Federal regulators may have to take a different approach in drafting a securitization rule after stumbling badly in their first effort to define which mortgages are safe enough to exempt from risk retention.

Under pressure from Congress, industry and consumer groups, the six federal regulatory agencies working on the risk-retention proposal extended the comment from June 10 to Aug. 1.

Critics say the initial proposal drew such widespread opposition because it went beyond congressional intent by requiring a 20% downpayment on qualified residential mortgages. (Only QRM loans will be exempt from risk retention. Securitizers will have to retain up to 5% the credit risk on non-QRM loans.)

Consumer groups complained that the 20% downpayment would exclude otherwise creditworthy borrowers whose only fault is they don't have rich parents or cannot save much money.

Senators who last year authored the QRM provision of the Dodd-Frank bill claim they never intended downpayments to be a critical factor in defining the QRM. And it now appears that banking agencies are under pressure to add low-downpayment language or eliminate it entirely as a defining factor.

Industry and consumers are likely to press regulators to use proven underwritten standards (and mortgage insurance) in determining which loans are exempt from risk retention.

The Center for Responsible Lending does not want a downpayment requirement written into the risk retention rule. "Low downpayments did not cause this crisis—bad underwriting did," said CRL spokesman Kathleen Day.

She stressed the need for verifying income, credit history and outstanding debts. Even lowering the downpayment to 10% would still arbitrarily cut out many creditworthy borrowers. "It is sound underwriting that Dodd-Frank mandates, which really addresses the cause of the crisis—not downpayment," she said.

Bill Himpler, executive vice president of the American Financial Services Association, said solid underwriting standards are more important than strict debt-to-income ratios or loan-to-value ratios. And considering how tight credit is right now, they don't need to make it tighter, he said. "It is just going to prevent a recovery in the housing market."

He believes regulators can review the risk-retention standards after a few years and tighten up if necessary.

National Community Reinvestment Coalition president John Taylor said a 3% downpayment would be acceptable to most people but wants regulators to raise the strict DTI ratios, which is 28% on the front end. "It is not unusual for blue-collar workers to use 37% to 38% of their household income for mortgages. Yet, they can have very high credit ratings and be very responsible borrowers," he said.

Meanwhile, now that regulators have extended the comment period, they have a chance to step back and rethink their proposal. It also gives them an opportunity to correct a basic mistake: moving ahead with the QRM proposal before considering the parameters of something that sounds similar, a "qualified mortgage" definition which also was mandated by Dodd-Frank. (The QRM and QM are two separate provisions.)

The Federal Reserve Board is charged with defining the QM which includes an "ability to repay" standard. Lawmakers directed the Fed to establish underwriting standards for a QM, allowing prudent lenders to be shielded from litigation. Shortly after regulators issued their QRM proposal, the Fed issued its QM proposal.

The Fed's proposal creates a "legal safe harbor" if the lender originates standard, fully amortizing mortgages not exceeding 30 years and the points and fees do not exceed 3% of the loan amount. The borrower's income and assets must be verified and the lender must qualify the borrower based on the maximum interest rate during the first five years of the loan.

The regulators should have issued a QRM after they reviewed the QM proposal, according to Bob Davis, senior vice president of the American Bankers Association. "They didn't follow the instructions of Congress for the QM and QRM," Davis said.

The ABA executive noted that the ability to repay standard and certain limitations on loan types are sufficient to guarantee a low probability of default. The comment period on the QM proposal ends July 22 and the Fed will hand over the rulemaking responsibilities to the new Consumer Financial Protection Bureau on that date.

The QM controls the "underwriting variables at the point of origination, which is where they really matter," said Barry Zigas. The Consumer Federation of America's director of housing policy noted that the QM can be drafted to "preclude the most pernicious and most unstable kinds of underwriting because lenders will not want to accept the liability."

Then the question arises what additional restrictions or limits should be imposed by the QRM. Zigas stressed that product features such as prepayment penalties and payment-option ARMs are the ones most responsible for defaults. If those are excluded, "maybe you have eliminated the biggest source of risk in the mortgage system," the CFA director said.

Several industry observers and sources expect that regulators will have to revise the QRM proposal and issue it again for comment once there is a better feel for what the QM will look like. It would not be "wise to finalize the QRM standard until you know what the QM standard is," Davis said.

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