Loan originators no longer must have ‘skin in the game’

Editor's note:

This article originally appeared in the Financial Times on February 27, 2018.

In the Dodd Frank Act, Congress directed the federal financial agencies to adopt risk retention rules for originators of loans, such as mortgage brokers, which quickly sell them to pool sponsors who in turn sell securities based on those loan pools. Congress wanted these originators to retain approximately 5 percent of the risk of the loans they quickly sold to have “skin in the game”—a monetary incentive to diligently check out borrowers before making loans to them.

On February 9, the DC Federal Court of Appeals invalidated the application of these risk retention rules to managers of funds that raised capital from investors to buy collateralized loan obligations—leveraged loans made to companies below investment grade. The Court decided that the relevant statutory provision should not cover such fund managers because they did not “sell or transfer” loans to a securitization pool.

While the Court was probably right as matter of statutory interpretation, the decision eviscerates what little was left of the risk retention rules. The federal financial agencies, by granting broad exemptions to these rules, have allowed most originators of US loans to insure or sell them to pool sponsors without bearing any risk of loss. In other words, these agencies have re-created one of the main causes of the financial crisis—originators of mortgages who can make quick profits without having any “skin in the game.”

The home mortgage market in the US is now dominated by the Federal Housing Administration (FHA) and the Federal National Mortgage Association (Fannie Mae), together with its sister association nicknamed Freddie Mac. The FHA insures 100 percent of the principal and interest payments on home mortgages originated by banks and mortgage brokers. Fannie Mae and Freddie Mac buy whole mortgages from these same originators, and then sell securities based on these pools with a 100 percent guarantee of the principal and interest on the underlying mortgages.

At least 90 percent of home mortgages in the US are insured by FHA, or bought by Fannie Mae or Freddie Mac. Thus, originators of such mortgages would seem prime candidates for the risk retention rules as contemplated by Congress. Unfortunately, the federal regulatory agencies have issued rules with a broad exemption to any bank or mortgage broker originating a mortgage that is insured by FHA. Similarly, the agencies have exempted such firms if they sell a mortgage to Fannie Mae or Freddie Mac.

Moreover, the regulatory agencies have gradually watered down the requirements for the other main exemption applicable to the small portion of US home mortgages not backed by FHA, Fannie Mae or Freddie Mac. Initially, the agencies proposed that this exemption, called the Qualified Residential Mortgage (QRM), be available only if the borrowers make a 20 percent down payment on the mortgage.

This made sense because low down payments are an excellent predictor of defaults by borrowers on their home mortgages. However, due to heavy lobbying by the real estate industry, this down payment requirement was eventually eliminated.

In the final rules, the regulators said that an originator did not have to retain 5 percent of the risk of a mortgage, despite selling it quickly to a securitization pool, as long as the originator followed the basic rules for a qualified mortgage—e.g., avoiding excessive fees or points, and verifying the borrower’s ability to repay. In addition, the monthly payments for a QRM may not exceed 43 percent of the monthly income of the borrower.

In short, the financial regulators have totally undermined the objectives of Congress in adopting the risk retention requirements by exempting almost all US home mortgages from these requirements. These exemptions are now justified by regulators and legislators in a misguided effort to promote home ownership.

However, on February 14, Fannie reported losses of $6.5 billion, triggering a US Treasury capital infusion of $3.7 billion. When the next financial crisis occurs, the US government is likely to incur much bigger losses because originators of home mortgages can insure or sell them, and make a profit, without having any “skin in the game.”

Robert Pozen has been a nonresident senior fellow at Brookings since 2010. In 2015, he generously committed to endow the Director’s Chair for the Urban-Brookings Tax Policy Center. Until 2010, Pozen was executive chairman of MFS Investment Management and, before 2002, served in various positions at Fidelity Investments. He did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is currently not an officer, director, or board member of any organization with an interest in this article.