Depending on who you talked to, the risk-retention proposal out Tuesday would either restore sensible standards to the lending market or result in a significant credit crunch.

Even before the plan was out, regulators were in something of a defensive crouch, emphasizing that an exception to the new standards — for qualifying residential mortgages (QRM) — was narrowly crafted on purpose and is not designed to capture most mortgages.

"It's important for people to understand that the QRM rule is going to be a small slice of the market," Federal Deposit Insurance Corp. (FDIC) Chairman Sheila Bair told reporters. "It doesn't mean everybody is going to have to comply with these standards with a mortgage going forward."

But plenty of others were unconvinced. They argued that the QRM criteria, which would force borrowers to make a 20% down payment and comply with income, debt and credit history requirements, are so narrow that the plan would significantly curtail lending. Sen. Kay Hagan, D-N.C., who drafted the risk-retention provision in the Dodd-Frank Act, said the plan looked inflexible.

"The 20% down payment looks to me as to be too rigid and it would unnecessarily prevent the middle-class, first-time homebuyers from being able to get an affordable mortgage," Hagan said in an interview.

Analysts agreed. While regulators may not be intending to set national underwriting standards, analysts said, the QRM effectively does so — and would prevent many borrowers from getting a loan. "Fundamentally with a 20% down payment unless you're rich, have a high income or have rich parents, it's going to be a major hurdle," said Brian Chappelle, a partner at the Washington consulting firm Potomac Partners. "We haven't gotten a housing recovery in place yet. By imposing these additional restrictions, I think it actually creates more risk for the government."

Industry representatives said there would be dire consequences if the risk-retention plan is not changed before it is finalized.

"This rule potentially has a disastrous impact on the market," said Robert Davis, executive vice president of government relations for the American Bankers Association. "This will require risk retention for a large percentage of mortgages. I've already had email replies from bankers about how much this will curtail their lending if this goes into effect."

The plan was drafted by several regulators, including the FDIC, the Office of the Comptroller of the Currency and the Federal Reserve Board. It would force lenders to retain 5% of the credit risk of loans they securitize, but the government-sponsored enterprises would be considered already in compliance because they retain all of the credit risk.

That did not sit well with some lawmakers, who argued the GSEs were getting an inappropriate exemption at the expense of the government. "Basically what you are saying is if this was a private institution doing this, if it was a bank, if you were a securitizer you would be required to have some capital behind it," said Rep. Scott Garrett, R-N.J., the chairman of the House subcommittee with oversight of the GSEs. "Where is the actual capital that would be behind this? Right now it is just the good faith and credit of the United States."

Regulators have pledged to revisit the issue once the GSEs are out of conservatorship.

While the risk-retention plan exempted certain asset classes, like well-underwritten auto loans, from the proposal, the QRM received most of the attention, with many industry groups calling for an expanded set of criteria.

"The proposed QRM definition is so narrow that there will be very limited or any opportunity for securitizers to meet that definition particularly since the GSEs have an exemption and it's expected that most of the loans they will be originating will be in the QRM space," said Tom Deutsch, executive director of the American Securitization Forum.

The Securities Industry and Financial Markets Association (SIFMA) said it was critical that market analysis be undertaken of the proposal.

"The QRM definition appears to be narrowly crafted," Richard Dorfman, managing director and head of SIFMA's Securitization Group, said in a statement. "A market impact analysis of this QRM proposal is imperative, including consideration of proposed servicing standards and how the QRM definition aligns over the long term with the conforming loan market that is eligible for the GSEs, and will be another focus of SIFMA's comments on this proposed rule."

Though the National Association of Realtors said regulators had gone too far, the agencies did leave options on the table to expand QRM. Under one, there they could create a second class of loans that would require some risk retention, but not the full 5%. Under another option, regulators could significantly expand QRM criteria but require more risk retention for any loan outside of that status.

Speaking with reporters after an FDIC meeting, Bair acknowledged that some would want to expand the QRM definition.

"I respect their viewpoint," Bair said. "But it's the exception, not the rule. I think it's appropriate to keep it narrow."

She was backed by Acting Comptroller of the Currency John Walsh, who said QRM was meant to be narrow. "While the rule is drafted to provide flexibility, it is important to bear in mind that its purpose to is to implement a risk-retention requirement," Walsh said. "Because risk retention is the rule's focus, any exemption from risk retention is intended to be narrow, and include only loans of high credit quality. This balance is important. Expanding exemptions too broadly could cause credit availability outside the exempt category to evaporate." But it appeared not all regulators were on the same footing. John Bowman, acting director of the Office of Thrift Supervision, said he hoped the QRM would serve more as a model for the industry.

"I would hope that the provisions of QRM and other possible exemption levels that could come out of this regulation and its further iterations … would serve not as a limit but would serve as an impetus to encourage the availability of credit in the market going forward," Bowman said.

Analysts were quick to note that the proposal was only the first step in a long process. Comments are expected due back June 10.

"We also caution that this is the start of the fight and not the final battle," Jaret Seiberg, an analyst for MF Global's Washington Research Group, wrote in a note to analysts. "We expect industry to pressure the Department of Housing and Urban Development, the administration and the rest of the regulators to further moderate the proposal to lessen the potential impact on housing finance."

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