Congress would most likely need to make such a change because regulators have already exempted the overwhelming majority of RMBS from risk retention — a Dodd-Frank provision which was to require RMBS sponsors to hold on to a small equity slice of their deals.
“I think risk retention was the least intrusive thing that the government could have done in that situation, said Frank, "[but] regulators have essentially done away with risk retention. Instead we have a series of restrictions on what you can do and what you can’t do.”
Frank would rather it were the other way around, to allow lenders to make their own judgments of risk rather than rely on criteria like loan-to-value ratios and income metrics to determine whether mortgages can be securitized by government sponsored enterprises Fannie Mae and Freddie Mac. Lenders are also exempt from liabilities if the loans they originate meet the prescribed metrics and the borrower’s ability to repay the notes can be shown to have been considered by the lender.
“The problems that resulted from 100% securitization, 0% retention, weakening the lenders' incentive to be careful happened more in the residential mortgage space than anywhere else, but that is now the one area that is exempted from it,” Frank said.
If mortgages meet the metrics regulators prescribed, they can be called qualified mortgages. Any mortgage guaranteed by Fannie and Freddie is automatically a qualified mortgage though. That means that the agency’s loan requirements are determining which mortgages are originated, rather than lenders who would be incentivised to originate better loans if they were required to retain some of the risk associated with them, according to Frank.
“When I heard the argument that risk retention in residential mortgages in particular was going to be fatal, I had to wonder whether I was misinformed when I was told that there were residential mortgages issued in America before 1980,” Frank said. “Before 1980 there was 100% risk retention on residential mortgages: the bank made the loan; the bank kept the loan.”
A tough fix
The prospects for a housing finance system in which regulations mandate only that issuers retain some skin in the game for RMBS rather than prescribe certain loan metrics seem bleak based on Frank’s assessment of Congress.
Frank said that it would be difficult for government to modify the Dodd-Frank act at this point because of divisions in Congress. “There is a divide obviously between Democrats and Republicans obviously, [but] there is also seriously a divide in economic issues within the Republican Party.”
It would be difficult for Congress to reform Fannie Mae and Freddie Mac, for example, because Republicans in the House do not want to replace the GSEs with another type of entity. “They just want to axe them,” Frank said.
Republicans in the Senate on the other hand favour the replacement of Fannie and Freddie with chartered entities that could sell credit hedges for mortgages to people undertaking a 30 year fixed rate mortgage application, according to Frank.
“The prerequisite of the negotiation would be the acceptance for the framework,” Frank said. “You would get that from Senate Republicans but you wouldn’t get it from House Republicans.”
Regarding potential changes to the Volcker Rule, Frank said that he was hoping for an acceptance among the rule’s critics that the entire rule would not be repealed so tweaks and improvements could be made where necessary.
Frank said one of the shortfalls of the Dodd-Frank Act was the exclusion of auto dealers from regulation by the Consumer Financial Protection Bureau. Frank said auto dealers lobbied their way out of the Act. Global banks “don’t even come close” to the political power that auto dealers have, according to Frank.