07/16/2010 01:32 pm ET Updated May 25, 2011

Financial Reform: Safer Mortgages, Fewer Borrowers, And a Lock on Home Lending for Big Banks

Though the financial reform bill is broad in scope, consumers will feel the most direct impact from the provisions that overhaul the process of getting a mortgage.

The mortgage provisions are a top to bottom restructuring of how a home gets financed and valued, the types of mortgage products that can be offered, how the lender is compensated, along with new rules for investors who provide mortgage capital.

The signing of the bill by the President is not the end of the process of mortgage reform, but only the starting gun in a multi-year regulatory effort to put flesh on the bones of the legislation. The decisions to be made by regulators are as important to determining what the mortgage market looks like as the bill itself. Congress has punted to regulators much of the work of deciding what new mortgage standards will be.

We argued a year ago (in this essay in Huffington Post) that the financial reforms proposed by the President were helpful to restoring borrower and investor confidence in a broken mortgage market. And while the final bill includes important reforms, significant questions remain about the impact on how the mortgage market will operate.

  • The Bill is Jet Fuel for Concentration of Mortgage Risk: One of the likely outcomes of the bill is that the largest financial institutions will increase their already bloated share of the mortgage market. Five banks today control in excess of 65% of the mortgage market -- the financial bill will accelerate this trend by favoring banks over independent lenders. This was a deliberate decision pushed by Chairman Frank and the administration on the theory that large banks were easier to regulate than myriad independent lenders. Thus risk retention requirements, compensation rules, and licensing standards are all tilted toward large banks. The result is that the big will get bigger -- and the level of mortgage risk will concentrate further -- though the administration argues that more competent regulators and safer mortgage products alleviate the concern about "too bigger to fail".
  • A Smaller Mortgage Market With Fewer Qualified Borrowers: The new law places significant hurdles to offering any mortgage products outside the "plain vanilla" category. Regulators must define what is inside or outside the plain-vanilla box. Clearly, firm regulation of mortgage products is necessary in light of the subprime meltdown. But exactly where regulators draw the line will have a substantial impact on what kind of mortgages are available and which borrowers will qualify for a mortgage. Already we have seen that non-traditional borrowers have virtually fallen out of the home-buying market, other than thru government guaranteed FHA loans. Last year, rejection rates for African American and Latino borrowers skyrocketed for non-FHA loans. Will new mortgage standards be flexible enough to allow for reasonable credit risk determinations -- or will plain vanilla mortgages mean plain vanilla homeowners?
  • Indefinite and Increased Government Support for Mortgage Market: The bill further increases the dependence of the mortgage and housing market on federal support. Private capital is already scarce in housing -- over 95% of mortgages today are guaranteed directly or indirectly by FHA and other government agencies. Private securitizations will be helped by new rules that create transparency and requirements that rating agencies do their homework before rating a mortgage security. But other parts of the bill impose new liability on securitizers for the underlying mortgages originated by third parties, and requirements to retain capital when transferring risk. The full contours of these rules won't be issued by regulators for 2-3 years -- extending a period of uncertainty that has dissuaded private investors from restarting the flow of mortgage capital. Meanwhile, the federal footprint in mortgages will become deeper and deeper in order to keep the housing market from the dreaded double dip -- and making the unwinding of federal intervention that much more difficult.

Bottom line: Consumers will see "safer" mortgages, but fewer of them will qualify. They will have fewer choices of mortgage lenders as concentration of mortgage lending by a few big banks accelerates. And virtually all mortgages will be government backed for the foreseeable future, with little chance of unwinding federal support. Uncle Sam will be the nation's mortgage lender for most of the next decade.