from the Federal Reserve
Six federal agencies approved a final rule requiring sponsors of securitization transactions to retain risk in those transactions. The final rule implements the risk retention requirements in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
The final rule is being 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. As provided under the Dodd-Frank Act, the Secretary of the Treasury, as Chairperson of the Financial Stability Oversight Council, played a coordinating role in the joint agency rulemaking.
The final rule largely retains the risk retention framework contained in the proposal issued by the agencies in August 2013 and generally requires sponsors of asset-backed securities (ABS) to retain not less than five percent of the credit risk of the assets collateralizing the ABS issuance. The rule also sets forth prohibitions on transferring or hedging the credit risk that the sponsor is required to retain.
As required by the Dodd-Frank Act, the final rule defines a “qualified residential mortgage” (QRM) and exempts securitizations of QRMs from the risk retention requirement. The final rule aligns the QRM definition with that of a qualified mortgage as defined by the Consumer Financial Protection Bureau. The final rule also requires the agencies to review the definition of QRM no later than four years after the effective date of the rule with respect to the securitization of residential mortgages and every five years thereafter, and allows each agency to request a review of the definition at any time. The final rule also does not require any retention for securitizations of commercial loans, commercial mortgages, or automobile loans if they meet specific standards for high quality underwriting.
The final rule will be effective one year after publication in the Federal Register for residential mortgage-backed securitizations and two years after publication for all other securitization types.
The following sections concerning dissent were added by Econintersect – and were not provided by the Federal Reserve:
Securities Exchange Commissioner Daniel M. Gallagher stated in part:
Regulators are often pilloried for fighting the last war instead of planning for the next. Today’s rulemaking takes the untenable housing policy that injected irrational exuberance into mortgage lending and, as a result, caused a catastrophic financial crisis and chisels that failed policy into the stone tablets of the Code of Federal Regulations. In other words, it manages to take the policies that lost the last war and adopt them as the government’s preparation to win the next.
The Dodd-Frank Act very rarely provides the SEC with an opportunity to deal with the actual causes of the financial crisis. As I made clear in my dissent to last year’s re-proposing release for this rulemaking, I do not believe that the federal government should be dictating prescriptive risk management standards, as the rules adopted today will do for mortgage securitizers.Despite these misgivings, if it prevented adoption of the QRM standard being approved today, I would have voted to adopt the original 2011 proposing release with its firm, thoughtful definition of “qualified residential mortgage” or, in fact, the 2012 re-proposal had the agencies chosen to adopt the strong and meaningful alternative definition of qualified residential mortgage it set forth. The definition of QRM, which the agencies have disgracefully abdicated to the Consumer Financial Protection Bureau by linking it to their definition of “qualified mortgage,” is sure to become the key standard by which federal housing policy will be shaped for as long as today’s unfortunate final rule stands. Had it instead been defined in a manner which would have restored the sanity that has long been absent from federal housing policy, it would have been so great a victory for American taxpayers that I would have been willing to look past my natural objections to the rulemaking mandate and cast an affirmative vote. Needless to say, it was not so defined, and my vote is an unconditional no. Of the many dissenting votes I have had to cast over the last three years, this one hurts the most given the dire consequences that I believe will result from today’s vote.
The Commission rightfully joined the other agencies in voting to issue the 2011 proposing release and its meaningful standards for QRMs. As with any proposal to substantively reform a fundamentally cronyistic system, however, the blowback was fierce. All regulatory agencies, of course, should always take great care to review and address the comments that we request in any rulemaking, making changes to proposed rules based on the new information and perspectives that the comment letters provide. We should also, however, have the wisdom and courage to take into account the nature and motives of the commenters and the special interests that some of them represent. In other words, regulators working to adopt a final version of a proposed Henhouse Protection Rule should not abandon their independent judgment by capitulating to the views imposed upon them by a barrage of letters sent in by the Feed the Foxes Foundation and their allies, no matter how many copied, form “comment” letters they receive.
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The Commission has often been accused in this new era of Dodd-Frank regulation of failing to adopt systemic risk as our mandate, an accusation tempered neither by the fact that we already have a tripartite mandate we are obligated to pursue nor by the fact, as I recently noted, that fulfilling our mandate to maintain fair, orderly, and efficient markets, facilitate capital formation, and protect investors is by far the best manner by which the SEC can contribute to the reduction of systemic risk.
Today’s rulemaking on “risk” reinforces the conclusion that the SEC should not succumb to political pressure by refocusing its mandate on systemic risk. Systemic risk regulation, in practice, seems to consistently involve making private markets suffer in favor of constantly enhancing government authority and intervention. The present rulemaking, consistent with that interpretation, will ensure that the currently suffocating private mortgage market will continue to be stagnant or finally die off in favor of ensuring that the overwhelming majority of mortgages will be owned or guaranteed by the same federal housing agencies that led the country down the path to destruction over the past several decades. The awfulness of today’s rulemaking makes the oft-discussed issue of GSE reform all the more important, and I for one hope that legislation such as Chairman Jeb Hensarling’s PATH Act will make it to the President’s desk in the next Congress.
It is time for this Commission to declare that it is no longer willing to play the frog to the prudential regulators’ scorpion. We are increasingly called upon to cross the river with them on our back by going along with their ideas, only to have them sting us halfway to the opposite shore, drowning us both. The Volcker Rule, for example, is yet another terrible idea implemented through a torturous joint rulemaking process, already causing chaos in the financial world despite the compliance date being nine months away while doing nothing to make our financial system safer. Today’s rule, in some ways, is even worse, given that we had in place a 2011 proposing release that would have implemented an unfortunate Dodd-Frank mandate in a manner that would at least establish some level of sanity in our mortgage markets by adding a QRM label that had meaningful requirements and would set a new standard for mortgage lending.
Instead, we are not only reverting to the meaningless standards of the past but also placing a new government imprimatur on mortgages that meet those low standards. By applying the government’s QRM label—with its unambiguous declaration that a loan is “qualified”—to virtually any residential mortgage, we render the new standard meaningless at best, deleterious at worst. It was securitizations of what we called subprime RMBS carrying triple-A ratings from credit rating agencies implicitly endorsed by the government as “nationally recognized statistical rating organizations” that played a major role in the last crisis. For the next, there won’t even be the “subprime” moniker to dissuade investors from purchasing securitizations of low-quality loans. Instead, residential mortgages with zero percent down and weak loan-to-value ratios that in the past would have been called subprime will now carry the same “quality” endorsement from the government as solid mortgages with significant down payments and strong LTV ratios. When every mortgage is labeled as “qualified,” investors should assume none really will be.
I have been severely disappointed with the process for this joint rulemaking, which minimized almost to the point of eradication the ability of individual Commissioners to have their voices heard. It’s fitting, then, that the failures of this process continued right up to the present voting stage. I note, in particular, the impropriety of one of the rulemaking agencies releasing a full public copy of the adopting release before any of the other agencies had voted on the rule.
There isn’t much more to say that I haven’t already said in my dissent to the re-proposing release or in public fora over the past year. I note that the final rule includes a new provision mandating periodic review of the QRM definition, inserted at the insistence of this agency. While I appreciate this effort to at least partially address the disastrous consequences that could arise from the sheer folly of abdicating the definition of QRM to the CFPB for perpetuity, the history of this rulemaking does not give cause for optimism. The alternative definition of QRM set forth in the re-proposing release appears now to have been nothing more than a fig leaf reluctantly introduced as a concession to the SEC by its fellow participants in the joint rulemaking. As far as I was able to discern in my limited capacity as a mere Presidentially-appointed voting member of one of the agencies party to this rulemaking—which is admittedly not much, given the extremely opaque nature of the negotiations that allowed individual Commission members no voice or even access to the deliberations—at no point was that alternative definition seriously considered for the final rule. Similarly, it would be downright Pollyannaish to expect the agencies that had to be persuaded to even include the review mechanism in the final rule to take the requirement seriously. Certainly nothing over the course of this or indeed of any of the mandated joint Dodd-Frank rulemakings leads to optimism on that front.
This rulemaking process marked a crossroads in our long, ongoing Dodd-Frank implementation process, a rare opportunity to address a genuine cause of the last financial crisis and perhaps set the tone for the implementing rulemakings still to come. When two roads diverged in a wood, one representing the standard, well-trodden path of kowtowing to special interest groups and politics, the other a courageous, rarely taken path of doing the right thing despite the pressure to fall in line with the loudest lobbyists, the agencies, including the Commission, took the one far, far more travelled by. And when the histories of the next financial crisis are written, that, I’m afraid, will prove to have made all the difference.
Securities Exchange Commissioner Michael S. Piwowar stated in part:
As a joint rule promulgated under the authority of the Exchange Act, such rulemaking must comply with the requirements of Section 23(a)(2) of the Exchange Act to consider the impact on competition as well as Section 3(f) of the Exchange Act, which requires, when determining whether an action is necessary or appropriate in the public interest, consideration of whether the action will promote efficiency, competition, and capital formation, in addition to the protection of investors.
Today’s adopting release includes a section entitled “Commission Economic Analysis” that discusses the considerations of our own economists with respect to the joint rule. Glaringly absent, however, is an economic analysis from any of the other rulemaking agencies – the Office of the Comptroller of the Currency, the Federal Reserve Board of Governors, the Federal Deposit Insurance Corporation and, in the case of residential mortgage securitizations, the Department of Housing and Urban Development and the Federal Housing Finance Agency. The lack of any such efforts is particularly troubling given the significant number of discretionary choices made in promulgating the final rule. Most importantly, the Commission’s economists did not prepare a specific economic analysis addressing the scope of the underwriting exemptions for qualified mortgages and other assets from the risk retention requirements, since those provisions were to be adopted by the banking regulators alone.
Last December, when the Commission considered another joint rulemaking regarding prohibitions on proprietary trading and certain relationships with private funds – Section 619 of the Dodd-Frank Act, more commonly known as the Volcker Rule – I was advised that economic analysis was not required because that rule was being promulgated under Section 13 of the Bank Holding Company Act, which does not require economic analysis. Today, however, we are promulgating a joint rulemaking under the authority of the Exchange Act, which contains certain explicit requirements. The rulemaking agencies thus have a duty to comply with the requirements under that act, a duty they have failed to perform.
The failure of the other rulemaking agencies to expressly adopt an economic analysis is all the more important given the broader economic concerns that the joint rule raises. The Commission’s economic analysis observes that the intended benefits of securitization include reduced cost of, and expanded access to, credit for borrowers, ability to match risk profiles for specific investor demands, and increased secondary market liquidity. Yet, the Commission’s economic analysis notes that mandatory risk retention could impose significant costs on the financial markets. These costs are likely to be passed on to borrowers, either in terms of increased borrowing costs or loss of access to credit, and thus will cut directly against the intended benefits of securitization.
The Commission’s economic analysis also indicates that if risk retention is too low, it may not adequately align the incentives of investors and sponsors. On the other hand, an excessive level of risk retention may lead to less availability of capital, increased borrowing rates, and a more limited supply of credit. Despite the clear need to appropriately calibrate the level of risk retention in order to avoid significant unintended consequences, the staff states that it has not determined an optimal level of retained risk and yet the agencies are adopting the imprecise and arbitrary statutory risk retention level of five percent. It is most unfortunate that, rather than choosing to pursue an informed course of action to determine optimal levels of risk retention – which certainly differ among asset classes with different risk profiles – banking and housing regulators have decided to throw up their hands and simply decide that getting it done is more important than getting it right. For instance, the final release is dismissive of the alternatives identified by commenters in the context of open market collateralized loan obligations.
More broadly, I remain concerned about the continued dominant role in housing finance played by the two government-sponsored enterprises (GSEs) that required the largest taxpayer-funded bailouts in history – the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). According to the most recently posted conservator’s report, these two GSEs account for 78% of all residential mortgage backed securities issuances and, when combined with Ginnie Mae issuances, total nearly 100% of the market. These GSEs currently have a competitive advantage over private securitizations due to lower funding costs as a result of an explicit federal guarantee. One result of the dominance and competitive advantages of the GSEs has been the crowding out of the private sector in housing finance – and let’s not forget that the entire securitization process was a private sector innovation.
I am also troubled by last week’s news – the timing of which was undoubtedly coordinated with this week’s rulemaking – that the Federal Housing Finance Agency is pushing Fannie Mae and Freddie Mac to consider programs that would make it easier for borrowers to obtain mortgage loans with down payments as low as three percent. As prominent housing market scholar Mark Calabria remarked, “[t]hree percent [down payments] can disappear and become zero real quick…This is the sort of thing that gets people underwater.”
Given the apparent ease with which the majority of this Commission working hand-in-hand with the Administration’s housing market policy makers are willing to further entrench the government in this market and continue to crowd out the private lenders, I have considerable skepticism as to whether taxpayer-backed GSE-sponsored securitizations will ever be subject to the risk retention requirements and be forced to operate on the same level playing field as private securitizations.