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Banks win another reprieve from post-crisis regs

August 29, 2013: 5:00 AM ET

Regulators balk on a rule that was meant to insure sensible mortgage lending.

Barney Frank

Barney Frank lent his name to the bank reform bill.

FORTUNE -- Regulators have, once again, backed down on a piece of financial regulation put in place in the wake of the financial crisis. And that's too bad.

On Wednesday, six government agencies, including the Federal Reserve and the Federal Deposit Insurance Corp., proposed relaxing a rule in Dodd-Frank that was meant to limit risky mortgage lending. The proposed alternative will make it easier for banks to pass off the losses they have on no-money-down home loans onto the federal government, at least for now, and investors.

It's the latest change in rules intended to remove the threat of another financial crisis. In July, the Federal Reserve decided to scrap a related rule that would have forced banks to put aside additional capital when making subprime, as well as no-money-down, loans in order to cover potential losses.

MORE: Hank Paulson: Why Fannie and Freddie remain a huge threat

The new rule change will make it easier for banks to pass off potential losses from those loans. Congress wanted Dodd-Frank to put an end to that.

In the run-up to the housing bubble, banks typically sold off a large majority of the home loans they made to either Fannie Mae and Freddie Mac -- the government-backed mortgage guarantors that insurer banks against losses -- or to investors through mortgage-backed bonds. Many of those deals ended up going sour, costing investors hundreds of billions of dollars in losses. Fannie and Freddie had to be bailed out by the government.

Many people believed that the banks were only willing to make the risky mortgage loans, which inflated the housing bubble and resulted in investor losses, because bankers knew they were going to sell those loans off. In order to change that, Congress had included a rule that would force banks to retain 5% of all but the safest mortgage deals. The question was always how to define what was a safe mortgage, or a qualified residential mortgage, as the rules called them.

From the start, the qualified mortgage rule was a hot button issue for the banks. Mitt Romney brought it up as something he would scrap in the first presidential debate.

Initially, the Feds settled on the idea of down payments as an indicator of how risky a home loan is. Borrowers who put at least 20% down, the Feds argued, were much more likely to follow through on paying their mortgage loans than those who put nothing or little down. People who put no money down were more likely to be speculators.

The new rules will eliminate the down payment requirement. Instead a mortgage will be deemed "qualified" if it's a fixed-rate mortgage to borrowers who have documented their income and don't have debt payments that exceed 43% of their income.

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Regulators have relaxed a number of rules that were set in motion by Dodd-Frank. The odd thing about the qualified mortgage rule was that it gained the ire of both banks and consumer advocates. Groups like the Center for Responsible Lending opposed the down payment rule, arguing that the rule would make the hurdle bigger for many Americans who want to be homeowners.

And that is true. But it would also be a bigger hurdle for people who want to be multiple homeowners, or people who want to be homeowners but shouldn't. The discipline and ability to be able to save up $40,000 for a $200,000 home seems to be a pretty good litmus test for whether you will be able to come up with your monthly mortgage payment.

And it's not like banks can't make these no-money-down loans. They will just have to hold onto 5% of the deals. All regulators were saying is if banks were willing to make no-money-down loans, it can't be a no-money-down proposition for them as well. The parity seems right.

At the height of the credit bubble, in early 2007, I flew to Florida to meet hedge fund manager John Devaney, who was buying up mortgage bonds. He said, at the time, that one of the secrets to his success, which had helped him accumulate a $36 million jet, a $10 million helicopter, a $45 million art collection, and a $22 million yacht called Positive Carry, was recognizing before others that no-money-down loans were just as safe as other mortgages. But that observation was, like others, a mirage of the housing bubble. Devaney's $650 million hedge fund was completely wiped out in the housing bust.

Devaney has apparently made somewhat of a comeback. His faulty thinking about mortgages is, in part, back as well.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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