Investment Banks Are Afraid of Your Mortgage

George SorosWhile House reps sleep in after their weekend health care marathon, this afternoon the Senate Banking Committee starts poring over the financial reform bill introduced by Senator Christopher Dodd (D-CT).

A little detail in there is set to have a huge impact. It boils down to a prudent bit of behavior known colloquially as "eating your own dog food."

Dodd's bill asks the investment banks that package and sell mortgage-backed securities to keep 5 percent of everything they sell on their own books. And no cheating allowed, so they can't use derivatives like credit default swaps to protect themselves from taking a hit on stinker securities.

The idea is simple: if investment banks share the risk, even a little piece of it, they'll think twice before backing risky mortgages and then dumping them them in the form of toxic securities on unsuspecting investors.

Good idea, right? Well, be prepared to defend it, because the lobbyists are lining up.
The Mortgage Bankers Association wants "plain vanilla" mortgages – 30-year, fixed rate loans with substantial down payments -- to be exempt from the 5 percent requirement. Those loans are relatively safe, they argue. That's true. But here's the catch: if the mortgage bankers get their way, the safety of the 30-year fixed mortgage could be a thing of the past.

Exempting plain vanilla mortgages would open up great temptations for lenders to insert other risky features in order to boost their bottom lines. So, ironically, the loans that traditionally have been the safest could become potential carriers of invisible time bombs.

The mortgage bankers aren't the only ones pushing back against the 5 percent rule. The American Securitization Forum -- an investment industry trade group seeking to establish standards for the business of trading in securities backed by credit cards, car loans, student debt and mortgages -- wants securities firms to decide what form they want to keep the risk in, with a percentage being just one of the options. The group opposes the rule as it now stands.

Executive Director Tom Deutsch warned Housing Wire: "Senator Dodd's legislation's 5 percent retention proposal will severely limit the amount of future securitization, thus making it harder and more expensive for ordinary Americans to get badly needed credit for new cars, homes or businesses."

But would it? Dodd's bill already says that banks can hold on to less than 5 percent if the securities meet certain high standards of safety, which will be set by the Securities and Exchange Commission and federal banking regulators. Banks can also kick some of that 5 percent over to the mortgage companies that sell the loans. That 5 percent could therefore become 3 percent, or even less.

Even 5 percent -- which the House of Representatives agreed to last year - is much lower than what many experts think is necessary to make investment banks think twice before churning out high-risk mortgage-backed securities. An earlier version of the Senate bill called for 10 percent.

And others have proposed getting even more aggressive. Investor George Soros (pictured) has called for lenders themselves to hold on to 10 percent of the risk and be the first to take a loss.

No doubt securities dealers will make less money than they would have if they could sell every bit of the dog food, I mean mortgage backed-securities, they manufacture. But if they won't eat it, why should anyone else?
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