Key exemptions in the Dodd-Frank Act allowed lenders to securitize risky mortgages

In 2011, in an effort designed to prevent a repeat of the often times shoddy underwriting practices that were pervasive during the years leading up to the current mortgage crisis, the Federal Deposit Insurance Corporation and the Federal Reserve proposed a rule under the Dodd-Frank Act requiring lenders to retain some risk related to the loans they securitize.

Under the rule, these entities were to retain a 5 percent stake in any loan bundled for a secondary market that has borrowers with imperfect credit and down payments of less than 20 percent. However, this proposed rule includes key exemptions that essentially allow lenders to continue to securitize risky mortgages as long as they are insured by federal agencies or the loans are sold to Fannie Mae and Freddie Mac.

When this rule was announced, big lenders were thought to have won out because they can afford to hold these kinds of loans in their accounts and continue to originate loans.

A new proposed rule may soften an already weak proposal

Just last week, the Wall Street Journal announced that a new proposed rule may soften what was already perceived to be weak requirements in the original proposal. The new rule is rumored to exempt more loans than the initial policy, and is due out for public comment soon.  According to reports, six U.S. regulators, including the Federal Deposit Insurance Corporation and the Federal Reserve, will be proposing the new rule.

Lenders and consumer groups lobbied against the original proposed rule claiming that it could hamper the infusion of private capital into the mortgage market and would raise costs for first-time home buyers.  In contrast, many experts believe that loosening these skin-in-the-game rules is the wrong choice long-term, because they address a major cause of the economic crisis by trying to align the interests of issuers and investors.

Regardless of the outcome, critics will point fingers

In the meantime, it will be interesting to see how the much talked about Dodd-Frank Act will actually be applied. It has already been three years since its passage and its impact has yet to be entirely realized. But no matter the outcome, commentators will surely take the opportunity to point fingers at the backers of any rule if the economy’s recovery stagnates or if careless underwriting once again becomes an issue.