A proposal that would require that companies securitizing mortgages retain 5 percent of the risk on all but the safest loans could leave borrowers who are unable to put at least 20 percent down on a home purchase paying higher fees and interest rates, critics say.

The new risk retention requirements were mandated by Congress in the Dodd-Frank Wall Street Reform and Consumer Protection Act, which contains a number of provisions intended to address problems created when loans are bundled into mortgage-backed securities and sold to investors.

The loan securitization process keeps money flowing into mortgage lending, helping make borrowing more affordable. But the process also insulated loan originators from losses and encouraged risky underwriting practices during the boom, critics say.

Regulators have some flexibility in implementing the new law as they draw up the definition of what will constitute  "qualified residential mortgages" exempt from the risk retention requirements.

This week, the Federal Reserve and five other federal agencies proposed that borrowers must put at least 20 percent down for a residential loan to qualify for an exemption, and that points and fees on a qualified loan not exceed 3 percent of total loan amount.

The proposal — which is open for comments until June 10 — would also trigger risk retention requirements on mortgages when front-end debt-to-income ratios exceed 28 percent, and back-end ratios exceed 36 percent.

Lenders seeking exemptions would be required to verify and document the borrower’s monthly gross income, monthly housing debt, and monthly total debt using the borrower’s monthly housing debt to calculate the front-end ratio and total monthly debt to calculate the back-end ratio.

The risk retention rules would apply to "private label" mortgage-backed securities (MBS) not backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Private label MBS, which were the main source of funding for subprime lenders during the boom, all but disappeared after the housing crash but could reemerge as the government winds down Fannie and Freddie.

"Fundamentally, this rule is about reforming the ‘originate-to-distribute’ model for securitization, and realigning the interests in structured finance toward long-term, sustainable lending," said Federal Deposit Insurance Corp. Chairwoman Sheila Bair in a statement. "If we are truly interested in restarting securitization, then we must restore investor confidence and the soundness of the securitization model."

Real estate industry groups took issue with the down payment threshold, with the National Association of Realtors claiming borrowers seeking loans that don’t meet the standards for "qualified residential mortgages" could end up paying higher fees and interest rates totaling 3 percentage points or more.

A narrow definition of a qualified residential mortgage, with "an unnecessarily high down payment requirement, will increase the cost and reduce the availability of mortgage credit, significantly delaying a housing recovery," NAR said, as "hundreds of thousands" of would-be buyers would be excluded from homeownership.

Writing on the blog Calculated Risk, housing economist Tom Lawler questioned those and other industry claims about the impacts of the proposed risk retention rule, concluding that it would add only "a little more cost of doing business" in the market for private-label MBS.

The private-label MBS market, Lawler said, is already broken, and "no real progress has been made to ‘fix’ the old ‘built to fail’ model," which is riddled with conflicts of interest not addressed by risk retention.

Using a back-of-the-envelope formula, Lawler estimates that the actual effect of risk retention on mortgage rates would be closer to 20 basis points, or one-fifth of a percentage point.

Any additional differential in rates charged to borrowers of nonqualified residential mortgages would be due to the premium that investors would expect for investing in securities not guaranteed by Fannie, Freddie, and Ginnie Mae, rather than risk retention requirements. Ginnie Mae guarantees payments on MBS backed by loans insured by the Federal Housing Administration, Department of Veterans Affairs and Department of Agriculture.

NAR said risk retention requirements for private-label MBS could boost demand for FHA-insured loans, at a time when the government is trying to rein the FHA’s market share back to historical levels. That could prompt "severe tightening of FHA eligibility requirements and higher FHA premiums to prevent huge increases in its already robust share of the market," NAR warned.

The Mortgage Bankers Association (MBA), National Association of Home Builders (NAHB), and American Securitization Forum (ASF) issued similarly dire warnings.

As proposed, the risk retention rule would disqualify about 5 million potential homebuyers, resulting in 250,000 fewer home sales and 50,000 fewer new homes being built per year, NAHB claimed.

The "extremely rigid proposals" for a qualified residential mortgage, ASF said, will keep "a significant amount of private capital on the sidelines." That, the group said, "will only serve to further depress home prices nationwide and keep first-time home buyers out of a housing market suffering from a severe oversupply of available homes."

The MBA said that while the rule might "prove workable for commercial real estate financing, we have profound concerns about its implications for residential mortgage financing and the nation’s economy today and for generations to come."

The rule should allow for consideration of a borrowers entire credit profile, the MBA said, allowing lower down payments for borrowers with a strong payment history and debt-to-income ratios on the lower end of the scale.

It’s not just industry groups that are concerned that loans to borrowers making less than a 20 percent down payment won’t be considered "qualified residential mortgages."

Before the proposed risk retention rule was published, the Center for Responsible Lending and the Consumer Federation of America joined with NAR and NAHB in urging regulators to avoid an approach that relies on "arbitrary down payment requirements"

"If the regulators impose a 20 percent — or even a 10 percent — minimum down payment requirement … hundreds of thousands of creditworthy households will be excluded from homeownership because of the dramatic increase in the wealth required to purchase a home," the groups said.

It would take 14 years for a family saving $3,000 per year to come up with the down payment on a $170,000 home. Although regulators said they are willing to consider a 10 percent down payment threshold for qualified residential mortgages, it would take the same family 9 years to come up with that, the groups said.

The groups said a better approach would to define qualified residential mortgages as those with strong documentation, proof income to support the monthly payment for the life of the loan, reasonable total debt servicing loads, protections from payment shock, and prohibitions on high-risk loan features like negative amortization and balloon payments.

In drafting the proposed rules, regulators said they "carefully considered how to incorporate a borrower’s credit history into the standards" for a qualified residential mortgage.

Although loan originators often rely on credit scores in making loan underwriting decisions, for example, regulators were uncomfortable with incorporating them into the definition of a qualified residential mortgage because credit scoring models are developed and maintained by privately owned companies and may change.

Instead, the proposed rules define "derogatory factors" for borrowers that would disqualify a mortgage from being exempt from risk retention requirements.

Under the proposal, loans to borrowers who are currently 30 or more days past due on any bill, or who have been 60 or more days past due on a bill in the last 24 months, would not be considered qualified residential mortgages. Neither would loans to borrowers who have declared bankruptcy, been foreclosed on, or engaged in a short sale or deed in lieu of foreclosure in the last three years.

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