The foreclosure crisis is -- maybe -- starting to come back to haunt the big banks and mortgage lenders. If you follow this blog regularly, you know about the ongoing negotiations regarding sanctions against the banks and proposed new rules to encourage mortgage modifications. Another aspect of the foreclosure crisis has been the securitization of mortgage debt, where the big banks sold off the risk involved in mortgage loans. When they sold the debts, they made it sound like the loans were solid. Now we all know better.

The Dodd-Frank Act mandated that in the future the big banks would have to retain a 5% stake in securitized loans, so that they would always share some of the risk even if they sold off and securitized their mortgage loans. The banks hoped two things: that exemptions from the rule would be so big they could keep doing what they have been doing, and/or that the definition of retention of 5% would be so loose that they wouldn't really have to retain any risk at all.

As far as defining retention goes, they didn't get exactly what they wanted, but they did get some wiggle room. When it came to exemptions from the rule, though, they got the door slammed in their face. The regulators said "no way."

The question was how to define "qualified residential mortgage," which refers to mortgages that qualify for exemption from the rule. The banks wanted everything to qualify except for the riskiest mortgages, which they aren't offering anymore anyway. But the regulators said no - only the most solid "old fashioned" mortgages would qualify to be entirely securitized with no risk retained by the bank.

For instance, buyers would have to put 20% down in order for their mortgage to qualify for complete securitization. Second mortgages would only qualify if the loan was for 75% or less of the value of the property. It would have to be for 70% or less of the property's value if the borrower withdrew cash in the deal. In the real estate boom years, millions of mortgage loans were made that were nowhere near this stringent, and they were regularly securitized.

Fort Lauderdale "stop foreclosure" attorneys noted that the banks did get regulators to agree to broad definitions of retaining 5% of the risk. The banks can hold onto loans that are identical to securitized loans, and maintain risk that way, or they can opt to take the first 5% of losses on the loans, or they can hold 5% of every class of security. They can also use a combination of these methods. The regulators essentially decided that any of these ways of retaining risk would be effective, so the banks will be able to decide which way they want to use.

After a comment period during which regulators will take feedback, the rule could be revised before going into effect.

Source: New York Times "Regulators to Set Rules on Mortgage Securities" 3/28/2011