Regulators Propose Banks Retain More Risk when Securitizing Mortgages(Update 1)

Updated from 12:20 p.m. ET with reactions from the industry.

NEW YORK ( TheStreet) -- Federal regulators on Wednesday proposed a revamped risk retention rule that would require banks to retain 5% of credit risk for any residential mortgages that they securitize and sell to investors, unless the mortgages meet certain criteria.

The risk retention rule is being proposed to ensure that banks have enough "skin-in-the-game," to encourage them to better manage their underwriting processes. The rules do not apply to commercial mortgage loans, commercial loans or auto loans of low credit risk.

Mortgage loans that meet the definition of a "qualified residential mortgage" (QRM) would also be exempt from the risk retention rules.

In the original proposal, the agencies proposed conservative underwriting standards, including a 36 percent debt-to-income requirement, a 20 percent down payment requirement, and credit history standards. That proposal was met with howls of protest from the industry, which argued the rule would severely curtail the availability of credit to middle class borrowers, many of whom cannot afford a large downpayment.

Under the revamped proposal, qualified residential mortgages would match the definition of the "qualified mortgage"(QM) as defined by the Consumer Financial Protection Bureau earlier this year.

Essentially, as long as the monthly mortgage payment does not exceed 43% of the borrower's income and is devoid of toxic loan features such as negative amortization and interest-only payments, the bank will be exempt from retaining even 5% of the risk on its balance sheet.

The exemption from risk-retention also applies to loans that are backed by Fannie Mae ( FNMA) and Freddie Mac ( FMCC), so long as the companies remain in conservatorship.

However, the regulators are still seeking comment on an alternative proposal. The alternative approach would take the QM criteria as a starting point for the QRM definition, and then incorporate "additional standards that were selected to reduce the risk of default."

Among those additional standards, regulators are proposing that the borrower should have put down at least 30% down on the loan.

In other words, under this alternative proposal, a securitizer would have to retain risk for even a qualified mortgage, if the loan-to-value ratio exceeds 70%.

The industry reaction to the proposal has been mostly positive, welcoming the move to align the definition of QRM with QM.

"This will encourage lenders to continue offering carefully underwritten QM loans, including those with lower down payments. As a result, it will help the economy and ensure the largest number of creditworthy borrowers are able to access safe, quality loan products at competitive prices," Frank Keating, President of the American Bankers Association said.

However, there is still likely to be opposition to the regulators' alternative approach.

"While we strongly support the core proposal, we remain concerned that the regulators are still considering an alternative option that would add a 30% down payment or equity requirement to the QRM definition," David Stevens, president and CEO of the mortgage bankers association said in a statement. "As we detailed in our original comments on the rule, such steep down payment requirements are unnecessary to accomplish the purposes of the QRM standard and would severely impair access to credit for all but the most well-heeled borrowers."

The proposal was issued jointly by the Board of Governors of the Federal Reserve System, the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission.

-- Written by Shanthi Bharatwaj in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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