Chairman Bair's Statement on Credit Risk Retention Notice of

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Chairman Bair's Statement on Credit Risk Retention Notice of Proposed Rulemaking
March 29, 2011

FDIC Chairman Sheila C. Bair delivered the following statement at the FDIC's Board Meeting today: "This morning we are proposing to address a key driver of the housing crisis: misaligned economic incentives arising from the widespread use of private securitization to fund mortgage lending. Almost 90 percent of subprime and Alt-A originations in the peak years of 2005 and 2006 were privately securitized. During that period, the separation of originating and securitizing loans from the risk of loss in the event of default fed a massive amount of lax, unaffordable lending which fueled the housing bubble. Since neither lenders nor securitizers appeared to hold any real risk in the transaction, the "originate-to-distribute" model of mortgage finance misaligned incentives to reward the volume of loans originated, not their quality. The consequences for our economy have been severe.
Today, the market is trying to find a new model. Title IX of the Dodd Frank Act seeks to address the defects of the prior model of securitization by imposing requirements for transparency, due diligence, representations and warranties, and retention of credit risk. The SEC has already proposed rules to address transparency.
The rule before the Board today proposes new standards for retention of credit risk to help ensure that securitizers will hold "skin in the game" which will align their interests with those of bondholders. This will encourage better underwriting by assuring that originators and securitizers can not escape the consequences of their own lending practices. Fundamentally, this rule is about reforming the "originate-to-distribute" model for securitization, and realigning the interests in structured finance towards long-term, sustainable lending. If we are truly interested in restarting securitization, then we must restore investor confidence and the soundness of the securitization model. As required by Dodd-Frank, the proposed rule creates a comprehensive framework for risk retention.
The proposed rule is unusual in terms of the large number of questions posed for comment. The issues are numerous and complex, and it is vital that we receive comment from all interested parties. I'd like to spend just a moment discussing a couple of areas that have received considerable comment already – those being the Qualified Residential Mortgage exemption from the risk retention requirements and our proposal to incorporate minimum servicing standards in the QRM exemption.
The general rule set out in Dodd-Frank is to require issuers of securitized loans to retain a 5 percent interest in the risk of loss. The law provides an exception to that rule and directs the agencies to set a standard for underwriting and product features that, as shown by historical data, result in a lower risk of default such that risk retention is not necessary. The QRM is the exception, not the rule, and as such, I believe should be narrowly drawn. Properly aligned economic incentives are the best check against lax underwriting. Because QRM loans are exempt from risk retention, the proposed QRM definition sets appropriately high standards regarding documentation of income, past borrower performance, a low debt-to-income ratio for monthly housing expenses and total debt obligations, elimination of payment shock features, a maximum loan-to- value or LTV ratio, a minimum down payment, and other quality underwriting standards. This does NOT mean that under the rule, all home buyers would have to meet these high standards to qualify for a mortgage. On the contrary, I anticipate that QRMs will be a small slice of the market, with greater flexibility provided for loans securitized with risk retention or held in portfolio.
Many have expressed concern that imposing a specific LTV standard, such as 80 percent, or a specific down payment standard, such as 20 percent, will impair the access of low- and moderate-income borrowers to mortgage credit. As a consequence, we are seeking comment on the impact of the QRM standards on low- and moderate income borrowers as we consider the comments on the NPR and work towards a final rule. We take these concerns very seriously and want to make sure they are fully addressed. In particular, I would welcome comment on how and whether we can assure that the unique needs of LMI borrowers can be met through FHA programs as well as appropriately underwritten portfolio lending and risk retention securitizations.
Also included in the QRM standards are loan servicing requirements. Continued turmoil in the housing market caused by inadequate and poor quality servicing underscores the need to make sure that future securitization agreements provide appropriate resources and incentives to mitigate losses when loans become distressed. Servicing standards must also provide for a proper alignment of servicing incentives with the interests of investors and address conflicts of interest. The servicing standards included as part of the QRM requirements address many of the most significant servicing issues. I am particularly pleased that the servicing standards require that there be financial incentives for servicers to consider options other than foreclosure when those options will maximize value for investors. The proposed standards also require servicers to act without regard to the interests of any particular tranche of investors; to disclose any second-lien interests if they service the first lien; and to workout and disclose to investors in advance how second liens will be dealt with if the first lien needs to be restructured. I welcome comment on the proposed servicing reforms, whether they can be strengthened, and whether they should apply more generally to all private securitizations, not just QRMs.
In thinking about the impact of this proposed rule, we need to keep in mind the following facts:
First, the QRM requirements will not define the entire mortgage market, but only that segment that is exempt from risk retention. Lenders can – and will – find ways to provide credit on more flexible terms, but only if they then comply with the risk retention rules.
Second, what matters to underserved borrowers is not just the volume of credit that is available, but also the quality of that credit. More than half of the subprime loans made in 2006 and 2007 that were securitized ended up in default, which hurt both borrowers and investors and triggered the financial crisis. By aligning the interests of borrowers, securitizers and investors, our new rules will help to avoid these outcomes and keep default rates at much lower levels. They will also help avoid another securitization-fed housing bubble which made home prices unaffordable for many LMI borrowers.
Finally, the private securitization market, which created more than $1 trillion in mortgage credit annually in its peak years of 2005 and 2006, has virtually ceased to exist in the wake of the crisis. Issuance in 2009 and 2010 was just 5 percent of peak levels. This market needs strong rules that assure investors that the process is not rigged against them. The intent of this rulemaking is not to kill private mortgage securitization – the financial crisis has already done that. Our intent is to restore sound practices in lending, securitization and loan servicing, and bring this market back better than before.
Clearly staff has worked very hard to prepare the proposed rule, and I want to compliment them on their diligence and patience in working through the many issues and many perspectives represented on the interagency group. I commend the staff at all of the agencies for designing a tailored set of rules implementing the statutory 5 percent risk retention requirement in a manner that is reflective of existing markets and securitization structures. I look forward to reviewing the comments in response to these rules."