An extraordinary number of individual US Senators have written to the SEC, some during the June 10-Aug. 1 extended comment period, out of a concern that the proposed risk retention regulations are too stringent and do not conform to the legislative intent of Section 941 of the Dodd-Frank Act. These comment letters are in addition to earlier comments by the three Senate co-authors of Section 941, Senators Johnny Isakson (R-GA), Mary Landrieu (D-LA), Kay Hagan (D-NC), who said that the proposed risk retention regulations go beyond the intent and language of Dodd-Frank by imposing unnecessarily tight down payment restrictions that unduly narrow the qualified residential mortgage definition.
Senator John Kerry (D-MA) said that he was worried about the proposed qualified residential mortgage exemption and the unintended consequences that the twenty percent down payment on which the exemption is conditioned could have on responsible, creditworthy homebuyers. Given clear Congressional intent to exempt lower-risk mortgages from the retention requirement and the positive market incentive that this exemption creates, Senator Kerry was surprised to learn about the proposed twenty-percent down-payment prerequisite to the exemption. This bright-line, across-the-board requirement for the qualified residential mortgage exemption seems at once too broad and too narrow, he said, and certainly too restrictive, especially since it applies even to creditworthy homebuyers, and even in instances where these homebuyers obtain mortgage insurance, and even though studies have shown that the size of a down payment does not necessarily correlate with the risk of default.
Similarly, in her comments, Senator Kelly Ayotte (R-NH) said that the proposed regulation goes far beyond the intention of Dodd-Frank and imposes an unnecessarily narrow qualified residential mortgage definition on prospective home buyers. It was Congress' clear intent that underwriting standards guide the development of final regulations defining the qualified residential mortgage exemption. The foundation of a healthy mortgage market is built on strong underwriting standards not on overly restrictive equity requirements, noted Senator Ayotte, and this is precisely why Dodd-Frank notably lacked instruction on down payment levels from the very unambiguous parameters on what should be considered, including the documentation of income and assets, debt-to-income ratios, and mortgage insurance on low down payment loans.
In his comment letter, Senator James Inhofe (R-OK) said that Congress intended to create a broad exemption from risk retention for historically safe mortgage products when it included the qualified residential mortgage exemption in the Dodd Frank Act. Section 941 requires the qualified residential mortgage definition to be based on underwriting and product features that historical loan performance data indicate result in lower risk of default. In his view, the proposed regulation goes beyond the intent and language of the statute by imposing unnecessarily tight down payment restrictions that unduly narrow the qualified residential mortgage definition and increase consumer costs and reduce access to affordable credit. Well underwritten loans, regardless of down payment, were not the cause of the mortgage crisis, posited Senator Inhofe, who added that the proposed regulation also establishes overly narrow debt-to-income guidelines that will preclude creditworthy home buyers from access to affordable housing finance. He said that extensive additional requirements for qualified residential mortgages in the proposed rule swing the pendulum too far and reduce the availability of affordable mortgage capital for otherwise qualified consumers.
Senator John Cornyn (R-TX) is worried that the proposed rule will result in an unlevel playing field for private capital. Loans insured by the Federal Housing Administration (FHA) are statutorily exempt from the risk-retention requirements, he noted, while loans insured by private mortgage insurers would not necessarily be included in the qualified residential mortgage definition. In the Senator’s view, this could not only limit the choice for first-time homebuyers to FHA-backed loans, but would also make reforming the housing market and limiting taxpayer exposure more difficult in the future. At a time when increased private financing and less government involvement is sought, he reasoned, putting in place an insurmountable barrier to accessing private market financing would be counterproductive. The last thing that should be done, he said, is to impose poorly thought-out regulation that is based on a rigid, one-size-fits all approach that further strains the financial market and stifles innovation.
In a wide-ranging comment letter, Senator Carl Levin (D-MI) said that the proposed regulations adopt an independent metric tripwire approach to disqualify a loan as a qualified residential mortgage that is inconsistent with Congressional intent and is not reflective of modern underwriting and risk management practices. Under the proposed approach, the primary creditworthiness criteria that would have to be met to qualify a mortgage as a qualified residential mortgage would be: a first-lien property, a loan-to-value ratio maximum of 80 percent, a down payment of at least 20 percent, a back-end debt-to-income ratio maximum of 36 percent, and the absence of any derogatory credit history factors.
Rather than have each independent metric act as a disqualifying tripwire, said the Senator, the regulations should allow the creditworthiness metrics to be considered collectively on a per loan basis. In this way, he reasoned, a moderately riskier measure on any one of the objective criteria could be mitigated by safer measures on other criteria. This would follow a best practice of lenders who consider such metrics holistically and routinely and reasonably allow a higher-risk factor to be offset by other lower-risk factors. For example, a borrower with significant liquid assets, a steady job, and a low debt-to-income ratio would likely pose very little risk of default. Allowing this creditworthy borrower to buy a home with a 10 percent down payment would likely produce a mortgage with a very low risk of default, yet under the proposed rule, it would not qualify as a qualified residential mortgage.
According to Senator Levin, the creditworthiness criteria used to define a qualified residential mortgage should also be those that respected research has shown are necessary to accurately determine which mortgages can reasonably be deemed the safest. Congress provided some guidance in Dodd-Frank, but did not provide an exhaustive list of what creditworthiness metrics should be used. While the proposed regulations identify metrics that research has shown to be good risk indicators, he continued, some of the criteria should be revised to reflect their relative impact on credit risk.
The creditworthiness criteria would exclude borrowers who experienced a 30 or 60-day late payment over the previous 24 months. The Senator said that this provision should be revised to require a degree of materiality with respect to the late payment. Being 30 days late on an objectively small debt payment should not disqualify an otherwise qualified borrower from obtaining a qualified residential mortgage loan.
Also, while loan-to-value and down payment criteria may be appropriate risk indicators, imposing an 80 percent loan-to-value threshold and a 20 percent down payment requirement would be overly strict. Research has shown that mortgages with down payments of significantly less than 20 percent may not be significantly more likely to default than loans with a 20 percent down payment, if other metrics reflecting a low risk loan are present. That is why loan-to-value and down payment criteria should be considered in combination with other creditworthiness criteria on a per loan basis.
In addition, the proposal makes no mention of mortgage insurance as a risk reducing factor that could mitigate higher loan-to-value ratios. Federal interagency guidance dating back to 1993 has accounted for the use of mortgage insurance to offset the risk of higher loan-to-value loans, he noted, and thus the qualified residential mortgage exemption should consider the role of mortgage insurance as a longstanding tool used to mitigate risk in some loans.
Senator Levin also urged the SEC and the banking agencies to expand risk retention requirements to synthetic asset-backed securities with collateral that references self-liquidating financial instruments. Those synthetic instruments would then be subject to risk retention in the same manner as their underlying assets.
Currently, the proposed regulation exempts all synthetic securitizations from any risk retention requirement. Since synthetic securities that reference self-liquidating financial instruments are inherently reliant upon the referenced assets for their value, he observed, it is reasonable to include them within the definition of asset-backed securities.
Moreover, given the multiple abuses involving synthetic CDOs examined by his Subcommittee, the need for risk retention requirements to align the securitizer's incentives with those of the CDO investors is compelling. In addition, an unintended consequence of excluding them from any risk retention requirement could be to create a new incentive for securitizers to issue synthetic asset-backed securities.
Finally, Senator Levin was troubled by the proposed regulation allowing securitizers of residential mortgage-backed securities to meet their risk retention requirement by retaining a horizontal, first-loss residual interest amount equal to at least 5 percent of the par value of all asset-backed securities interests issued in a securitization transaction. Troubling because this option would essentially allow the securitizers to retain the equity tranche at the bottom of their securitizations, which is the tranche that is likely the most difficult to sell. Authorizing retention of the equity tranche would, however, replicate the same practice that was prevalent during the run-up to the financial crisis. In the Senator’s view, history has shown that retaining the equity tranche was not enough to align the securitizer's incentives with those of investors in the securitization's other tranches.