Federal regulators recently proposed new risk retention rules for mortgage-backed securities. The rules appear to be a major concession to the real estate finance sector. The Financial Stability Oversight Council, which includes the Federal Reserve, the Federal Deposit Insurance Corporation, and the Securities Exchange Commission, issued the new rules designed to end certain lending practices that played a part in the 2008 financial tsunami.
New MBS risk retention rules at a glance
The proposed rules require banks and other mortgage-backed securities players to retain 5% of the credit risk on their books. This requirement was mandated by the Dodd-Frank reform measure. The aim of the financial overhaul was to include loans deemed to be “qualified mortgage loans.”
This definition would have included a majority of loans currently being offered, but industry supporters argued that such a provision would have hurt the housing market recovery. In response, the Feds have come up with a plan that is far more limited in scope.
In short, the new proposal scraps an earlier plan to exempt only those loans with at least a 20% down payment. Now, the 5% risk retention requirement will apply to certain loans including those where borrowers only make interest payments for a certain set time period (interest-only loans), loans where the principal balance actually increases, and loans with a debt-to-income ratio of 43% (as opposed to a 36% DTI).
The contemplated plan continues the full guarantee on payments of principal and interest provided by Federal National Mortgage Association (OTCBB:FNMA) and Federal Home Loan Mortgage Corp (OTCBB:FMCC) while the lending giants remain in the Treasury Department’s conservatorship.
Whether the proposal will create a safer lending and securitization marketplace remains unclear. Final rules are subject to revisions as the regulators will accept comments until Oct. 30, 2013. In the meantime, the proposal will benefit the broader real estate finance sector.
How will new MBS risk retention rules affect the lending market?
If the proposed rules are implemented, mortgage lenders and secondary market makers like Federal National Mortgage Association (OTCBB:FNMA) and Federal Home Loan Mortgage Corp (OTCBB:FMCC) as well as a leading real estate mortgage lender and seller/servicer like Wells Fargo & Co (NYSE:WFC) will be affected in different ways.
While last year was profitable for Federal National Mortgage Association (OTCBB:FNMA) and Federal Home Loan Mortgage Corp (OTCBB:FMCC), they still owe the Department of Treasury about $180 billion. The housing giants have been refinancing this debt by selling bonds at lower interest rates in order to repurchase their higher interest rate offerings. Moreover, each has revenues of about $100 billion. But paying back the government bailout debt will take about five years.
In the meantime, the price per share of the common stock is hovering around $1.20. Some analysts correctly note that owning preferred stock of Federal National Mortgage Association (OTCBB:FNMA) and Federal Home Loan Mortgage Corp (OTCBB:FMCC) is the way to go because these shareholders will be paid first if and when the Treasury Department unwinds its conservatorship. The Federal Housing Finance Authority (FHFA) could convert those shares into common stock, however.
Given the current common share price, continued guarantees provided under the new risk retention plan, and a lending market still in a shaky recovery, Federal National Mortgage Association (OTCBB:FNMA) and Federal Home Loan Mortgage Corp (OTCBB:FMCC) do not look like they are on the path to prosperity.