Why Banks Are Still Wary of Credit Risk Retention Plan

WASHINGTON — Regulators' second stab at crafting rules that would require lenders to retain the risk of loans they sell into the secondary market is decidedly more popular than the first attempt, but not everyone is giving it high marks.

Lenders are mostly relieved that regulators broadened an exemption for mortgage securitizers to avoid a 5% risk retention requirement, although at least one large bank protested the move. Still, the bulk of the criticism has focused on the plan's potential impact on securities backed by leveraged commercial loans.

"If the proposed rule were to be adopted, businesses would have fewer funding options, higher borrowing costs and reduced credit availability," wrote David Hirschmann, who heads the Chamber of Commerce's Center for Capital Markets Competitiveness, and Steve Judge, head of the Private Equity Growth Capital Council, in an Oct. 28 letter.

The risk retention provision remains one of the top unfinished items for regulators implementing the Dodd-Frank Act. But the six agencies faced heavy pushback to their original 2011 proposal. The biggest complaint was over suggested criteria for the ultra-safe "Qualified Residential Mortgages," which under the law are exempt from risk retention. Banks and consumer groups said the criteria, including a minimum 20% down payment, were too narrow and would exclude too many deserving borrowers.

In their re-proposal released in August of this year, the regulators did a complete reversal. The new proposed QRM criteria would include no down payment minimum. Instead, the definition would be aligned with that of loans considered to be "Qualified Mortgages". The QM standard, used by the Consumer Financial Protection Bureau to define loans that have extra legal protections, does not include a down payment requirement.

The vast majority of the nearly 200 commenters - including individual banks, industry trade associations and consumer groups - said the broader QRM definition was right on target.

"In formulating their QRM recommendations, the agencies have done an admirable job balancing these considerations: on one hand, they wanted QRM loans to have a low default rate; on the other hand, if QRM is too tight, it will impede efforts to bring private capital back into the market and will further restrict credit availability," Laurie Goodman, director the Urban Institute's Housing Finance Policy Center, said in an Oct. 29 letter. "The right balance would thus appear to be precisely where they have landed with their main proposal: that QRM equal QM."

Although all six agencies signed off on the proposal, some top regulatory officials have voiced reservations, and the proposal included a question asking commenters' opinion about an entirely different idea to increase the down payment minimum to 30%. (The regulators were the Department of Housing and Urban Development, Federal Deposit Insurance Corp., Federal Housing Finance Agency, Federal Reserve Board, Office of the Comptroller of the Currency and Securities and Exchange Commission.)

Echoing critics who say the new criteria are too broad - including former FDIC chief Sheila Bair and recently retired Congressman Barney Frank - a comment letter from PNC Financial Services questioned the revised definition.

"As an exemption to the risk retention rule, QRM should not be defined in a manner that would leave only a small fraction of the residential mortgage market subject to risk retention," wrote E. Todd Chamberlain, chief executive of PNC Mortgage. "An exemption that swallows the rule, and includes too broad a portion of the residential mortgage market, would make QRM, i.e., no risk retention, the norm, rather than an exception."

But many of the submissions highlight the rule's effect not on mortgages but on instruments known as collateralized loan obligations, or CLOs. The securitization instruments typically comprise of large corporate loans that are often syndicated and made to leveraged companies.

The six regulators, in their new proposal, appeared sympathetic to concerns of CLO managers that their inclusion in the 2011 draft among those required to retain credit risk could be financially disastrous.

The new proposal would allow certain large banks that arrange for loans in the tranches - known as "arrangers" - to retain the minimum credit risk instead of the managers. But many institutions and trade groups, both of which have contended that Dodd-Frank's risk retention provision was not meant to include CLOs, now say the alternative option outlined by regulators is no better.

"Arrangers will not meaningfully pursue that alternative for a range of risk management, market operation, and financial considerations, and the agencies' proposal would in any event generate a series of adverse consequences in the form of increased systemic risk, diminished efficiency of the relevant credit markets, and decreased availability and increased cost of credit - all harming the public interest," R. Bram Smith, executive director of the Loan Syndications and Trading Association, said in an Oct. 30 letter.

Among the problems, critics argue, is that the new proposal would force arrangers to hold the retention piece for the entire life of the deal. That is inconsistent, they say, with the typical practice of banks involved with CLOs to try and hedge their risk.

Some of the nation's largest banks, while praising the new criteria for the mortgage exemption, at the same time commented that the arranger option for CLOs would be unworkable for them.

"The requirement that arrangers such as Wells Fargo hold additional exposure to a borrower, in the form of a risk retention interest which is unhedged and held to maturity without consideration of the credit quality of the borrower or other economic factors, is generally inconsistent with prudent lending practices and discouraged by our internal lending policies which are derived in part in response to regulatory safety and soundness requirements related to this type of exposure," said Timothy J. Sloan, senior vice president and chief financial officer at Wells Fargo, in an Oct. 30 letter.

Bank of America agreed. Kenneth L. Miller, deputy general counsel for the B of A, said in an Oct. 30 letter that "the options in the re-proposed rule for broadly syndicated CLOs to satisfy the risk retention requirements are unfortunately unworkable in light of the realities of the operation of the CLO market and the syndicated loan and leveraged finance markets more generally."

Still, commenters were much more complimentary of the new proposal than they were of the original draft, largely because of their support for aligning QRM with QM.

"Strong public policy supports the agencies' decision to align the QRM and QM definitions," Bianca Russo, a managing director and associate general counsel at JPMorgan Chase, wrote in an Oct. 30 letter. "This approach will preserve access to credit for the most financially vulnerable Americans, including first-time homebuyers, residents of low and moderate income communities, and members of historically disadvantaged minority groups."

But large companies active in investing in residential mortgage-backed securities, including MetLife and Prudential, said the QRM definition should remain narrow to ensure that more lenders who sell loans to the secondary market have "skin in the game."

"We believe the recommended approach for RMBS, which would define QRM to be equal to the... QM definition, is inadequate and essentially promotes practices that are arguably at the heart of what led the markets into the financial crisis," Richard B. Rogers, managing director of Prudential Fixed Income Management, wrote in an Oct. 30 letter.