Riding the Horse Backwards

At a DC conference, dauntingly titled Mortgage Regulatory Forum, Barney Frank, the Congressman from Massachusetts whose name eponymously joins Dodd in the landmark Dodd-Frank Act, spoke about a "revolt" against the risk retention regulations embodied in the Qualified Residential Mortgage rules required by that Act.

We've heard about this risk retention requirement by its euphemistic cognate, rather barbarically described as to "keep skin in the game." I will be publishing a comprehensive article soon about the Act's provision regarding this "skin in the game" mandate. And I will see that you get a copy of the article. For the time being, though, maybe we should reflect a bit on Congressman Frank's worries.

But first, before speculating on Frank's musings about a revolution, let's begin with a story.

Snideley Whiplash and Dudley Do-Right

You might remember the cartoon character Dudley Do-Right of the "Dudley Do-Right of the Mounties" series, a part of the Rocky and Bullwinkle show. Dudley was forever saving Nell Fenwick, Mountie Inspector Fenwick's beautiful daughter, from the machinations of the evil Snideley Whiplash and Tuque, his equally nefarious sidekick. Whereas Dudley is garbed in the bold red uniform with shiny gold buttons of the Royal Canadian Mounted Police, Snidely wears black on black: suit, cape, stove pipe hat, boots - even a black, twisted, handlebar moustache.

Snidely was bent on doing naughty things to the hapless Nell, like tying her to a railroad track. And Snideley's arrogance was only exceeded by his sheer joy when conniving some evil exploit to be perpetrated on the innocent.

But Dudley would save Nell, usually just by dumb luck, free her from the railroad tracks, and boldly stand before her in a puffed-up, prideful "my hero" pose. And then Nell would thrillingly come running into Dudley's open arms, thanking him profusely for saving her!

Actually, no. Nell never did run into Dudley's arms. That just never happened. Not even once!

In fact, Nell would show her gratitude not to Dudley but to Dudley's horse, aptly named Horse, also dressed up like a Mountie. Dudley often rode Horse backwards, galloping boldly to the scenes of Snideley's pernicious schemes.

Even when Dudley had freed Nell from the chains holding her to the railroad tracks, she would hardly notice him. Instead, she gently stroked Horse's snout and elicited his big, charming, toothy smile. For the most part, Nell ignored Dudley, even when he saved her from Snideley's perilous plans.

Poor Dudley Do-Right! He really never did get the grateful recognition he thought he deserved. He never did win Nell's hand in romance. And yet Dudley never gave up on seeing himself as the bold hero responding with courageous alacrity to Nell's call of distress!

"Skin in the Game"

In a proposed rule issued by federal financial regulators, and pursuant to Dodd-Frank, there will soon be a requirement for sponsors of certain asset-backed securities to retain at least 5% of the credit risk of the assets underlying the securities. For "asset-backed securities" read mortgage securitizations. This is being referred to as "risk retention," or that "skin in the game" phrase I mentioned above.

According to those in favor of risk retention, the purpose of this rule is to coalesce underwriting guidelines into an incentivized alignment with securitizers and investors, through promoting a certain set of underwriting standards. The risk retention provision would exempt asset-backed securities that are collateralized exclusively by residential mortgages that are eligible as "qualified residential mortgages," now known, of course, as QRMs.

Many regulators have signed on to the QRM and risk retention provisions, since their view essentially is that "credit risk retention," the name given to the QRM concept, should be required because they believe it encourages prudent underwriting and securitization.

However, consider this: it is simply not known if 5% is even the appropriate amount of risk to be retained in order to align incentives! Indeed, there is scant statistical support for any such percentage whatsoever.

From a Distance

From a high altitude of consideration, the composite criteria of a QRM are the "plain vanilla" variety perfectly familiar to residential mortgage loan originators: 80% LTV; 20% down payment plus closing costs; 28% front-end ratio, and 36% back-end ratio.

Underwriting to the QRM guidelines means that securities backed by QRMs will not require securitizers to retain credit risk. Of course, there's far more to what constitutes a QRM and how it is structured. 

Recently, I spoke with a supervising prudential regulator, an old friend, and asked if QRM will crowd out the development of other products that could serve the consumer. His view was that the QRM criteria allow for innovation and, in any event, if they adversely affect a consumer's access to credit, then QRM standards may need to be changed. I must admit, I do not find that response very satisfying.

Markets are active, not passive. Much too often, though, regulatory requirements tend to be reactive, rather than responsive, mostly due to politicians catering to their constituencies and lobbyists. Since when did politicians and regulators so fully replace market action or override underwriting models that lenders undertake as part of making a market, pricing in risk, and developing loan products that respond to consumer needs?

"Revolt"

Congressman Frank seems to have concluded that the recent economic meltdown was largely caused by the housing bubble - presumably, that would be the housing bubble that he declared would never take place. So, "credit risk retention" is now being advanced as a policy that can help to avoid another housing bubble.

Here's the prevailing narrative: in 2008 and 2009, we went into the Great Recession, and now we're experiencing high unemployment and weak growth. Was the housing bubble the ultimate cause?

Most people seem to think so. They believe that the housing bubble burst in 2006 and led to a severe financial crisis in 2008, intensifying a recession that had begun in December 2007. And the Fed did what it could, through targeting inflation to prevent the crash, but could not stem the tide.

Here's another narrative, one actually supported by facts: the housing crash did not lead directly to a recession or high unemployment, although it seems to have been a proximate cause.

More than two-thirds of the decline in housing construction happened between January 2006 and April 2008. During that period, though, the unemployment rate rose only slightly, from 4.7% to just 4.9%. And statistics demonstrate that most of the workers who lost jobs in housing construction were subsequently reemployed in other fields. It wasn't until October 2009 that unemployment soared to 10.1%, with job losses spread out across almost all sectors of the economy.

Indeed, the financial crisis did have its roots in the housing bubble, and there were consequent systemic failures of financial institutions, yet for some odd reason this situation did not set off alarm bells at the Fed until much too late.

There is a world of difference between a proximate cause and the ultimate cause.

Bottom Line: monetary policy failed to predict the problem and the Fed did not respond soon enough.

Fallacy of the "Blame Game"

The assumptions of the first narrative have dominated politics and have led to the QRM remedy.

Thus it is that we have this statement from Mr. Frank:

"I am disappointed at this revolt against risk retention that was so clearly at the center of this."

"All the other problems we had ... they all centered on the system for selling to other people loans that shouldn't have been made in the first place."

"It's simply not possible with any conceivable number of regulators to monitor every loan. If the people making the loans do not have an incentive not to lend to people who can't repay, there is no way we will prevent those kinds of loans from being made." (My emphasis.)

That sweeping statement is certainly not supported by the facts. I have discussed this fallacy of the "blame game" in detail elsewhere, for instance in my three-part series on the Dodd-Frank legislation.

Yet the "revolt" is not just coming from lenders. Consumer advocacy groups want to ensure homeownership for qualified borrowers among low and middle income families, without having to be turned away due to a market that has been deincentivized from lending to them.

Nell and the Horse

Maybe there was a really good reason why Nell preferred to show her gratitude to the Horse, rather than to drape herself around Dudley Do-Right's neck in gleeful appreciation and unbounded thanks.

I wonder if you could suggest what Nell's reason might have been.

What do you think?

Please feel free to comment!

Jonathan Foxx is the President and Managing Director of Lenders Compliance Group.

The Smoking Gun - Loan Originator Compensation

COMMENTARY: by JONATHAN FOXX

Jonathan Foxx is a former Chief Compliance Officer of two publicly traded financial institutions, and the President and Managing Director of Lenders Compliance Group, the nation’s first full-service, mortgage risk management firm in the country.

On April 6, 2011, the TILA loan originator compensation rule (Rule) went into effect, despite the best efforts of numerous industry organizations, a federal agency, congressional legislators, and private citizens to prevent such implementation. Although the NAIHP has withdrawn its appeals case in order to pursue other options, the NAMB continues its legal challenge in the US Court of Appeals - DC.

A week before the April 1, 2011 statutorily effective date a letter was written to FRB Chairman Bernanke, requesting significant revisions to the Rule - revisions that strike at critical issues contained in the NAIHP and NAMB's objections.

Commentary and Outline

This Commentary offers a brief outline. I am leaving out citations, where possible, for ease of reading. This outline is not meant to be comprehensive, authoritative, or relied upon for legal advice. It offers only a brief synopsis of the argumentation. For citations, exhibits, and argumentation, please read the letter. (See below.)

The word that is heard perishes, but the letter that is written remains.
- Ancient Proverb 

On March 24, 2011, Barnie Frank (D-MA), the House's counterpart to the Senate's Christopher Dodd (D-CT) - now former Senator Dodd - wrote a letter to Chairman Bernanke requesting revisions to the FRB's implementation of the Rule.

Why Frank sent this letter to the FRB eight months after the enactment of his eponymously named legislation known as the Dodd-Frank Act (DFA) - otherwise known as the Wall Street Reform and Consumer Protection Act - after the commencement of litigation, after most of the mortgage industry leadership had spoken with many elected officials in congress to prevent implementation, after the SBA Office of Advocacy had requested a delay, after key organizations had lobbied all along against the Rule, and just days before the effective compliance date - why, that is, Mr. Frank decided to send this letter at the last minute, as it were, is anybody's guess.

Perhaps we can venture a guess or surmise some possible motives.

But, let's review the letter.

A letter does not blush.
- Marcus Tulius Cicero

In the letter, Mr. Frank wants the Rule to go into effect, but he would like the Rule amended "immediately thereafter" for two changes. How a federal statute affecting an entire industry can go into effect and then immediately thereafter not go into effect - that he does not say.

According to Mr. Frank, who is now the Ranking Member of the House Financial Services Committee, the Rule "go[es] beyond what was required" and the "two problems unnecessarily interfere with borrowers' ability to obtain loans from mortgage brokers," and revising the Rule accordingly "would not damage the core underlying consumer protections."

Yes, of course, the cited provisions are "problems" - precisely so.

Nevertheless, Mr. Frank believes:

"It is important that the rule take effect as scheduled, and that the Federal Reserve take immediate action to correct the two problems created by the rule."

Problem # 1

The Rule "appears" to prohibit a mortgage brokerage firm that is receiving compensation for a loan from the consumer from paying any compensation related to that loan to an employee of that firm.

According to Frank, this is because the rule:

"appears to include language that states that when a loan originator receives compensation from the consumer on a loan, no loan originator at all can receive compensation related to that loan from any source."

This interpretation differs from Section 1403 of the DFA, which "merely states" that if a loan originator receives compensation from the consumer, that originator cannot receive compensation from another source.

Frank avers that this statutory provision is meant to prevent "double dipping." However, the FRB's Rule is "more restrictive" because it prevents the sharing of the consumer-paid compensation by the firm with an employee for that employee's work on the loan.
Stating the obvious, Frank continues:

"I would note that such sharing of compensation would not involve an increase, directly or indirectly, in the level of fees paid by the consumer."

Here's his recommended change:

The language should be revised to allow employee compensation in this circumstance.

Problem # 2

Referring to - but not specifically stating - the Rule's requirements regarding the restrictions on making small fee reductions at loan closing to cover shortfalls which sometimes result because of last minute third party fee changes, or to cover the cost of a short extension of a loan lock when the loan failed to close within the window of the original loan lock, Mr. Frank thinks that the Rule is too restrictive.

Here's his recommended change:

The practice should be allowed (1) if the fee reduction is at the request of the borrower and is made within a short period (i.e., 24 hours) of the loan closing, and (2) if limited by frequency of such use, implemented through either the dollar or percentage amount of the reduction.

Festina Lente (More Haste, Less Speed)
- Ancient Latin Proverb

Mr. Frank's one-and-a-half page epistle to Chairman Bernanke ends as abruptly and politely as it begins, with these words:

"I believe that both of these provisions should be revised expeditiously by the Federal Reserve through an appropriate action or proceeding at the earliest possible time. Thank you for your consideration of these requests."

Guess, if you can, and choose, if you dare.
- Pierre Corneille

So, why this letter? It is not as if the FRB has a history of abiding by the requests of Congress. Recently, in fact, it took an Act of Congress to pry the FRB's financial data about distribution of "bail-out" funds from the FRB's closeted grasp.

And, at the time of the letter's writing, the FRB was already embroiled in resisting a stay of the Rule. Given the timing, is it really likely that the FRB would have been willing to change course on the basis of Frank's requests? I think not.

Ascertaining motive is always a very elusive undertaking.

In determining what sector of the mortgage origination industry benefits most and is best protected by Mr. Frank's recommended changes to the Rule, it is a good idea to follow the money - in more ways than one!

Our Library contains a copy of the Letter from Barnie Frank to Ben Bernanke.

What do you think?

Please Leave Your Comments Below!