By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, January 18, 2011; 10:52 PM
Federal officials took two steps Tuesday to attempt to reduce the likelihood of a second financial crisis caused in large part by large declines in the housing market.
The first would try to tackle the problem of foreclosures. The Federal Housing Finance Agency, which oversees the massive mortgage finance companies Fannie Mae and Freddie Mac, said it would consider a new approach to how home loans are managed by banks. Critics say the current system makes it more lucrative for a bank to foreclose than to find ways to modify loans to allow struggling borrowers to stay in their homes.
The second would try to curtail reckless mortgage lending by more tightly regulating what firms can do with the loans they make. Currently, banks can pool mortgage loans together into an investment and sell that to investors around the globe, passing on all the risk associated with the loans. But a report released by the Treasury Department, as required by the Dodd-Frank law overhauling financial regulation, endorsed the law's prescription that banks be forced to hold on to a portion of the investment, making it difficult for a bank to ignore the risks associated with lending.
Recognizing that private firms and government programs have had difficulty carrying out a large number of modifications to mortgages to avoid foreclosures, the FHFA said it would consider several approaches to how banks should manage home loans. Studies have shown that foreclosure is often more profitable for a company, known as a mortgage servicer, that collects the monthly payments on mortgages and passes them on to investors who own the mortgages.
However, it is often not the best path for borrowers, who lose their homes, or investors, who lose money.
When a loan is modified, payments to a servicer can decline. But if the borrower is in default, the servicer adds fees on the account and can collect when the house is sold, even at foreclosure.
Among other proposals, the FHFA said that it would consider a new compensation structure for servicers whereby they would receive fees for restructuring mortgages to avoid foreclosures.
"As the recent problems in managing mortgage delinquencies suggest, the current servicing compensation model was not designed for current market conditions," said Edward J. DeMarco, the FHFA's acting director. "The goal of this joint initiative is to explore alternative models for single-family mortgage servicing compensation that better address the needs of borrowers, servicers, originators, investors and guarantors."
The FHFA cautioned that it would not expect any servicing model to be in place before summer 2012.
Senior Obama administration officials hailed the proposal.
"It is clear that the mortgage servicing compensation model is broken and should be fixed," Treasury Secretary Timothy F. Geithner and Secretary of Housing and Urban Development Shaun Donovan said in a letter Tuesday. "That is why we support your decision today to review the structural flaws in the current mortgage servicing compensation model."
The Securities and Financial Markets Association, a lobby representing many firms involved in the buying and trading of mortgages, said the agency was taking a balanced approach and considering the needs of all parties involved in mortgage servicing.
Meanwhile, the Treasury Department released a report endorsing a proposed rule requiring that banks that pool mortgages into securities and sell them to investors retain a portion of the investment and thus share in the risk. The Dodd-Frank law required that banks retain at least 5 percent of the risk a particular investment would default.
Certain assets that meet very high standards are exempted.
During the years leading up to the financial crisis, lenders and banks pooled risky home loans into securities and sold the securities to investors, which let the lenders book a profit and release the risk.
Some banks have warned that too stringent risk-retention requirements could gum up the financial markets, making banks wary of selling securities.
The report recognized this danger, saying: "If risk retention requirements are too stringent, they could constrain lending, and consequently, the formation of credit."
The report suggested approaches to avoid this possibility and create standards by which the risk-retention requirement could be waived if, for instance, borrowers commit a large enough down payment or have a very high credit score in combination with other factors.
"This study broadly endorses the concept of risk retention, but it also recognizes the risk of applying it to every loan," said Jaret Seiberg, an analyst with the Washington Research Group, a policy analysis firm.