Once upon a time, hardly anyone defaulted on a mortgage. Bankers made sure that their borrowers had mortgages they could afford, because if they didn’t, the bank would suffer a loss. Lenders were highly motivated to keep homeowners in their castles. Then, early last decade, mortgage securitization exploded on the scene, disrupting the fairy tale. Big, ugly giants with names like Countrywide Financial and New Century packaged huge pools of mortgages, sliced them up into securities, and sold them to investors, who now bore the risk if the loans defaulted. Because the mortgage bundlers — or “securitizers” — were paid upfront, they had powerful incentives to generate as much volume as possible, with little regard to whether homeowners could afford the loans. “I’ll be gone, you’ll be gone” or “IBG/YBG” became their mantra. They pushed loans whose interest rates would later spike, and of course, the infamous NINJAs — mortgages that required no income, no job, and no assets. Yield-hungry investors snapped them up. And as we all know, this story did not end happily: Millions of mortgages defaulted, leading to the worst financial crisis since the Great Depression and a still-struggling economy.
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We thought the Dodd-Frank financial-reform law fixed all this by requiring securitizers to keep some skin in the game. Under the law, for every dollar of loss suffered by mortgage-backed securities investors, at least 5¢ must be borne by those who securitized the mortgages. In that way, the law aligns the interests of borrowers, securitizers, and investors in making sure mortgage loans are affordable and sustainable over time. Unfortunately, in an effort to get the 60 votes needed under Senate rules to move Dodd-Frank forward, the bill’s sponsors agreed to make a limited exception to the skin-in-the-game requirement. The law exempted loans meeting standards so tight that there was little, if any, chance they would default. But as it turns out, that wasn’t good enough for the financial and housing industries. They are now arguing for regulatory changes that would allow this exception to swallow the rule. Enlisting the aid of several affordable-housing advocates, they have argued that making securitizers retain risk will lead to higher mortgage rates, hurting low-income families who can’t meet tough mortgage standards. Instead, they say, loan bundlers shouldn’t have to retain any risk if the loans they securitize meet the basic lending standards set by the Consumer Financial Protection Bureau. Those standards, however, focus on consumer protection, not on system stability. They address the most egregious pre-crisis lending practices, such as failure to document income, but they include no down payment requirement and permit total mortgage and other debt payments to reach a whopping 43% of pretax income. (The industry standard was closer to 35% before the subprime craze.) Virtually all mortgages being originated today already meet those standards.
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Obviously, having to bear 5% of the losses on defaulting loans will increase securitizers’ funding costs. But those costs will be offset by the benefits of imposing some financial accountability on them to make sure mortgages carry terms that are affordable. We saw the disastrous results of IBG/YBG when mortgage bundlers could walk away from the loans they securitized. And far from helping low-income families, they gouged less sophisticated borrowers with mortgages carrying steep rates and fees because those loans commanded bigger upfront payments when securitized and sold to investors.
Instead of loosening standards to appease the industry, regulators should make it virtually impossible for securitizers to escape having skin in the game. The consumer bureau’s lending standards are helpful, but financial accountability can be a much more powerful tool to discourage irresponsible lending. Securitization’s skewed incentives transformed home ownership from the American dream to a Brothers Grimm nightmare. We need to make sure it never happens again.
Sheila Bair is former chair of the FDIC. Barney Frank is the former chairman of the House Financial Services Committee and co-author of the Dodd-Frank Act.
This story is from the June 10, 2013 issue of Fortune.
