Friday, August 30, 2013

Weakening a Weak Rule: Mortgage Backed Securities

Weakening a Weak Rule:  Mortgage Backed Securities

While many of us are winding up our summers, lobbyists have been hollowing out one of the key provisions of the Dodd-Frank law.  The original financial reform proposal required financial institutions to retain on its balance sheet 5% of any mortgage-backed securities that it decided to sell.  During the real estate bubble, banks and other lenders created pools of toxic mortgages, which they packaged up and sold off to investors.  The mortgage originators earned their fees and got all of the risk off their books.    The initial proposal was devised so that mortgage originators would be far more conservative in underwriting mortgages.  After all, if they underwrote bad mortgages they’d suffer along with outside investors, as they’d retain 5% of the exposure. The concept is called “having skin in the game.”

Castoff (1999)

As Dodd-Frank ground its way through the legislative process, banking and real estate interests were making progress in watering down this provision.  You may recall that former Senator Christopher Dodd had received a “special” mortgage from Countrywide, so there already was a close relationship between one of the legislation’s chief sponsors and the industry.  In the end, Dodd-Frank instructed the regulators to establish rules that exempt certain highly qualified (safe) mortgages from the 5% requirement. 

Even the provision enacted by Congress might have been bad news for financial executives if the final rule were too broad.  A broad rule would put a crimp in executive bonuses and the value of stock options.  If an institution had to set aside capital to cover 5% of a large proportion of the loans it decided to sell, the company’s return on capital would be lower, and its ability to generate additional mortgage business would be diminished. Not surprisingly, the lobbyists pushed the six regulatory agencies with oversight responsibility to promulgate a very narrow rule.  Sure enough, the Federal Reserve, the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission have just agreed to exempt all but the most toxic mortgages from the 5% requirement.  Since most of those types of mortgages aren’t being underwritten at the moment, the new regulation will be meaningless.

The industry lobbyists are right when they argue that the set 5% set aside would slow down their clients’ businesses as well as mortgage issuance.  Frankly, that’s what the regulation should do.  It is unfortunate that Congress left wiggle room by allowing the regulators to create exceptions and didn’t enact a strict 5% requirement.  It is astounding to me that we insist on a margin of safety when it comes to tangible consumer products, prescription drugs, food, and aviation, but in finance we let our businesses operate on the edge of soundness.  Even animal feed has to have a margin of safety.

If the regulators finalize this rule you can count on two things.  First, Wall Street’s brightest minds will engineer new mortgage products that meet the letter of the rule, but foist all the risk on investors.  Second, we’ll eventually have a new generation of distressed homeowners who were seduced into selecting toxic mortgage products.  How can I be so certain of this outcome?  The last housing bubble and subsequent collapse wasn’t our first experience with the excessive risk of the mortgage business.  In the late 1980s we went through a similar period of improper mortgage lending.  Despite large losses and scandals (remember the Keating Five?[1]), Congress enacted ineffective reforms.  In little more than a decade, a new generation of operators were brewing up a toxic mortgage stew that ignited the Great Recession.

Sadly, it only took five years for all six government agencies with jurisdiction over this issue to be recaptured by the industry.  Only one SEC commissioner, Daniel Gallagher, issued a dissent.  So much for reform.  Here’s the reality. Our regulators are hard at work protecting Wall Street’s interests, while making sure that our next financial crisis comes sooner rather than later. 

[1] Charles Keating was the Chairman of Lincoln Savings, which became insolvent after a spree of mortgage lending.  When the regulator (Federal Home Loan Bank Board [FHLLB]) tried to move on the thrift, Senators McCain, Glenn, DeConcini, Cranston, and Riegle intervened.  In the wake of the savings and loan crisis, Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which created the Office of Thrift Supervision to replace the FHLBB.  The OTS was an incredibly weak regulator that turned a blind eye to the latest mortgage crisis.  The OTS was swept away by Dodd-Frank.

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