Bank regulators are holding open meetings beginning Tuesday to discuss a controversial risk-retention rule for mortgages - and its even more controversial carve-out, reported CNBC's John Carney.  Under Dodd-Frank, banks are required to retain at least 5% of the risk on mortgages they securitize.  The object, here, is to make banks more careful about making loans and structuring mortgage-backed securities (MBS's) if they were required to keep a part of the credit risk - i.e., had some "skin in the game." 

What's happening, according to Mr. Carney, is that financial companies may have found a way to get around the law by manipulating a carve-out for "qualified residential mortgages."  Lawmakers punted on the definition of a qualified residential mortgage when Dodd-Frank was written, and instead instructed regulators with deciding what mortgages are safe enough to avoid the risk-retention rules.  Obviously, many financial firms would like to see an expansive definition that would reduce their need to retain risk.

The very first companies to begin agitating for an exemption from risk-retention were Fannie Mae and Freddie Mac. Lobbyists argued that mortgages backed by either Fannie or Freddie should automatically be included as qualified mortgages - which should have been somewhat shocking given the pair's relative incompetence when it comes to risk management.  There is only one possible reason to exempt mortgages they back from the risk-retention rule:  because if the mortgages they back go sour, the tax-payers are on the hook.  And then there's the FHA.

This led to other risks, as banks would find it far cheaper to create mortgages that could run through the FHA, Fannie, and Freddie than purely private markets.  This would set back attempts to reinvigorate private lending and remove taxpayer backing from the market. Purely private lending would wither. 

nIstead of just getting rid of the qualified mortgage exemption for the FHA and refuse to extend it to Fannie and Freddie, Wall Street came up with another approach: let's expand the exemption even further to include qualified private insurers as well.  The NYTimes's Gretchen Morgenson explained what's wrong with this approach:

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured.

But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans. Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington.

To continue reading, go to:   [CNBC.com, 3/29]