Order Code RS22722
September 17, 2007
Securitization and Federal Regulation of
Mortgages for Safety and Soundness
Edward V. Murphy
Analyst in Financial Institutions
Government and Finance Division
Summary
Rising defaults in the subprime mortgage market have drawn attention to the
regulatory framework for mortgage lending. Traditionally, banks subject to federal
regulation have extended loans to potential home buyers and kept the loans in their own
portfolios. Alternatively, mortgage lenders can sell their loans to the secondary market,
where the loans are transformed into mortgage backed securities (MBS), in a process
called securitization. Securitization allows banks and non-banks to offer mortgages
without retaining a long-term interest in the loans themselves. Non-bank lenders are
often outside the safety and soundness regulation of federal bank examiners, although
they are still subject to the consumer protection mandates of the Truth in Lending Act
(TILA).
Guidances issued by the financial regulatory members of the Federal Financial
Institutions Examinations Council (FFIEC) help maintain prudent lending standards for
covered institutions. Securitization of loans originated by non-banks, however, allows
some mortgage lending to escape these guidances. The underwriting standards of
Fannie Mae and Freddie Mac, regulated for safety and soundness by the Office of
Federal Housing Enterprise Oversight (OFHEO), could still influence underwriting
standards of non-bank lenders. Caps on the loans they could purchase, and other factors,
however, have limited the influence of these government-sponsored-enterprises’ (GSE)
underwriting standards.
There is some evidence that the underwriting standards of non-banks that chose to
securitize loans outside of Fannie Mae and Freddie Mac became weaker as the housing
boom progressed. Indicators of excessive debt appear to have weakened more than
indicators of weaker borrower payment history. Potential reforms of securitization and
the non-bank lending channel are now under consideration. This report will be updated
as conditions change.
Disruptions in the mortgage market have drawn attention to the potential for lenders
to engage in imprudent underwriting. Many borrowers may have become overextended
because their loans, in hindsight, are not sustainable. Although federal bank examiners
are primarily concerned with the financial stability of the system, one byproduct of their

---

CRS-2
regulations may be to limit the chances that borrowers will be offered imprudent loans by
regulated institutions. Securitization, which transforms pools of loans into marketable
securities, may have contributed to looser underwriting standards, because it creates a
non-bank source of mortgage funds, which is outside federal bank examination.
A non-bank mortgage originator can open a line of credit to fund its lending, rather
than accepting deposits or raising its own capital. The originator then draws down the
line of credit to make loans. The originator sells the mortgages to the secondary market
and uses the proceeds to pay back the line of credit and extends more loans. Once in the
secondary market, the mortgages can be packaged together and held in passive trusts. The
trusts can then distribute the mortgage payments by a pre-arranged formula to securities,
called mortgage-backed securities (MBS), which are purchased by investors. This
securitization of mortgages has increased the supply of funds available for mortgage
lending, but has also reduced regulation; nothing in the non-bank mortgage originators’
activities triggers safety and soundness regulation by traditional federal bank examiners.
Although disclosure rules for consumer protection are federally regulated and apply to all
loans, the prudence of the lenders’ underwriting is disciplined only by the perceived
willingness of investors to purchase the loans. This report discusses the network of
federal mortgage regulators and the impact of securitization on prudent mortgage
underwriting.
Bank Safety and Soundness Regulation
and the Limits of Federal Agency Guidance
The United States has a complex financial regulatory structure that varies both by
institutional setting and banking function. Federally chartered national banks, for
example, are subject to safety and soundness examination by the Office of the
Comptroller of the Currency (OCC). Savings associations chartered at both the state and
federal level are subject to safety and soundness examination by the Office of Thrift
Supervision (OTS). Bank holding companies are subject to safety and soundness
regulation by the Federal Reserve (FRB). Table 1 provides a list of banking institutions
and their safety and soundness regulators. The federal banking regulators with
examination powers cooperate through the Federal Financial Institutions Examinations
Council (FFIEC), which includes the OCC, OTS, FRB, the National Credit Union
Administration (NCUA), and the Federal Deposit Insurance Corporation (FDIC).
The agencies of the FFIEC, including the Federal Reserve, issue safety and
soundness guidances for their covered institutions, but these guidances do not have the
force of regulation on lenders who are not subject to the standards of one of the agencies.
For consumer protection, in contrast, the FRB issues binding regulations on all lenders

---

CRS-3
through Regulation Z of the Truth in Lending Act (TILA).1 Non-bank mortgage
originators using the securitization channel are subject to federal consumer protection
regulation, but may escape federal safety and soundness regulation. The FFIEC
guidances on real estate lending, subprime lending, and alternative mortgages apply,
therefore, to only a portion of the mortgage market.
Table 1. Regulators of Banking Institutions
Charter and
Safety/Soundness
Consumer
License
Examination
Protection
National Banks
OCC
OCC
FRB & OCC
State Member Banks
State
FRB & State
FRB & State
Insured Federal Savings
OTS
OTS
FRB & OTS
Associations
Insured State Savings
State
OTS & State
FRB, OTS, & State
Associations
FDIC-insured State
State
FDIC & State
FRB, FDIC, & State
Nonmember Banks
Non-FDIC-insured State
State
State
FRB, FTC, & State
Banks
Federal Credit Unions
NCUA
NCUA
FRB & NCUA
State Credit Unions
State
State
FRB, FTC, & State
Bank Holding Companies
FRB
FRB
FRB & FTC
FDIC - Federal Deposit Insurance Corporation
FRB - Federal Reserve Board
FTC - Federal Trade Commission
NCUA - National Credit Union Administration
OCC - Office of the Comptroller of the Currency
OTS - Office of Thrift Supervision
During the period 1997-2006, the share of mortgages securitized grew significantly,
increasing from 49.2% in 1997 to 67.7% in 2006. In dollar terms, the value of mortgages
securitized grew from $423 billion in 1997 to $2 trillion in 2006. The growth of this
securitization channel may have facilitated more lending by institutions not subject to
federal bank examiners, although some of the increase in securitization share came from
regulated banks also selling to the secondary market.
The GSEs and Federal Influence on Non-Bank Underwriting
The absence of federal regulation of non-banks using securitization does not
necessarily mean that there is no federal influence on non-bank underwriting. Many
1 TILA is found at 15 USC 1601 et seq, Regulation Z is 12 CFR Part 226.

---

CRS-4
mortgages are securitized by government sponsored enterprises (GSEs), especially Fannie
Mae and Freddie Mac. Lenders planning on selling their mortgages to the GSEs would
have to conform to the underwriting standards of those institutions, which are subject to
safety and soundness oversight by the Office of Federal Housing Enterprise Oversight
(OFHEO). Standards enforced by OFHEO could indirectly influence the willingness of
the GSEs’ lending partners to extend credit for more risky mortgages.
A number of factors limited the influence of the GSEs’ underwriting standards as the
housing boom progressed. First, there is a cap on the size of the loan that the GSEs are
allowed to purchase, called the conforming loan limit. Loans larger than the cap,
currently $417,000, are called jumbo loans and must be securitized outside the GSEs.
Securities from issuers other than the GSEs are called non-agency MBS. Due to the fact
that the housing markets in some high cost areas, such as California, were particularly
active during the boom, and mortgages in these areas are more likely to be above the cap,
non-agency MBS grew faster than the overall market.
Second, the GSEs did not enter the risky subprime market directly, instead, they
purchased the more senior (and therefore less risky) securities of non-agency subprime
MBS. A lender planning to sell to a non-agency MBS issuer would be unlikely to alter
underwriting standards for GSE purchases of senior securities. One reason the GSEs
purchased non-agency subprime MBS was that the Department of Housing and Urban
Development’s (HUD) housing goals were rising. HUD’s housing goals mandate that the
GSEs purchase a minimum share of their mortgages for lower-income borrowers and in
underserved areas. The GSEs received pro-rated credit toward their housing goals for
their share in non-agency MBS. In this way, the GSEs provided additional funds to
subprime markets without a corresponding extension of their underwriting standards.
Third, there was a relatively high proportion of refinances during the boom. The
decline in interest rates caused a drop in the share of mortgages that were goals-qualifying
for GSE purchase. Higher-income home owners disproportionately took advantage of the
opportunity to refinance. This meant that relatively large mortgages, which are generally
not goals-qualifying, grew as a share of the GSE-eligible market. As a reference, the
share of GSE-eligible mortgages that were refinances in the first quarter of 1995 were
26%, but the share of mortgages that were refinances in the first quarter of 2003 were
80%.

Non-Agency MBS and Weakening Underwriting Standards
It is difficult to assess the underwriting standards of non-agency MBS because the
information is proprietary. There is some evidence, however, that underwriting standards
loosened as the housing boom progressed. The results of one study of the boom, by UBS,
are presented in Table 2.2 The table shows an increase in the average risk of loans
underwritten in 2005. For example, interest-only mortgages (I/Os) rose from 0.0% of
subprime loans in 2000 to 26.5% of subprime loans in 2005, before falling back to 16.3%.
An interest-only requires a reset to a higher payment even if interest rates do not change.
2 “The U.S. Subprime Market: An Industry in Turmoil,” Thomas Zimmerman, UBS presentation,
[http://www.prmia.org/Chapter_Pages/Data/Files/1471_2576_Zimmerman%20Presentation_p
resentation.pdf].

---

CRS-5
Other risk indicators, such as debt-to-income ratio (DTI) and combined-loan-to-value
(CLTV), also increased during 2001-2005. Interestingly, the primary indicator of
borrower payment history, the FICO3 score, improved during 2000-2005 from 590 to 627,
although it fell back to 624 in 2006. This suggests that the use of nontraditional products
such as I/Os and debt-burdens may have played as important a role as the payment
histories of the borrowers. On the other hand, improving economic conditions and rising
house prices could generally improve FICO scores and increase the size of loans relative
to incomes even if underwriting criteria had not loosened.
Table 2. Selected Risk Indicators in Non-Agency Subprime MBS
2000
2001
2002
2003
2004
2005
2006
I/O %
0.0
0.0
0.7
3.7
15.3
26.5
16.3
FICO
590
598
612
621
623
627
624
CLTV
35.4
42.4
45.3
51.8
57.6
62.3
62.8
Full Doc
73.8
72.9
67.5
64.9
62.2
58.3
56.8
DTI
38.6
39.1
39.4
39.7
40.3
41.0
41.8
Source: UBS
I/O% - Percent of loans that are interest-only
FICO - Average borrower credit score under Fair-Isaacs
CLTV - Average loan-to-value ratio (combined with any 2nd)
Full Doc - Percent of loans with full documentation
DTI - Debt-to-income ratio
Options for Improving Underwriting
Extend Coverage of Agency Guidance. Recent testimony by the financial
regulatory agencies suggests that loans subject to their guidance have fared much better
than non-agency MBS originated by non-banks.4 On the one hand, the guidances of the
FFIEC provided for more prudent underwriting standards and closer scrutiny of subprime
loans even before the housing markets cooled off. On the other hand, the guidances are
administered by bank examiners within an existing institutional framework and it is
unclear how non-bank lenders would be incorporated. Could they be subject to
examination by existing agencies and personnel, or would there need to be significant
changes to agency structure or staffing?
Do Nothing. The market has already improved underwriting standards and
punished the riskiest lenders with bankruptcy and the investors in the riskiest securities
with significant losses. Underwriting standards for non-agency MBS were essentially set
3 The term FICO comes from scores developed by the Fair Isaacs credit reporting firm.
4 Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation on Recent
Events in the Credit and Mortgage Markets and Possible Implications for U.S. Consumers and
the Global Economy before the Financial Services Committee, Sep 5, 2007.

---

CRS-6
by the willingness of investors to accept the estimated risk of the mortgage pools.
Because investors rarely had detailed knowledge of the loan pools, they often relied on
ratings agencies to evaluate the risk. While house prices were rising, a troubled borrower
could sell the house rather than default, which held down expected default rates. Since
housing markets have slowed down and loan defaults have been rising, markets have been
re-evaluating the risks in non-agency MBS. As a result, MBS ratings have been falling,
and funding for the riskiest mortgages has already all but dried up. A disadvantage of
taking no action is that while the market has already raised current underwriting standards
there is no assurance that a future boom and bust cycle will not be repeated.
Originator Liability. Mortgage originators, including brokers and lenders, could
be made liable for defaults if underwriting standards are unsuitable for the borrower’s
circumstances. One advantage of this approach is that originators have direct contact with
borrowers and have a great deal of information about each borrower’s circumstances,
relative to MBS investors or financial regulators. Originator liability could ensure that
mortgage brokers and lenders retain a stake in the long-term performance of their loans.
A disadvantage of this approach is that suitability is difficult to define, subject to
significant uncertainty and litigation risk, and determined only after events occur that
trigger defaults.
Assignee Liability. The secondary purchasers of mortgage loans, assignees, could
be held liable for unfair, deceptive, or unsuitable mortgage originations. The advantage
of this approach is that it would encourage secondary market participants to be more
vigilant in monitoring the practices of mortgage brokers and lenders. This approach also
gives aggrieved borrowers potential redress if a thinly capitalized mortgage originator
goes bankrupt before the borrower can seek compensation. A disadvantage of this
approach is that if liability is unclear, investors will not be able to quantify and price it,
and the market may shut down.
Set National Underwriting Guidelines in Law. National underwriting
guidelines could be set in statute or an agency could be authorized to establish national
underwriting guidelines by regulation. Official standards for debt-to-income ratios, FICO
scores, and other risk indicators could be announced. Banks, non-banks, and borrowers
could all be made aware of a single set of prudential limits on loan terms. On the other
hand, mortgage markets would become less flexible and borrowers with nontraditional
sources of income or other characteristics would have difficulty qualifying for loans.
Disclosure, Counseling, and Financial Literacy. Borrowers have the most
information about their own financial condition and plans; yet they may not fully
understand the complexities of new mortgage products. Improved mortgage disclosure
could aid borrowers’ decisions and minimize any deceptive or misleading marketing. To
the extent that part of the problem is caused by borrowers taking out unsustainable loans,
a more financially sophisticated populace might minimize the chances of default by
making more prudent mortgage decisions. Home buyer counseling and financial
education could potentially reduce the probability of defaults and preserve market
flexibility. On the other hand, few people buy houses often enough to become experts and
even sophisticated borrowers with full information could be susceptible to overconfidence
when anticipating house price appreciation.

---