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The Death Of Mortgage Banking And The Shadow Banking System

 April 07, 2009 01:42 PM

House Financial Services Committee Chairman Barney Frank and friends introduced the Mortgage Reform and Anti-Predatory Lending Act of 2009 (H.R. 1728) on March 26, according to The Los Angeles Times' "Bill would fundamentally reform home mortgage industry." The most chilling provision of the bill for the shadow banking system is the extension of liability for underwriting violations to third-party securitizers. Together with the 5% capital requirement for originators of all production except 30-year fixed rate loans, this will lead to the end of most mortgage bankers.

My understanding of the players is mortgage brokers originate loans for commercial, savings and mortgage banks as correspondents or independent agents. They do not warehouse or maintain their own capital for production. Mortgage bankers both originate and warehouse loans prior to sale or securitization and are therefore dependent on the almost nonexistent warehouse financing. Even loans originated for sale to Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) must be financed for a short period of time.

Banks no longer trust mortgage brokers and are now relying on their own retail networks for originations. And if mortgage bankers cannot even get adequate warehouse financing where are they going to come up with the 5% capital requirement for ARMs and other exotics? This will limit the few surviving mortgage brokers and bankers to only writing the safest 30-year fixed rate production.

Consumer protections include: forbidding payments to loan originators based on interest rate and type of loan, minimum mortgage quality standards, loan officer "duty of care" related to home buyers' income and ability to pay, and the "net tangible benefit" test for refinancing.

Mortgage originators are so scared that The Dallas Morning News' "Mortgage rates are great – if you can qualify" reports that they are being even more strict than Fannie (FNM) and Freddie (FRE) require to insure their loans get purchased.

Mortgage banks are not depository institutions, so beyond the 5% of ARMs and exotics they do not have capital requirements to be impaired by maintaining liability on securitizations. The GSEs do require a minimum of capital, but the capital requirement is not based on production. The real issue in the new liability is whether mortgage bankers will be reliable counterparties for investors in their whole loans and securitization.

Banks on the other hand have little to gain capital wise in securitizations if they cannot remove the risk from their balance sheet. This will seal the fate of the 20-year old shadow banking system that Ben S. Bernanke and Timothy Geithner are desperately trying to resuscitate. It does not matter that investors and the actual trusts are excluded from liability; capital relief was the primary motivation of banks feeding the shadow banking system.

Eventually the government will realize that promoting basic savings through a basic banking system is the route to long term financial recovery. The Federal Reserve should be charged with balancing interest rates paid on savings with interest rates charged on lending. The needs of savers for income should not be sacrificed for the needs of borrowers. Increased incentives to savers will make more money available to lend, thus promoting long-term economic growth and eliminating any need for a shadow banking system.

Monopolizing the banking system and creating disincentives for savings provides only short term economic relief. Having the FDIC penalize banks for offering higher savings rates is just one example. The shadow banking system was a black swan in the history of banking and should never be resurrected.

Disclosure: Author is long FNM and FRE.

[Related -Dividend Investing Risks]

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