcommittee, thank you for the opportunity to testify on the Federal Housing Finance Agency’s (FHFA’s) participation in the joint agency rulemaking for the implementation of the credit risk retention requirements for asset-backed securities in the Dodd-Frank Act.
One of the widely recognized causes of the financial crisis of 2008 was the poor quality of loans collateralizing many asset-backed securities, with subprime mortgages being the most flagrant culprits. Too often, lenders made loans that they would not have been willing to hold themselves only because they knew they could sell them to securitizers at an attractive price. Pools of such loans were used to back securities that were structured so that most of the securities received high credit ratings and were purchased by investors who gave little attention to underlying loan quality.
This "originate-to-distribute" model lacked the proper incentives for the origination and securitization of high quality loans, with fair terms for borrowers and proper underwriting to prudent standards. Risk retention better aligns the incentives between securitizers and investors and reduces information asymmetries by requiring that securitizers of asset-backed securities have a financial stake in the performance of loans underlying a security, or "skin-in-the-game." Through risk retention, including exemptions for loans with characteristics that imply a lower risk of default, securitizers will have a disincentive to acquire poor quality loans for securitization, which, in turn, will make originators less interested in making such loans. Investors, therefore, should be more willing to provide capital for residential mortgages and other types of loans. This may be an important step in facilitating the return of private capital to the residential housing market and other lending markets that benefit from securitization.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203), enacted on July 21, 2010, requires in Section 941 that the federal banking agencies (Office of the Comptroller of the Currency, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC)) and Securities and Exchange Commission (SEC) jointly prescribe regulations to require that securitizers retain a portion of the credit risk of loans that collateralize asset-backed securities. The Act included FHFA and the Department of Housing and Urban Development (HUD) among the joint rulemaking agencies for the purpose of the residential mortgage asset class and also for jointly defining and creating an exemption from the risk retention requirements for qualified residential mortgages (QRM). The Act charged the Chairman of the Financial Stability Oversight Council with the responsibility to coordinate the rulemaking.
The agencies jointly released a notice of proposed rulemaking (NPR) the last week in March 2011. The public comment period runs through June 10, 2011, after which the agencies will consider the comments and publish a final rule. The Act provides for the final regulations to become effective one year after publication for residential mortgages, and two years after publication for the other asset classes.
This proposed rule is the product of a long and deliberative process. It started well before the passage of the Dodd-Frank Act under the aegis of the President’s Working Group on Financial Markets (PWG) in 2009. Over a period of several months, many of the same regulators that have proposed this rule discussed earlier proposals by the SEC and the FDIC to require or reward some degree of risk retention in securitizations.
After enactment of the Dodd-Frank Act, the Department of the Treasury began hosting meetings of the banking agencies, SEC, FHFA and HUD for the purpose of coordinating the rulemaking on risk retention. It was FHFA’s goal, along with the other agencies, to develop draft rules in line with the Act’s express language and its intent to align the interests of investors and securitizers and to provide for growth and stability in the securitization market in a responsible manner. In developing the rule, the agencies sought to have a meaningful level of credit risk retention, while reducing the potential for the rule to affect negatively the availability and cost of credit to families and businesses. We also recognized that the NPR is not a final product, and we included more than 170 questions for public comment, to assist in shaping the final rule.
In today’s testimony, I am going to focus on some areas that received a lot of attention by the agencies and have also been the subject of early public commentary. They include the tightness of the underwriting standards for the QRM exemption, especially the required down payment; the types of risk retention allowed, including the premium capture accounts that would be required for some securitizations and the special risk retention rules proposed for Fannie Mae and Freddie Mac (the Enterprises); and the servicing rules associated with the QRM exemption.
Standards for Qualified Residential Mortgages
The Act directs the agencies to define QRM, taking into consideration those underwriting and product features that historical loan performance data indicate result in a lower risk of default. These features include documentation and verification of borrower financial resources; housingand total debt-to-income payment ratios; mitigation of payment shock on adjustable-rate mortgages; mortgage insurance to the extent that it reduces the risk of default; and restriction of high-risk features, such as negative amortization, interest-only payments, and prepayment penalties.
The agencies must require that securities consisting of one or more non-QRM loans be subject to retention of not less than five percent of the credit risk, but the Act provides latitude for the agencies to specify the permissible forms of risk retention and to allow the securitizers to allocate some or all of the risk retention to loan originators.
The proposed QRM standards were designed to reflect an understanding that Congress intended that risk retention be the norm, with only the best loans exempt. For risk retention to be successful, there needs to be a sufficient quantity of non-QRM loans of acceptable quality, so that non-QRM securities can achieve a reasonable degree of liquidity. If non-QRM loans are relatively scarce, their costs will be higher and their availability will suffer.
The main requirements for a loan to meet the proposed QRM standards are:
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Loan must be a closed-end, first-lien, owner-occupied mortgage.
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Home purchaser must make a minimum down payment of 20 percent of the purchase price plus closing costs. Subordinate financing is not allowed on purchase loans. Rate and term refinances and cash-out refinances must have combined loan-to-value ratios (LTVs) no greater than 75 percent and 70 percent, respectively.
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Borrower’s mortgage debt payments cannot exceed 28 percent of income and total debt payments cannot exceed 36 percent of income.
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Loan terms cannot exceed 30 years, and interest-only, negative-amortization, balloon loans, and prepayment penalties are not eligible. Points and fees cannot exceed three percent of the loan amount, and there are payment caps on adjustable rate mortgages to mitigate payment shock.
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Borrowers must be current and cannot have missed two consecutive payments on any consumer debt in the past two years; and cannot have had a bankruptcy, foreclosure or short sale within the past three years.
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Servicing standards must incorporate loss mitigation practices and address subordinate liens.
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Mortgage insurance may not be used to meet the borrower equity requirements. While mortgage insurance reduces loss severity, the agencies did not find substantive evidence that default rates have been reduced by mortgage insurance. The rulemaking solicits public comments in this area.
In developing the standards for QRM, the agencies examined the historical performance of loans with different risk attributes. FHFA contributed to this analysis by examining the delinquency performance of loans acquired by Fannie Mae and Freddie Mac over the period from 1997 to 2009 for each of the major QRM risk factors. FHFA posted a Mortgage Market Note titled "Qualified Residential Mortgages" on its website on April 12, 2011. That document summarizes the methodology we used and provides quantitative results.[1]
Our analysis estimated the number of loans that would and would not have met the QRM standard in each year and calculates the percentages of those loans that have been 90 days or more delinquent so far. Loans meeting the QRM standards varied from close to 10 percent of Enterprise acquisitions that were originated during the boom years when underwriting standards were lower, to about 31 percent for 2009 originations, or 27 percent when considering only purchase loans. The debt-to-income ratios had the strongest impact on the share of loans meeting the QRM standard. However, that result may reflect some underreporting of income by applicants who knew that they would qualify for the loan without reporting higher income.
FHFA also evaluated the impact of varying the required down payment from 20 percent. Lowering the QRM’s minimum down payment to only 10 percent would have increased the share of qualifying Enterprise loans used for home purchase by just 5 percentage points, from 27 percent to 32 percent. The additional loans would be much riskier, though. Their ever-90-days delinquency rates were consistently 2 to 2.5 times higher than the rates for QRM loans. Because these were all Enterprise loans, virtually all of the loans with LTVs above 80 percent had mortgage insurance, so allowing higher LTV loans only if they had mortgage insurance would not have improved the results.
Concerns have been raised about the impact this standard would have on the availability or cost of finance for homebuyers who are unable to put down 20 percent of the purchase price. The agencies expect to receive a significant number of comments on this issue and will consider them carefully before issuing a final rule. Loans that do not achieve QRM status and are not purchased by an Enterprise or guaranteed by FHA would subject securitizers to the higher costs associated with risk retention, and those costs might well be passed on to borrowers.
In evaluating the potential impact of risk retention, it is important to distinguish between the effect of existing risk-based pricing and the effects that might be caused by risk retention. Some commentaries on the proposed rule indicate that only borrowers who can put 20 percent down will be able to get the best rates. But significant differences in rates based on credit risk already exist today. Freddie Mac, for example, will pay its best price only for loans with LTVs of 60 percent or less and borrower FICO scores of 700 or more.
In considering how much risk retention might add to borrowers’ costs, it is well to keep in mind that interest rates on jumbo loans, which do not currently have any serious securitization options—QRM or non-QRM—available, have been about 60 basis points above those on the largest loans available for securitization through Fannie Mae or Freddie Mac. In effect, that spread is currently the cost of not being able to securitize any portion of those loans. It seems reasonable to anticipate that in a market environment that is receptive to private label securities, risk retention would have a much smaller effect on mortgage rates because it would only prevent lenders from securitizing five percent of their loans.
As required by the Dodd-Frank Act, the standards that define QRM are associated with a low risk of default based on historical data. Investors should be willing to purchase securities backed by pools of such mortgages without the retention of credit risk by the securitizer. However, because QRM has been defined in the NPR as the best class of loans, rather than an average class of loans, there should continue to be many loans made to creditworthy borrowers that fall outside of the QRM standards. The five percent risk retention requirement on securities backed by such loans will help to increase investor confidence and encourage originators and securitizers to maintain prudent underwriting standards, without the race to the bottom that was prevalent in the boom years.
While the proposed QRM standard requires a 20 percent down payment and does not recognize mortgage insurance as a source of meaningful reductions in mortgage defaults, FHFA expects that securitizers and investors will continue to recognize the value of mortgage insurance and other credit enhancements as a vehicle for the reduction of loss severity in the event of default. Therefore, borrowers should continue to have access to mortgage credit without making a 20 percent down payment.
Forms of Risk Retention for Non-QRM Loans
The agencies have proposed in the NPR more than one way for securitizers to satisfy the risk retention requirement for non-QRM loans. The NPR provides a menu of options that would allow the market to determine the most appropriate form of risk retention for a particular deal that satisfies the needs of the investor community, at the lowest cost to the securitizer. This will benefit market liquidity and may allow the market to develop a consensus on risk retention over time.
A securitizer may meet the risk retention requirements for residential mortgage loans through an unhedged five percent of the credit risk in the form of:
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A vertical slice with pro-rata exposure to each class,
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A horizontal slice consisting of the most subordinate class or classes,
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A combination of vertical and horizontal slices, or
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A randomly selected sample of loans.
The NPR allows a securitizer to share the retained risk by allocating a portion of the requirement to originators, but only to originators that provide at least 20 percent of the aggregate loan balances and take at least 20 percent of the retained risk. The rule also allows for resecuritizations of existing securities without the retention of credit risk, but only for structures that result in a single class that simply passes through the cash flows of the underlying securities, rather than redistributing the credit risk between classes.
Finally, the NPR includes a premium recapture account, which comprises any proceeds of more than 95 percent of the par value of the securities. This would discourage security structures that permit the securitizer to take a substantial profit up front at the time of securitization. Structures that would provide an immediate gain on sale to the securitizer would need to include a special reserve account into which the entire surplus derived from the sale of the securities would be deposited, and funds in that account would be available to cover losses before any were imposed on investors. Structures giving the securitizers immediate cash gains were widely abused during the boom, and they generated some of the worst losses. The premium capture account requirement is designed to prevent such abuses by ensuring that the securitizer has a continuing interest in the performance of the underlying assets.
Treatment of Enterprise Securities
Although the Act authorizes the agencies to make exemptions separate and apart from the statutory exemption that applies to Ginnie Mae securities, the NPR does not exempt the Enterprises from the risk retention requirements. However, the proposed rule allows the full guarantee of the credit risk by Fannie Mae and Freddie Mac on their single-family mortgagebacked securities (MBS) to qualify as a permissible form of risk retention while they are in conservatorship with financial support from the U.S. Treasury.
The 100 percent risk retention by the Enterprises on their guaranteed MBS is obviously the maximum possible and far exceeds the five percent retention required by Section 941. Therefore, the NPR does not classify all of the Enterprises’ loans as qualified residential mortgages, but rather acknowledges that the risk retention by the Enterprises on almost all of their securities is already complete. Furthermore, since the risk retained by the Enterprises is itself backed by the Treasury through the Senior Preferred Stock Purchase Agreements and not by private capital, it is stronger than any other form of 100 percent risk retention by a private corporation.
The Enterprises’ guarantees and the backing of the U.S. Treasury appear to provide the necessary protection for investors and the proposed treatment of Enterprise MBS would thus be in the public interest. Retention of five percent of the securities issued would not result in a greater alignment of Enterprise interests with those of investors, and it would be inconsistent with the Enterprises’ agreements with the Treasury that require a 10 percent per year wind down in mortgage assets held for investment by each Enterprise. Simply excluding assets held for the purpose of meeting the risk retention rule from the retained portfolio for the purpose meeting the portfolio reduction targets would prevent forced sales of other assets or violations of the agreements, but it would not address the purpose of these provisions of the agreements with Treasury, which was to reduce the size of the Enterprises’ retained portfolios to limit taxpayer risks.
It seems unlikely that requiring the Enterprises to hold five percent of their newly issued securities would encourage private capital to enter the market to any significant degree. The added Enterprise costs would be only a few basis points, at most, and taxpayers would bear increased interest rate and operational risks from larger retained portfolios. There are more efficient and effective means to reduce the market share of the Enterprises and boost private participation in the secondary mortgage market. Congress has been considering a number of ways to lessen the government’s role in housing finance over time, including increasing guarantee fees over time and reducing the conforming loan limit. The Administration’s February 2011 white paper, "Reforming America’s Housing Finance Market," discussed these and other possible approaches. Since being placed into conservatorship, the Enterprises’ underwriting standards have been strengthened and several price increases have been initiated to better align pricing with risk. FHFA will continue to evaluate further changes along these lines, and we will continue to work with Congress on evaluating legislative approaches to encourage greater private sector participation.
Some Comments on the Mortgage Servicing Requirements for QRMs
The proposed rule includes several loan servicing requirements that must be met to receive QRM treatment. These address important problems in the servicing of mortgages that must be corrected, but they are not meant to constitute an exhaustive list that solves all problems. Indeed, as proposed, the requirements only apply to loans that are securitized as QRMs. Separately, FHFA has been working with the Enterprises to align the requirements that each places on its loan servicers, incorporating emerging best practices. At the same time, we have been working with the Enterprises and HUD to consider more effective methods of compensating servicers, and we have held discussions with other regulators as part of an effort to establish national servicing standards. The requirements in this proposal should be viewed as part of a much broader process of reform in mortgage servicing.
I will be happy to answer any questions you may have.
[1] Mortgage Market Note 11-02: Qualified Residential Mortgages
Contacts:
Corinne Russell (202) 649-3032 / Stefanie Johnson (202) 649-3030