Washington & Wall Street: Is Dodd-Frank Killing the Housing Recovery?

"Don't keep two measures at hand." 

Deuteronomy 25:14-16

News reports suggest that the banking industry is seeking ways to avoid one of the more ill-considered aspects of the 2010 Dodd-Frank Wall Street Reform legislation, namely Section 941 of the law dealing with “risk retention” on mortgage securities. Nick Timiraos and Alan Zibel of The Wall Street Journal report that regulators:

[A]re concerned that tougher mortgage rules for banks could hamper the housing recovery. The watchdogs, which include the Federal Reserve and Federal Deposit Insurance Corp., want to loosen a proposed requirement that banks retain a portion of the mortgage securities they sell to investors, according to people familiar with the situation.

I wrote a long and fairly technical comment on Section 941 of the Dodd-Frank law in Zero Hedge earlier this week, “Dodd-Frank, True Sale & Skin in the Game (Update 1).” For those of you who live outside the world of finance, what you need to know is that Dodd-Frank is hurting the housing market by imposing unreasonable economic limits on the world of private mortgage securities. 

Section 941 of Dodd-Frank is essentially a tax on issuers of private mortgage bonds, an economic penalty on private issuers of securities to support housing finance. The rule was put in place because nobody in Washington has the guts to enforce the securities laws or go after blatant acts of fraud against investors. The Dodd-Frank law requires the Fed and other regulators to set rules for “qualified residential mortgages” that don’t require risk retention, essentially the part of the market that is dominated by the US government housing agencies.

Net, net, Section 941 of Dodd-Frank kills the market for private mortgage securities.

One former staffer who worked on Section 941 opines: “[The Qualified Residential Mortgage rule] is likely the most mindless part of Dodd-Frank. In all the time I worked on the bill, I never heard a sound reason for "skin in the game" -- just simplistic platitudes from proponents who had no background in the area. It was clear from the outset that it could never be effectively implemented.” 

So the far-left in Congress achieves one of their key goals in Section 941, namely to cripple the private mortgage market and focus all housing finance market activity on the “qualified mortgage” sector. Depression era agencies like Fannie Mae and the Federal Housing Administration operate in a cozy cartel arrangement with the top four banks, killing any significant opportunity for the private sector in the US housing market.

As I noted in some detail in the Zero Hedge piece, the risk retention rules of Dodd-Frank reduce the amount of credit available to the housing sector by making it impossible for private investors to “sell” loans privately in the secondary markets. In effect, all mortgage securities become “covered bonds” that add no incremental leverage to the US economy. As I wrote at Zero Hedge:

Why is this important?  When a US government agency purchases a loan from a bank, they are increasing the leverage to the economy.  How? By giving the bank back its money so that another loan can be made.  (Watch the Frank Capra film “It’s a Wonderful Life” if you have not already done so.)  With the skin-in-the-game provisions of Dodd-Frank, however, it is virtually impossible for issuers of private mortgage securities to add any leverage to the US economy.  The best that a covered bond will do is give investors some comfort with regards to the quality of the collateral behind the security, but the covered bond remains on the balance sheet of the bank.”

Because of the monumental errors made by Barney Frank, Christopher Dodd and the other architects of Dodd-Frank, commercial banks have turned to other, even more risky practices of “selling” participations in mortgage loans to other banks. The Fed, OCC and FDIC all acquiesce in this practice of “risk-shifting,” even though we are obviously creating yet another systemic risk for the US financial system down the road.  

Loan participations are a repeat of the Penn Square Bank situation of the mid-1970s. A small Oklahoma shopping center bank caused an international funding crisis. The fiasco forced FDIC to do its largest-ever open bank transaction--guarantying ALL liabilities of the insolvent Continental Illinois National Bank. The Fed and FDIC outrageously ignore the situation with respect to loan participations -- even with the new and important "systemic risk" role delegated to these agencies under Dodd-Frank. 

Everyone is rushing to create “loan participations” because, unlike the Progressive Calvinist nightmare that is Dodd-Frank, participations are "simple" and need none of that messy "true sale" stuff involving lawyers and contracts. Loan participations also "reduce" reported assets for capital purposes, another dodge of the Dodd-Frank law encouraged by the Fed. Part of the reasons for the new source of systemic risk in loan participations is the ill-considered efforts in Dodd-Frank to fix a perceived systemic risk. The growing threat from loan participations is just another example of how government regulation always fails to anticipate future risks and so often is the cause of the next financial crisis.

If we really want to see the US housing sector continue to recover, we need to fix some of the more ridiculous provisions of the Dodd-Frank law, starting with a repeal of Section 941 requiring “skin-in-the-game” for private mortgage bonds.  Regulators also need to crack down on blatant acts of fraud such as informal “loan participations,” hideous transactions that make a joke out of the idea of financial regulation.    

As I noted in Zero Hedge: “If we really want to fix the markets for private mortgage bonds and help the US economy grow, we need less skin-in-the-game in an economic sense and more federal prosecutions for securities fraud.”


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