The Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R. 4173), recently signed into law by President Obama, is the most sweeping legislation regulating the U.S. financial services industry since the Great Depression. Some of the act’s provisions became effective immediately upon enactment. Most provisions, however, have a delayed effective date, require rulemaking by various federal regulators, or both. In addition, the scope and meaning of many of the act’s provisions are unclear. It is therefore difficult to predict with confidence the potential impact of the act on U.S. financial institutions and markets.
In many ways, the fight has just begun, despite the enactment of the 2,300-page bill. Within its provisions are a call for more than 400 new regulations and studies in all areas of the act. It is a lobbyist’s gold mine, especially because the impact of the bill will be determined by the outcome of these regulations and studies.
Many aspects of the legislation affect housing markets both directly and indirectly, none more so than the provisions relating to the securitization of mortgages. Here, as in so many other parts of the bill, the true impact will await the promulgation of new regulations and the results of several studies.
Under new rules to be written by federal regulators, securitizers – those who package mortgages for sale to investors—will be required to retain an economic interest in the credit risk of any asset they securitize, specifically including both single and multifamily mortgages. All forms of securitization are covered, including the types of securities at the heart of the recent tumult on Wall Street and the Securities and Exchange Commission (SEC) case against Goldman Sachs: collaterized debt obligations (CDOs), CDOs of asset-backed securities, CDOs of CDO interests (so-called CDO-squareds), and synthetic CDOs, among others—and the SEC can designate additional types of securitizations.
Virtually all details of the risk retention requirement have been left up to federal agency rulemaking. Federal officials will determine, for instance, whether the loss retained is first loss, pari passu or shared in tranches, and for how long it is to be shared.
The required risk retention will be at least 5 percent, except for securitizations solely of “qualified residential mortgages,” which will require no risk retention—though second-order securitizations of those qualifying residential mortgages are not exempt. Securitizations of other assets may require less than 5 percent risk retention if the originator meets underwriting standards to be prescribed in regulations.
Also excluded from the risk retention rules are securitizations that include only Federal Housing Administration–insured and Veterans Administration–guaranteed mortgages, as well as mortgages backed by other federal agencies. In a shot at Fannie Mae and Freddie Mac, both companies are excluded from the definition of a federal agency, meaning that all mortgages they back will be subject to risk retention requirements unless they are deemed qualified residential mortgages.
The act states that regulations governing commercial mortgage–backed securities (CMBS) may allow the risk be retained by a third-party purchaser that “specifically negotiates for the purchase of such first-loss position,” holds adequate financial resources, and performs due diligence on the individual assets in a manner approved by regulations.
The federal banking agencies, the SEC, the secretary of the U.S. Department of Housing and Urban Development (HUD), and the director of the Federal Housing Finance Agency will jointly define the term “qualified residential mortgage,” and a new Financial Stability Oversight Council will coordinate and oversee this process. This will be cumbersome, to say the least, though the law requires these regulations to be developed within 270 days of enactment and effective one year after they are finalized. Regulations for all other asset classes—such as commercial mortgages – are to take effect two years after finalization.
In defining a qualified residential mortgage, regulators are required to consider features such as the documentation relied upon to qualify the mortgagor, as well as:
- the residual income of the mortgagor after all monthly obligations;
- the ratio of housing payments of the mortgagor to his or her monthly income;
- the ratio of total monthly installment payments of the mortgagor to his or her income;
- the ways in which the potential for payment shock on adjustable-rate mortgages are mitigated through product features and underwriting standards; and
- mortgage guarantee insurance or other types of credit enhancement obtained at the time of origination, to the extent it reduces the risk of default.
The act encourages regulators to prohibit or restrict 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 leaves the regulators with considerable freedom. Will they restrict the definition of qualified residential mortgages to 15- and 30-year fixed-payment, fully amortizing loans, or will they allow for more choices? Will they include provisions regarding loan-to-value ratios, or will they put specific limits on the percentage of income allowable for mortgage or all debt payments?
In the future, almost all mortgages to be securitized will have to meet this definition. For most borrowers, then, only mortgage products meeting this definition will be available. While this is a necessary reform, drawing the definition too narrowly may affect the availability of credit for housing and, in turn, the affordability of housing for most Americans.
Among the many studies required by the act, the Financial Stability Oversight Council has 180 days to study the macroeconomic effects of the risk retention requirement, emphasizing any stabilizing effect on housing prices.
Some of the other provisions of the law affecting housing include:
- A $1 billion third round of funding is provided for the Neighborhood Stabilization Program. This round is by the same formula used in the first round of funding, and includes a 0.05 percent minimum of each allocation for states, a technical assistance carve-out (up to 2 percent), and an eligible use change allowing vacant properties to count toward the low-income setaside.
- The act reforms current mortgage origination practices by requiring lenders to ensure a borrower’s ability to repay, prohibiting unfair lending practices and establishing penalties for irresponsible lending, expanding consumer protections, requiring additional disclosures, and establishing an Office of Housing Counseling within HUD.
- The act provides $1 billion for low-interest loans to qualified unemployed homeowners with reasonable prospects for reemployment to help pay their mortgages and avoid foreclosure while unemployed.
This new law is an important response to the housing crisis – one that is perhaps not perfect in anyone’s eyes, but which has the possibility of correcting most of the worst abuses of the mortgage origination and securitization process over the past decade. It is, however, but a skeletal framework upon which the many regulators in Washington will have to build over the coming months. The key, as is so often the case, is in the details, and those are all coming in the new regulations and the studies soon to be underway. It will be several years, therefore, before anyone can say with any assurance what impact this law will really have.