March 30, 2011

Banks Must Have Skin In Game When Selling Mortgages: Summary Of Finreg QRM Rules

March 30, 2011

Banks Must Have Skin In Game When Selling Mortgages: Summary Of Finreg QRM Rules

Like driving a faulty-brake Toyota, working in the mortgage industry can make you wonder if large-scale regulatory change will ever stop. Just as companies finalize their loan agent compensation plans to comply with Friday’s Finreg deadline, now the they must turn attention to what loans do and don’t fall under risk retention guidelines.

Also under Finreg, these risk retention rules require banks to keep 5% or more of mortgages they sell so they have skin in the game. The FDIC has started defining which loans constitute “Qualified Residential Mortgages” (QRMs) that are exempt from risk retention rules. Below is a summary of those definitions. Also NYT summarized QRM topic well, and Bloomberg discusses how the new rule might actually increase the role of Fannie & Freddie.

Which Loans Are Subject To Risk Retention
QRMs are defined as mortgages that will not require any form of risk retention by any entity.

The proposal limits QRMs to below 80% loan-to-value ratio (LTV) for purchase loans, below 75% combined-loan-to-value ration (CLTV) for refinanced loans, and below 70% CLTV for cash out refinance transactions.

Negative-amortization loans, interst-only loans, and loans with significant rate increases are excluded from QRM status, so banks will have to retain the target 5% or more when they sell these loans.

Borrower debt-to-income ratios for are capped at 28% and 36% respectively, and for ARMs, these ratios are calculated at the maximum interest rate attainable in the first five years after origination of the loan.

There is also a restriction on the timing of prior delinquencies. In particular, mortgages made to borrowers who have been 60 days or more delinquent on a prior mortgage at any time in the preceding 24 months do not qualify.

Any loan pools with an explicit government guarantee or backed by Fannie & Freddie, as long as they are under conservatorship or receivership, are exempt from risk retention requirements.

Industry Impact Of Risk Retention Rules
In the short run, most experts see no significant effect on the mortgage origination and funding universe if what was proposed goes through. This is because more than 90% of current originations are done through the Fannie, Freddie and FHA which are not really affected by this proposal. The remaining origination volume is being funded through bank balance sheets, so is not affected by risk retention.

The proposals are out for comments, which are due by June 10th. Barclays Capital notes that the definition of risk retention exempt QRMs is slightly stricter than expected (but remember that Fannie, Freddie and FHA guaranteed loans remain qualified, currently +/- 90% of production).

This hints at tighter credit availability in the future, especially once Fannie & Freddie start pulling back.

The risk retention provisions for non-qualified mortgages are likely to benefit banks with large balance sheets. The REIT model of securitization is also likely to benefit. But for non-QRM mortgages, traditional wholesale and conduit mortgage origination channels likely become non-viable.

Accessing securitization channels will also become more difficult and/or expensive for smaller originators and banks for these kinds of loans. The “premium capture account” removes incentives for sponsors to profit upfront from securitization, strengthening the incentive alignment of risk retention. However, in its current proposed form, it significantly discourages securitization of any premium non-QRM loans.

For non-eligible transactions, the proposal calls for minimum 5% risk retention in several possible shapes – such risk would be retained by the sponsor of the deal. The sponsor has the ability to allocate risk to the originator (originator agreeing), provided the originator has supplied at least 20% of the pool and will retain at least 20% of the risk.

This prevents any risk retention being forced on smaller originators. Additionally, the originator is the “original” originator of the loan, and not an intermediary.

Effects On Big vs. Small Banks
Certainly the existing risk retention proposals benefit two entities – big balance sheet banks and REITs.

Barclays Capital notes that a big balance sheet bank can originate loans through its retail channel, and securitize them through its broker dealer while retaining the risk on its balance sheet.

Smaller originators and banks are at a disadvantage for two reasons.

First, due to the 20% floor, sponsors will have to retain risk on loans originated by these smaller entities. This implies that sponsors will typically pay a lower dollar price for these loans. Moreover, smaller originators cannot circumvent this by selling their loans to big banks because risk retention guidelines are tied to the original originator.

The only option for these smaller entities is, therefore, to either aggregate a significant number of loans, which is expensive, or to sell to a willing sponsor at a lower price.