Regulators: Wake up and smell the loan risks by Scott Olster @FortuneMagazine January 13, 2011, 4:39 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons While the number of disputes related to failed mortgages is on the rise, it doesn’t look like regulators are doing much about it. What will it take to put the risk-retention wheels in motion? By Eleanor Bloxham, contributor Disputes related to failed mortgages are ballooning amid the fallout of loan securitizations and sales made by some of the biggest banks. But, for the time being, it doesn’t look like the primary bank regulators are doing much about it. One example: The Federal Reserve Bank of New York is part of an investor group now asking Bank of America BAC to repurchase the mortgages it bought. The New York Fed sits in an interesting spot as both a concerned mortgage investor and as a regulator of the originators and securitizers that sell them. Despite suffering as an investor itself, the Federal Reserve has not offered any indication that it plans to increase regulatory supervision of the banks’ risk management practices when it comes to loan sales and securitization. The Federal Reserve has produced a report on the issues involved with securitizations and is working with other regulators on implementing the new financial reform bill’s “5% risk retention requirement,” according to spokesperson Barbara Hagenbaugh. (Under Section 941 of the U.S. Financial Reform bill, originators and securitizers will be required to retain at least some exposure to securitized loans, with some exclusions.) The Office of the Comptroller of the Currency, the other large bank regulator, believes that the underwriting standards for banks should be improved. Just the same, its principles have not changed in over a decade. Back in 1999, the OCC stated that in “recent examinations, our examiners have noted an unacceptable number of national banks with risk management systems or internal control infrastructures insufficient to support the institution’s securitization activities” and that “where examiners identify weak risk management practices or lax internal controls, bank management will be directed to take immediate corrective action.” There is no immediate indication, from the Federal Reserve or the OCC, of stepped up examination or enforcement of the largest banks’ securitization practices, at least for now. So the largest banks do not face additional scrutiny, giving no comfort to investors or insurers. But that doesn’t mean other regulators are sitting idle. In October of last year, Sheila Bair, chair of the FDIC, described the role of securitization and the risk issues in banks this way: “All along the chain of securitization — from originators, to securities underwriters and ratings agencies, to investors and regulators — insufficient attention was paid to both safety and soundness… the robo-signing controversy is just another indication of the need to improve institutional practices all along the chain… The misaligned incentives that have been built into the securitization process have left back-office operations far too weak to support a robust system of mortgage finance.” While the FDIC is not the primary regulator of the largest banks doing loan securitizations, it is taking action. In 2010, the FDIC changed its safe harbor policies for banks in receivership to encourage changes to banks’ loan securitization processes. FDIC acting general counsel Michael Krimminger says that the safe harbor changes will make it more difficult for certain securitizations to obtain high credit ratings. The SEC’s updates to Rule AB in 2011 requiring “more loan level disclosures throughout the term” will also be important, he said, as they will increase transparency within the system. “Banks argued when they were securitizing, they were not holding risk,” says Krimminger. But they were “holding more risk than they thought,” which has come to the forefront due to current issues related to “putbacks and reps and warranties.” Subprime lending can be profitable, but to do it profitably, bankers must add real value to the system, which can be done by providing a means of credit and credit coaching to less knowledgeable borrowers. The subprime mortgage securitization market is essentially “dormant at the moment,” Krimminger says, but regulators should not be complacent. “We don’t want to restart a market without necessary reforms.” We want a system that is “less risky to the economy and financial system,” without the “churning which led to the crisis.” In the past, Krimminger says, banks were focused on up-front income rather than long- term performance. As a matter of safety and soundness, regulators should encourage prudence and risk management at the banks. Banks get many benefits from the regulatory system, including low cost capital. In return, regulators should step up their oversight and encourage a restoration of principled banking where bankers focus on adding real, long-term value in their economic transactions, for themselves, their customers and for the economy as a whole. Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance, a board advisory firm.