Risk Retention and Fall of The Mortgage Industry

The Restoring American Financial Stability Act states its purpose as "promoting the financial stability of the United States by improving accountability and transparency in the financial system, to end 'too big to fail,' to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes."

But what the bill fails to mention is that it mostly fulfills legislators' interest in the popular pursuit of punishing-even eventually destroying-the mortgage industry as we know it. One highly discussed component of the bill is risk retention, whereby new standards of self-insurance are laid out to enforce the availability of reserve funds for the purpose of offsetting any unexpected financial claims. The proposed legislation requires mortgage originators to retain a material portion of the risk inherent in the loans they produce, a figure that is currently set at 10% of the principal balance of every newly originated loan. So for a $100,000 loan, that would equate to holding $10,000 capital for the life of that loan. But wait-major problems here. The policy in its current form does not accurately imply an understanding that mortgage bankers already do retain risk for every loan, via repurchase obligations, early payment default obligations and more. It also expects mortgage bankers to keep more of a retained interest in a loan than they actually generate in revenue for that loan.

For a $100,000 loan, a mortgage banker may generate up to $3,000 in revenue, however, after accounting for expenses, the lender may only make $1,000-far from the $10,000 required retained capital.

Consider this example: a company produces $100 million in one year, thereby needing to hold $10 million in retained interest. Another $100 million is originated in year two, requiring another $10 million be put on reserve. By year three, 20% of the loans are paid off from year one and 10% from year two, but $100 million is again originated for that year. So what does that mean? With $270 million in loans on the books the company must retain $27 million in interest, and it keeps snowballing.

Quicken Loans estimates that a mortgage company doing $1 billion each year in loans would need $486 million in retained capital after 10 years. That is why any mortgage company, no matter what size, would most likely be forced to go out of business.

Simply put, nondepositories have no way to obtain these funds and depositories would most likely shut down other parts of the bank or quit lending due to high capital requirements.

What is it that legislators are really trying to accomplish then? There is a stigma that mortgage bankers do not have a vested interest in the safety and soundness of the loans they produce. So ideally, requiring them to retain interest means they are more likely to ensure that a loan performs and will be more likely to avoid more risky products.

As opposed to relying on regulation that could potentially put most mortgage bankers out of business, the industry should rely on housing experts-Fannie Mae, Freddie Mac and the FHA-to dictate the solution. As a starting point, legislators should carve out Fannie Mae, Freddie Mac and FHA loans from the risk retention bill because those loans do not contain the risk characteristics associated with alt-A and nonprime loans.

A next step would be requiring lenders to adhere to the $2.5 million minimum net worth requirement already established by those three entities. As opposed to the tens of millions of dollars that would be required by the risk retention advocates, it is a much more workable solution. Finally, lawmakers should focus risk retention policy on the subprime and alternative loan sectors of the industry, where there is a public interest in ensuring that appropriate products are provided only to appropriate buyers.

Mortgage bankers already are making critical business decisions based on the expected negative impact of this proposed policy. For example, these individuals are slowing or stopping branch construction, suspending hiring decisions, eliminating geographic expansion and putting off key capital investments due to the potential damaging blow. Companies simply cannot make major, high-cost business decisions today without anticipating the impact of this legislation on their business tomorrow.

I advise you to respond now by calling your regulators, your state congressmen and your federal legislators. Tell them to save the mortgage industry and eliminate unreasonable risk retention policies from consideration.