Federal regulators recently proposed new risk retention rules for mortgage-backed securities. The rules appear to be a major concession to the real estate finance sector. The Financial Stability Oversight Council, which includes the Federal Reserve, the Federal Deposit Insurance Corporation, and the Securities Exchange Commission, issued the new rules designed to end certain lending practices that played a part in the 2008 financial tsunami.
New MBS risk retention rules at a glance
The proposed rules require banks and other mortgage-backed securities players to retain 5% of the credit risk on their books. This requirement was mandated by the Dodd-Frank reform measure. The aim of the financial overhaul was to include loans deemed to be "qualified mortgage loans."
This definition would have included a majority of loans currently being offered, but industry supporters argued that such a provision would have hurt the housing market recovery. In response, the Feds have come up with a plan that is far more limited in scope.
In short, the new proposal scraps an earlier plan to exempt only those loans with at least a 20% down payment. Now, the 5% risk retention requirement will apply to certain loans including those where borrowers only make interest payments for a certain set time period (interest-only loans), loans where the principal balance actually increases, and loans with a debt-to-income ratio of 43% (as opposed to a 36% DTI).
The contemplated plan continues the full guarantee on payments of principal and interest provided by Fannie Mae (NASDAQOTH:FNMA) and Freddie Mac (NASDAQOTH:FMCC) while the lending giants remain in the Treasury Department's conservatorship.
Whether the proposal will create a safer lending and securitization marketplace remains unclear. Final rules are subject to revisions as the regulators will accept comments until Oct. 30, 2013. In the meantime, the proposal will benefit the broader real estate finance sector.
How will new MBS risk retention rules affect the lending market?
If the proposed rules are implemented, mortgage lenders and secondary market makers like Fannie and Freddie as well as a leading real estate mortgage lender and seller/servicer like Wells Fargo (NYSE:WFC) will be affected in different ways.
While last year was profitable for Fannie and Freddie, they still owe the Department of Treasury about $180 billion. The housing giants have been refinancing this debt by selling bonds at lower interest rates in order to repurchase their higher interest rate offerings. Moreover, each has revenues of about $100 billion. But paying back the government bailout debt will take about five years.
In the meantime, the price per share of the common stock is hovering around $1.20. Some analysts correctly note that owning preferred stock of Fannie and Freddie is the way to go because these shareholders will be paid first if and when the Treasury Department unwinds its conservatorship. The Federal Housing Finance Authority (FHFA) could convert those shares into common stock, however.
Given the current common share price, continued guarantees provided under the new risk retention plan, and a lending market still in a shaky recovery, Fannie and Freddie do not look like they are on the path to prosperity.
Wells Fargo mortgage production falling
In the long run, Wells Fargo and other big lenders will benefit from the new risk retention rules. The bank is the largest originator of mortgage loans in the U.S., and the risk retention rule takes some of the regulatory burden and uncertainty of regulatory risk off the table.
This comes at a good time for Wells Fargo since its residential loan production is declining. The bank's financial head honcho recently said that rising interest rates over the summer have slowed down the housing market, affecting Wells Fargo's lending activity.
CFO Tim Sloan anticipates mortgage originations to be $80 billion in the third quarter, down from $112 billion in the second quarter. However, he was quick to point out the bank has a diversified business model that will provide earnings growth through other businesses. The bank's high roller said that two commercial real estate loan portfolio acquisitions during the quarter -- worth $6.4 billion -- should support the outfits' revenues.
The proof is in the numbers, of course, so investors should keep their eye on the company's next earnings announcement, due next month. That being said, the company's home loan production will rise again as the housing market takes the next step in its recovery. A less stringent risk retention requirement means the big bank will readily securitize and sell its portfolio of new residential loans.
The bottom line
In the final analysis, the proposed risk retention rule will allay the concerns of market observers who believed that a more stringent rule would have been another impediment to the housing recovery and hampered lending activity.
Investors with a long-term view should prepare for the next phase of the housing market recovery by carefully picking and choosing their spots in the real estate finance sector. Fannie and Freddie will continue to sit in limbo until lawmakers figure out what to do with the oversized orphans. Meanwhile, the Wells Fargo wagon is coming down the road.
Kyle Colona has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Kyle is a writer from the New York area. He has a broad background in legal and regulatory affairs in the finance sector, and his extensive body of work is accessible on the web. Colona is not a financial advisor. This article is for informational purposes only and should not be construed as financial advice.