Take a scalpel, not a hatchet, to Dodd-Frank Act

Donald Trump has said, “We’re doing a major elimination of the horrendous Dodd-Frank regulations, (but) keeping some.” But he hasn’t said what he wants to keep, or released a reform plan. He and Republican lawmakers are focused on bank regulation and reining in the CFPB.  There has been no mention of keeping provisions designed prevent another mortgage crisis. They are essential, because the last crisis cost millions of Americans their homes, jobs and wealth.

The seminal cause of the crisis was the risky mortgages made by lenders. “Option ARMs,” and “negative amortization” loans allowed borrowers to skip mortgage payments. Many borrows didn’t understand that missed payments were added to their mortgage’s principal. It was no surprise that the default rates on these mortgages were the highest. Dodd Frank provides disincentives to make risky loans and incentives to make safe ones, referred to as Qualified Mortgages (or QMs). They enjoy protections from liability that non-QMs don’t.

{mosads}Dodd Frank’s Ability to Repay Rule (ATR) requires lenders to exercise enough diligence to determine that borrowers can afford to repay their loans. Lenders of QMs are presumed to have satisfied ATR. Non-QM lenders don’t enjoy this presumption and could be liable for borrowers’ damages. Failure to meet ATR can also be asserted as a defense against foreclosure.

Defaults were frequent among “no doc” loans — loans made with scant borrower documentation. Other loans had teaser rates — low interest rates for a limited period. Borrowers defaulted when they were surprised on the reset dates. Under Dodd Frank, lenders must estimate for borrowers what their monthly payments will be six months before the rate resets. Also, no doc and teaser rate loans can result in ATR liability.

Dodd Frank prohibits “steering” — where lenders charge high interest rates to people who qualified for lower rates. It also prohibits the practice of obtaining appraisals that are knowingly higher than the value of the home to justify a higher loan amount.

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One wonders why lenders might make so many loans that were destined for default. Didn’t they worry about losses that impact their stock and compensation? Not so much. To get rid of the default risk, lenders frequently misrepresented and sold loans to Freddie Mac and Fannie Mae (the GSEs), and through public securitizations, some of which were guaranteed by bond insurers. Not surprisingly, the GSEs and bond insurers collected many billions of dollars from lenders that made misrepresentations, and from investment banks that securitized the loans and guarantied the lenders’ representations.

Currently, under Dodd Frank, lenders must retain five percent of the risk of default of mortgage pools they securitize — an incentive for rigorous underwriting and less onerous provisions.  ATR, QM and risk retention are powerful disincentives to originating loans with high default probabilities.

Many residential mortgage-backed securities (RMBS), including Collateralizes Debt Obligations, (CDOs) were given AAA credit ratings (the highest ratings) by Standard & Poor’s, Moody’s and Fitch. Many of these securities defaulted, which began a cascade of losses that triggered the financial crisis. Had those ratings been accurate, the financial crisis would not have occurred or would have been much milder.

Dodd Frank increases the ratings agencies’ liability for inaccurate ratings, lessens the pleading requirements for private actions against them, and makes it easier for the SEC to impose sanctions.

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Because issuers paid for ratings, rating agencies competed by giving higher ratings than their competitors — a major contributor to rating inaccuracy and the financial crisis. Dodd Frank requires, among other things, improved internal governance that limit the conflicts of interest that arise from the issuer-pay model. It also requires rating agencies to disclose their performance records and subjects them to fines, other penalties and deregistration for violating these rules.

These provisions will become more important as the private RMBS markets continue to make a comeback; $2.60 billions of RMBS were issued in the first quarter — a 65.3 percent sequential gain boosted by stronger demand from investors. This market will continue to grow as investors become more trusting of RMBS, and as the administration reduces the GSE’s role. And as interest rates rise, it will become more cost-effective for lenders to securitize their loans rather than keep them or sell them to the GSEs. Secretary Mnuchin said the GSEs should leave government control and that the incoming administration “will get it done reasonably fast.”

Dodd Frank is not “horrendous.” Many of its provisions are needed and should remain.  In reforming it, the administration and Congress should consider using a scalpel, not an axe.

Neil Baron advised the SEC and Congressional staff on rating agency reform.  He represented Standard & Poor’s from 1968 to 1989, was Vice Chairman and General Counsel of Fitch Ratings from 1989 to 1998, and was on the board of Assured Guaranty for a decade.

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