Defining Prudent Underwriting: An International Struggle

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In an attempt to insulate credit markets from the high-risk residential mortgage lending activities that threatened the global financial system in 2008, regulators both in the United States and elsewhere are seeking to impose stricter residential mortgage underwriting standards. Specifically, the U.S. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act[1] (“Dodd-Frank”) in part to create “Grade-A” designations for residential mortgage loans that meet stringent underwriting requirements and other criteria. Those loans may enjoy a presumption of compliance with certain federal laws, and some may also be exempt from economic risk retention requirements that will apply to other loans.

Meanwhile, the Financial Stability Board (“FSB”), an international body that monitors and makes recommendations about the global financial system, issued Principles for Sound Residential Mortgage Underwriting Practices[2] (the “FSB Principles” or the “Principles”) for consideration by the FSB’s participating jurisdictions.[3] While the Principles do not delve into the details of specific underwriting practices, even to the extent of Dodd-Frank, they do suggest a targeted approach to imposing stricter requirements.

As described below, while many agree on the end-goal of achieving tighter residential mortgage underwriting, the devil is in the details. The FSB, like the regulators in the U.S. and elsewhere, is struggling to define any actual standards or specific criteria for achieving that goal. That lack of clarity spooks creditors and investors in the residential mortgage market, and threatens the supply of available mortgage credit, particularly for first-time and low-income borrowers. Without clearer standards, lenders may shy away from making loans to anyone, particularly those with less than stellar credit. Moreover, without greater certainty with respect to assignee liability and risk retention requirements, secondary mortgage market participants may lose their appetite for purchasing or securitizing loans that do not meet the highest underwriting criteria.

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