As lawmakers continue to debate the regulatory reform bill on the Senate floor, it's increasingly hard to predict what the final provisions will say.
While the Senate, as expected, voted Wednesday to preserve the Federal Reserve Board's banking supervisory authority, it unexpectedly added an amendment to require minimum underwriting standards and was poised to undermine a key risk-retention provision.
Until now, the Senate has avoided addressing underwriting standards in the reform bill, but it voted 63 to 36 to add an amendment from Sens. Jeff Merkley of Oregon and Amy Klobuchar of Minnesota that would effectively ban yield-spread premiums and require lenders to verify a borrower's income. The measure would also order a proposed consumer protection bureau to write new rules that guarantee a borrower has the ability to repay a mortgage.
The measure was hailed by consumer groups, noting that it would apply to all mortgages, not just subprime ones or those originated by banks.
"We have always thought that any real financial reform would have to include stopping the mortgage abuses that caused this whole problem," said Julia Gordon, a senior policy counsel with the Center for Responsible Lending. "The importance of this amendment is that it applies to the entire mortgage market."
Even though few, if any, no-doc loans are being originated today, the industry said the amendment would still have an effect.
"This would have a pretty significant impact," said Laurence Platt a partner with K&L Gates. "It would not only create a federal underwriting standard, the penalties for not following it are pretty substantial."
The Merkley provision would require a mortgage originator ensure a borrower's ability to repay a mortgage for five years based on verifiable income documentation such as tax returns or other financial documents. Regulations implementing the standard would be left to the consumer protection bureau to write and enforce.
Lenders would only be presumed to have properly underwritten the loan if they followed that requirement and if the loan's total points and fees did not exceed 3% of the loan amount. Borrowers would have considerable power to sue if points and fees exceeded that level. Lenders would be on the hook for actual damages and enhanced damages, which bear no relationship to actual harm.
The Merkley provision would also ban yield-spread premiums by prohibiting brokers or any loan originator from compensation that varies based on any term of the loan except the principal amount.
Paul Leonard, a vice president of government affairs for the Financial Services Roundtable's Housing Policy Council, said the provision would give the consumer bureau too much power. Writing rules governing a bank's underwriting standards, he argued, "should be done by the prudential regulators."
The provision moves the Senate bill closer to the House version, which included measures that would enact sweeping new mortgage standards, including banning prepayment penalties and requiring a minimum debt-to-income ratio.
Some consumer groups hoped the House version would stick when the two chambers eventually meet to hash out a final bill.
"It falls short of the House version. I hope the House version prevails," said John Taylor, the president and chief executive of the National Community Reinvestment Coalition.
Still, while the amendment bolstered the bill's consumer protection provisions, the Senate also appeared ready to weaken a key measure that would require securitizers to maintain 5% of a loan's credit risk.
The amendment, by Sens. Mary Landrieu, D-La., Kay Hagan, D-N.C., and Johnny Isakson, R-Ga., would essentially establish a trade-off in mortgage lending.
Either lenders could underwrite mortgages in line with regulatory standards or they could retain some of the loan's risk.
"You can't make it work with a 5% risk retention," Isakson said on the Senate floor.
"Risk retention is not the cure all to good lending. Underwriting is. The only risk retention that will be required is when somebody is making a bad loan, which means that people will stop making bad loans."
Senate Banking Committee Chairman Chris Dodd justified the measure on the Senate floor Wednesday, saying that risk retention was only a necessary safeguard in instances where prudent underwriting failed to prevail.
"I'm not interested in having risk retention if in fact we have some good standards that are applying as things move forward so we don't end up where we were two years ago," Dodd said.
The risk-retention provision, as originally drafted in the Dodd bill, would have required lenders to retain up to 5% of the credit risk when selling loans into securities.
However it also gave regulators authority to create exemptions and to reduce the risk-retention requirement down to nothing.
The provision has been one of many strongly opposed by the banking industry.
They argued that the measure was written broadly enough that it could be applied to any loan and could have tied up capital and raised the cost of credit to borrowers.
The Landrieu amendment would direct federal banking regulators to establish a protected class of "qualified" mortgages deemed to be soundly underwritten and exempt them from the bill's risk-retention requirement.
Despite opposition from community groups, the amendment is expected to be approved by voice vote.
The Senate also adopted an unrelated amendment from Sens. Olympia Snowe, R-Maine, and Landrieu by voice vote that would clarify that the consumer protection bureau does not cover small businesses like orthodontists and jewelers.
The amendment says the bureau cannot regulate a business that meets a three-prong test: it sells nonfinancial products, it does not securitize its consumer debt and it meets the Small Business Administration's definition of "small."