The Federal Deposit Insurance Corp. (FDIC) occupies a unique position in the debate on securitization reform due to the agency's long-standing "safe harbor" policy.
And FDIC chairman Sheila Bair wants to use this advantage in pressing for reforms such as risk retention on sales and securitizations of mortgages, as well as changing the way servicers approach loan modifications and pay advances on MBS.
Congress, of course, is also at work on securitization reform. The House of Representatives has passed legislation that would require sellers and securitizers to retain 5% of the credit risk on mortgages. The Senate is expected to take up a regulatory reform bill next year that will also require securitizers to have "skin in the game" in the form of risk retention.
At the same time, the mortgage industry is contending with changes in accounting rules that will force banks — as well as Fannie Mae and Freddie Mac — to bring onto their balance sheets certain mortgages that have been securitized and sold to investors.
In the midst of this confluence of events, the FDIC is now revising its safe harbor policies, which for the past nine years provided important support for the securitization market. As the receiver of failed banks, the FDIC takes a hands-off approach on MBSsold to investors and does not seize the underlying mortgages when a bank fails. (This protects MBS investors for unexpected losses.)
The safe harbor is based on "sales" accounting, a book entry treatment that is being revamped by the Financial Accounting Standards Board (FASB). Come Jan. 1, companies that retain an interest in MBS or control the servicing rights (the GSEs) have to consolidate the mortgages on their balance sheets. This change places the FDIC at the forefront when it comes to providing capital relief for affected banks and thrifts that are going to see their balance sheets suddenly balloon. It also gives the agency leverage in revising the safe harbor so that it protects high-quality loans from seizure and strengthens the securitization process.
In terms of capital, the FDIC and the other federal regulators are relaxing the risk-based capital requirements and giving affected banks and thrifts a one-year transition period to adjust. "The capital relief we are offering banks for the transition should ease the impact of the accounting change on bank regulatory capital requirements and enable banks to maintain consumer lending and credit availability as they adjust their business practices," Bair said.
The FDIC also extended its safe harbor policy through March 31 and grandfathered all MBS that met FASB's previous sales test. (The agency likely will extend the current safe harbor again as it works with other regulators to set new standards for securitizations.)
Going forward, the FDIC chairman wants the safe harbor to promote securitizations that will lead to sustainable lending and discourage the issuance of MBS backed by risky loans. She attributes the breakdown in the private-label market to the "originate-to-distribute" model that ignored consumer protections and sound underwriting.
"The misalignment of incentives in securitizations has contributed to massive losses to insured institutions, to the Deposit Insurance Fund and to our financial system," Bair said at a FDIC board meeting. She argued that the FDIC should play a role in "correcting" the securitization process. "To ignore this responsibility would be to ignore our public trust." (The agency is now seeking comment on several ways to align the interests of MBS investors, lenders and servicers.)
Loss mitigation has been a "significant cause of friction" between servicers and RMBS investors, the FDIC says in a proposal that is being issued for a 45-day comment period.
Forcing servicers to make advances over a prolonged period can "serve to aggravate liquidity concerns, exposing the market to greater systemic risk," the FDIC says. The proposal suggests that servicers should be obligated to make only three advances to cover delinquent monthly payments by homeowners.
The FDIC also suggests that servicers should have more authority to undertake loan modifications. In terms of compensation, the FDIC is asking if servicers should be paid incentives to modify loans and reimbursed for actual expenses. To increase the quality of loans and underwriting, the FDIC is seeking comments on imposing risk retention requirement of 5% and introducing a loan seasoning requirement to reduce early defaults.
"One way to address this would be to require that mortgage loans to be seasoned, i.e., originated more than 12 months prior to the initial issuance of the RMBS," the FDIC proposal said.
"The legislation gives regulators a lot of flexibility," said Bair. "I think we should be thinking about it now and engaging in this process to have good qualitative standards." The FDIC chairman wanted to act quickly on the proposal with a shorter comment period but Comptroller of the Currency John Dugan raised objections to risk retention and loan seasoning provisions, forcing the FDIC to move slower on its reforms.
"Recent studies note that a policy of requiring a rigid minimum retention requirement risks closing down parts of securitization markets if poorly designed or implemented," said Dugan.
Office of Thrift Supervision (OTS) acting director John Bowman warned the FDIC securitization standards would apply only to insured depositories and it would give nonbanks an advantage in the MBS market. The OTS director urged the FDIC to work with the Securities and Exchange Commission and Federal Reserve Board to ensure the standards that emerge from this rulemaking apply to all lenders and securitizers.
Meanwhile, industry groups are very concerned about the FDIC proposal.
American Securitization Forum acting executive director Tom Deutsch noted that banks are facing higher capital demands as they consolidate existing MBS on their balance sheets. "It is very ironic," he said, that the risk retention proposal would require issuers to hold even more capital.
He noted that a 5% risk retention requirement would make it "very challenging" to issue a prime jumbo mortgage securitization even in good market conditions. "There may be parts of this proposal that go well over the line of requiring so much capital that America can't possibly recover from the credit crisis in the near term," Deutsche said.
The Community Mortgage Banking Project (CMBP) is very concerned about the complex changes facing the mortgage industry. The combined impact of the accounting changes and risk retention could be "potentially devastating" and sharply reduce securitizations and the availability of long-term fixed-rate mortgages, according to the CMBP.
"We believe Congress should ensure that any risk retention be limited to the higher-risk segment of the market, while protecting liquidity for safe, well-underwritten mortgage products," said CMBP managing director Glen Corso.