Four Key Questions about the Upcoming 'QRM' Rule

WASHINGTON — A key obstacle to re-launching private-label securitization has always been uncertainty about new regulations. But the market is about to get a dose of clarity.

After toiling away for three years, regulators are finally set to complete a rule this week requiring securitizers to hold 5% of credit risk on loans sold to investors. The rule, mandated by the Dodd-Frank Act, would exempt so-called "qualified residential mortgages" from risk retention.

The Federal Deposit Insurance Corp.'s release of the rule Tuesday will provide crucial details about how QRM ultimately will be defined, including whether a down payment is required to earn the exemption. But a looming question is whether more certainty about the securitization rule will help spark a market comeback.

A "positive development emanating from the finalization of the risk retention/QRM rule is … simply that it is being completed, which will provide some certainty to the asset-backed market," Brian Gardner, a policy analyst at Keefe, Bruyette & Woods, said in a recent note.

Here are four important questions about what the risk retention rule will contain, and how it will affect the market:

Will the final rule deviate from the 2013 proposal?
Perhaps the biggest question is whether regulators will go back on their approach unveiled last year for defining QRM, which was highly favorable to the industry. (The agencies drafting the rule are the FDIC, Office of the Comptroller of the Currency, Federal Reserve Board, Federal Housing Finance Agency, Securities and Exchange Commission and the Department of Housing and Urban Development.)

After initially proposing in 2011 that QRM requires a borrower to put down 20% — which provoked an outcry from bankers and consumer groups — the regulators made a 180-degree turn. Their 2013 "reproposal" equated QRM with the Consumer Financial Protection Bureau's definition for well-underwritten loans known as qualified mortgages, which do not have a down-payment requirement.

While last year's proposal also asked for comment on an alternative approach — an even more demanding "QM-plus" standard for QRM, which would include a 30% down payment — many observers predict the agencies will keep their QM-equals-QRM strategy.

"If we were in a position where the mortgage market was a lot stronger you might see a willingness to push back but I don't think with the current state of the housing market you are going to see regulators push back on this," said Mark Calabria, director of financial regulation studies at the Cato Institute.

Still, the fact that regulators asked for feedback about the alternative plan requiring a 30% down payment — which appeared to have support among certain officials — led some to speculate they could always go back to their original idea of setting an LTV level.

"We anticipate the final rule will strike a middle path," Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc., wrote in a note to clients after the proposal was unveiled last year. "This will be between the no-downpayment proposal and the 30% option, ending up at 10%."

Will regulators speak with one voice?
The QM-equals-QRM standard was hailed by the industry, but some key policymakers both past and present have questioned it.

They include former House Financial Services Committee Chairman Barney Frank, who in testimony at a July hearing said it was never lawmakers' intent to combine the two definitions. "Readers of the proposal will have a very hard time understanding why Congress would have created two separate categories, in two separate parts of the statute, if it intended they would be treated identically," he said.

Even some officials at the agencies that signed off on the proposal raised concerns, begging the question if they will support the final rule if it too lacks a down payment minimum.

When the proposal was released, FDIC Vice Chairman Thomas Hoenig, who holds one vote on the five-member FDIC board, appeared to lean toward limiting LTVs to 70% in the QRM exemption. "I'm very pleased that the 70% LTV is a question" in the proposal, he said last year. "That really does change the issue of whether or not there is risk retention. That is the whole goal here."

Meanwhile, Daniel Gallagher, an SEC commissioner, was blunter.

"What is the point of promulgating a risk retention standard and then exempting everything from it?" he said in a statement when his agency issued the proposal.

Could the agencies expand the exemption even further?
Despite the gains bankers made in last year's proposal, many in the industry have called for even more changes to expand the opportunities to be excused from risk retention.

For example, banks and others in the financial services industry have objected to the proposed treatment of collateralized loan obligations.

CLO managers had objected to their having to follow the risk retention requirement in the 2011 proposal. The regulators' attempt to assuage their concerns in last year's draft was no better received. The 2013 proposal would allow banks that arrange for loans in CLO tranches to retain the credit risk instead of managers.

That proposed solution is "unfortunately unworkable in light of the realities of the operation of the CLO market and the syndicated loan and leveraged finance markets more generally," Bank of America deputy general counsel Kenneth L. Miller wrote in a comment letter to the agencies.

Does a final rule mean a more robust securitization market?
For all the questions about how regulators craft the final risk retention rule, its implications may not be known for some time as the post-crisis securitization market tries to rebound.

Gardner said once the market knows what the final rule will say, it could lead to more activity.

"The rules are not retroactive so they do not apply to outstanding [asset-backed securities], but we think the lack of a rule did dampen the industry to some extent," he said. "The new rules should allow industry participants to gauge the rule's impact and proceed accordingly."

Others were less optimistic, particularly about how the rule will affect the mortgage securitization sphere. They believe the impact on the market will be minimal.

"I don't think you will see any immediate market impact," said Pete Mills, senior vice president of residential policy and member services at the Mortgage Bankers Association.

For one thing, the private-label mortgage-backed securities market is still outmatched by the government-sponsored enterprises Fannie Mae and Freddie Mac, which do not appear to be headed out of their government conservatorships anytime soon. Under the 2013 proposal, Fannie and Freddie get an automatic exemption from risk retention as long as they are still in conservatorship.

The rule will remove some of the regulatory uncertainty but the non-GSE market still pales in comparison to that of the two mortgage giants.

A final rule that keeps the regulators' broad QRM definition "theoretically would permit the creation of a private-label market that could compete against Fannie and Freddie" but "we use the term 'theoretically' because we are dubious that there will be a private market that competes successfully with Fannie and Freddie to securitize the same mortgages," Jaret Seiberg, an analyst at Guggenheim Securities, said in a recent note.

Yet Seiberg added that another question is whether regulators will allow an expiration period for the risk retention requirement.

"If that is set at three years or less, then it could open to door to some private deals," he said. "The alternative is risk retention for the life of the securitization. Under that scenario, we question how big this market can get as banks may be unwilling to balance-sheet large amounts of mortgage risk that they cannot hedge and cannot sell."