If you ask lenders what the biggest threat to their business is, most will cite lower home values, rising interest rates, or compliance headaches. Yet in early May, Congress had to pass an amendment to the Restoring American Financial Stability Act to head off what could have been a disastrous provision for non-bank lenders. Buried in the midst of the 1,300-page act, the major financial reform bill being debated by the Senate, was a provision that would have required all lenders to retain a portion—up to 5%—of a loan’s risk in accessible capital.
Thankfully, on May 11, the Senate unanimously passed an amendment co-sponsored by Mary Landrieu, D-La., and Johnny Isakson, R-Ga., that ensured that regulators will establish a category of “qualified residential mortgages” that would be completely exempt from the bill’s risk retention requirements.
For most nonbank lenders, retaining this level of capital would be catastrophic to their bottom line. If they close, it would mean more job losses just at a time when some local economies are beginning to see modest gains.
And consumers would lose, too. With fewer options in the marketplace, borrowers would be restricted to seeking mortgages from banks and credit unions. While banks and credit unions are a valuable and vital part of the marketplace, nonbank lenders provide borrowers more competition and choice.
The Senate wisely saw the unintended consequence of this provision and passed the Landrieu/Isakson amendment. The amendment directs the federal banking agencies, the secretary of Housing and Urban Development and the director of the FHFA to jointly define which mortgages will be exempted from the risk retention requirements.
The amendment does not spell out the exact terms, but it does direct the agencies to consider the following criteria when making a final determination:
1. The documented income of the borrower after all monthly obligations.
2. The ratio of the housing payments to the monthly income of the borrower and the ratio of all monthly installment payments to the borrower.
3. Ensuring there is no potential for payment shock on an adjustable rate mortgage.
4. Ensuring all loans have a loan-to-value ratio of 80% or mortgage guarantee insurance.
5. Prohibiting or restricting the use of balloon payments, negative amortization, prepayment penalties, interest-only payments and other features that have been demonstrated to exhibit a higher risk of borrower default.
This amendment will give nonbank lenders a more level playing field, but adjustments will still be needed. Those lenders who specialize in more risky loans will have to raise more capital or change their business model to target loans that would fall under the exemption. For most lenders who survived the mortgage crash, though, these changes have already been implemented.
While this is a huge win for the industry, there is still a lot of work to be done to ensure lenders have the ability to close loans and sell them on the secondary market without crippling their capital base.
The Senate has already considered how to include qualified commercial loans for exemptions, but nothing has been clarified concerning jumbo loans. The bill passed on a 59-39 vote on May 20. Other amendments to the passed bill affecting the mortgage industry include requiring lenders to maintain certain underwriting standards and an audit of emergency lending actions at the Federal Reserve. The underwriting standards amendment requires lenders to maintain more stringent underwriting standards and verify the borrowers’ ability to repay based on income and assets outside of the home’s value. It also bans mortgage lenders and originators from accepting payments based on the interest rate or other loan terms.
The intent of the amended risk retention provision is that retaining 5% capital should only apply to high-risk or subprime loans. The recently created category of Section 35 loans under Regulation Z is a strong definition of high-risk loans, and regulators should consider adopting those same definitions. This approach will make it easy to define which loans must carry a risk retention requirement, and it will not add any more costly compliance procedures to the origination process.
Lenders are already responsible for the risk of errors in the underwriting of loans, and borrowers receive the best rates and terms when there is a healthy, competitive marketplace. Driving competition and capital away from the mortgage market will only hurt financial stability and hinder technology innovation, not restore it.
Ty Jenkins is president and founder of Idaho Falls, Idaho-based DocuTech Corp., which provides compliance services and documentation technology for the mortgage lending industry.
