Still a Good Fit? Tough New Rules, Tough Market Conditions Prompt Tough Questions

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Restaurants couldn't function if menus changed faster than waiters could take orders, but for some reason banks are expected to cope with similarly maddening caprice. Since the housing-market meltdown in 2007, laws and regulations have continually changed. The Real Estate Settlement Procedure Act (RESPA) was revamped in 2008, followed by a series of Truth in Lending Act (TILA) revisions. Underwriting tightened; bank examiners cracked down; mortgage products were redesigned.

But before those reforms could get their sea legs, Dodd-Frank began roiling the waters. "Under that [law], we're going to have a complete reordering of all the disclosures in mortgage lending, less than two or three years after massive reforms were undertaken," says Rod Alba, vice-president mortgage finance and senior regulatory counsel at the American Bankers Association. "That's what has thrown the entire industry off-kilter. We're sitting on new reforms--and waiting on reforms of what was written pre-Dodd-Frank."

Among the unknowns is whether Congress will adopt President Obama's proposed expansion of the Home Affordable Refinance Program, which would allow underwater mortgage-holders to refinance their loans. The program would likely cost up to $10 billion--paid for, if the President has his way, by fees on large banks--in addition to the forced losses banks would take on many of those loans. It also could have repercussions in the secondary market. "If you're going to come in and abrogate contracts, it will affect the willingness of investors to hold mortgage debt," says Bob Davis, executive vice-president of mortgage markets, financial management, and public policy at ABA.

Another uncertainty is what loans can continue to be sold to Fannie Mae and Freddie Mac, or even what will become of the two government-sponsored enterprises (GSE), still in conservancy. Cape Cod Five Cents Savings Bank, a $2.1 billion-asset institution headquartered in Barnstable, Mass., has been very successful lending to individuals of low and moderate income. "We have enough scale right now that the ability to sell to Fannie and Freddie allows us to turn around and make loans to other people in our community," President Dorothy Savarese says. "If those are not considered a safe harbor, that's going to be problematic."

The strategic plan for the next phase of the GSE's conservancy, issued last month by the Federal Housing Finance Agency, is a step to ending some of the uncertainty about their future. The plan would shrink the agencies' role and build in a new infrastructure for the secondary mortgage market. It will take time, of course.

Unintended consequences

Fueled by refinancing and low interest rates, Cape Cod Five's mortgage business is "incredibly busy," Savarese says. Still, the implications of Dodd-Frank loom. "We completely agree with the desire of not letting people shed poorly underwritten loans onto the secondary market, but what shouldn't happen are unintended consequences," she says. "You don't want to pass a rule so strict that banks can't make loans to qualified borrowers, who are going to be able to repay."

Savarese is referring to the Dodd-Frank "qualified mortgage" (QM) provision, which sets an ability-to-repay standard. A second provision also is problematic. The "qualified residential mortgages" (QRM) provision requires mortgage-backed securities issuers to retain 5% of the credit risk if the underlying loans don't have a down payment of at least 20%--a rule critics say will shut many responsible borrowers out of the market.

Credit constriction is inevitable, many say, unless the provisions are adjusted. "Many of our bankers have said they won't originate any loans outside those safe harbors," Alba says. This prospect bodes badly for alternative loans that serve well certain banks and consumers.

For instance, balloon notes, heavily disfavored by Dodd-Frank, work well in agricultural communities. …