Picture a real estate market where conventional mortgage financing is divided into just two, unequal segments. I am not making this up:

  • "Grade A" loans that get the best rates available but require a minimum 30 percent down payment. Since most homebuyers don’t have that sort of cash sitting around, there aren’t large numbers of new mortgages in this category. It’s pretty much reserved for the credit elite — refinancers who’ve built up substantial equity and upper-income savers looking to buy a house.
  • "Grade B" loans are for everybody else. They come with 2 to 3 percent higher interest rates than Grade A, but allow smaller down payments. Because of the steeper interest charges and tough underwriting requirements, these loans also represent a challenge for many homebuyers. At the lower credit score ranges — and for just about any buyers with nontraditional or complicated credit — lenders avoid them altogether.

Sound like a smart way to run a housing recovery? You’ve got to be kidding. Yet something like this bizarre concept could actually emerge within the month from federal regulators’ ongoing closed-door deliberations to meet a key mandate of last year’s Dodd-Frank financial reform legislation.

Consumer groups, homebuilders, lenders, the title industry and the National Association of Realtors are worried enough about the possibility that last week 12 of them sent an unusual joint letter to regulators at the Federal Reserve, Treasury Department, Federal Deposit Insurance Corp., Securities and Exchange Commission, and the Department of Housing and Urban Development trying to wave them off.

Believe me, when the Center for Responsible Lending and the Consumer Federation of America line up shoulder to shoulder with the Mortgage Bankers Association and the American Land Title Association on a regulatory concern, you’ve got to take notice. These are not frequent bedfellows.

The issue that’s brought them together is what’s known as "qualified residential mortgages." The Dodd-Frank law ordered federal regulators to set aside a category of low-risk loans that would be exempt from a new "skin in the game" requirement.

That rule, in turn, forces lenders to retain a 5 percent financial stake — their own precious corporate capital — in pools of mortgages heading for securitization that don’t quite make the Grade A standard.

But what should high-quality Grade A loans look like? The law assigned eight federal banking, housing and financial regulators the task of coming up with a definition and listed some time-tested criteria for them to consider — full documentation of income and assets, reasonable debt-to-income ratio ceilings, and prohibitions against negative amortization and balloon payment features, among others.

That sounded straightforward. But in the looking-glass world of Washington, nothing is ever straightforward. Some of the banking agency representatives reportedly urged adoption of a super-strict, exclusive standard for the exception, as opposed to a broader definition that would allow far larger numbers of borrowers to obtain mortgages at low rates.

The country’s largest mortgage lender, Wells Fargo, weighed in with a controversial but influential recommendation to the regulators: Reserve Grade A solely for borrowers who put substantial amounts of their own skin in the game — to the tune of 30 percent down payments and up. No other criteria should count.

The rationale, according to Wells Fargo Executive Vice President John P. Gibbons — a former vice chairman of Freddie Mac and well known in banking circles: To be taken seriously in the capital marketplace, the Grade A category needs to be pristinely low-risk.

Any broader, more inclusive standard, he argued, would mean fewer securitizations for Grade B loans — thereby potentially denying large numbers of creditworthy people an opportunity to obtain home loans. Issuers of securities would not be as motivated to serve a small Grade B population as they would be if it were instead much bigger.

In their Jan. 11 letter, the 12 groups saw it starkly differently. A "definition that is too narrow would prohibit many first-time homebuyers" from entering the market, they warned the regulators, "especially if the definition includes an excessively high minimum down payment requirement."

Repeat buyers and refinancers "also would be adversely impacted" because many of them don’t have large equity positions in their properties, either.

"If the agencies establish a (standard) that is significantly tighter than current credit standards," according to the joint letter, "it would mean that millions of creditworthy borrowers would be deemed, by regulatory action, to be higher-risk borrowers. As a result, they would be eligible only for mortgages with higher interest rates and fees."

The groups cited industry studies that estimated the difference in interest rates between Grade A loans and Grade B could be 300 basis points — 3 percent higher for borrowers because they can’t put together big down payments.

"It’s insane," said Glen Corso, managing director of the Community Mortgage Banking Project, a group representing mid-sized lenders and a signatory to the letter. "If (the agencies) come out with a strict rule like what we believe they’re talking about, it will be incredibly damaging and contrary to the spirit of Dodd-Frank."

Regulators, for their part, are staying mum on the whole issue. Though their proposed rule was expected to be ready late last year, reported disagreements among the banking agencies and HUD have delayed the final product for weeks. It’s now expected to be issued either sometime this month or in February, but no later than April.

Where’s this all headed? Could the regulators actually come out with something as dumb and damaging as the consumer and real estate groups are worried about? No one can say for sure.

But when regulators believe that somehow the "safety and soundness" of banks might be threatened by a national mortgage standard they view as too permissive, nothing is off the table.

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