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.

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