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Divided SEC adopts mortgage rule, decries lax lending

By Sarah N. Lynch

WASHINGTON (Reuters) - U.S. securities regulators adopted a rule on Wednesday designed to avert another financial crisis, but two officials dissented, saying it did not do enough to discourage banks from lending to borrowers with shaky credit and then passing the mortgage risk to investors.

The Securities and Exchange Commission approved the so-called "risk retention" rule by a 3-2 vote, while the U.S. Federal Reserve unanimously adopted it later in the day in a public board meeting.

The rule requires banks to keep at least 5 percent of the risk on their books when they securitize loans. This "skin in the game" is aimed at aligning the bank's interest with investors that buy the loans.

But two Republican commissioners said they could not support the rule in part because they believe its exemption for low-risk mortgages is too broad and does not sufficiently crack down on lax underwriting standards. They also said the rule perpetuates the dominant role of government-sponsored enterprises like Fannie Mae in the housing market.

"Today could have been the day when the commission and its regulatory partners ... stood strong, resisted political and special interest group pressure, and courageously seized this golden opportunity to address the failed federal housing policy that was one of the central causes of the financial crisis," said Republican SEC Commissioner Daniel Gallagher.

Before the financial crisis, banks pumped up lending volumes, little concerned about the risks since they planned to unload the loans. The system imploded when subprime mortgage borrowers started defaulting.

The dissents by Gallagher and Michael Piwowar were widely expected, after they published a letter to the editor in the Wall Street Journal in June.

The Department of Housing and Urban Development also adopted the rule on Wednesday, following three other agencies which had given their nod on Tuesday. The six regulators were required by the 2010 Dodd-Frank Wall Street financial reform law to implement the rule.

Their concerns, however, reflect the broader public debate about the delicate balance between mortgage lending standards and the need to protect investors.

The most hotly contested issue centers on the scope of an exemption for ordinary "qualified" residential mortgages. In 2011, regulators originally proposed defining qualified mortgages as those requiring borrowers to make hefty down payments.

Regulators scrapped the plan after the industry pushed back, saying it would stifle the housing market for lower-income buyers.

In Wednesday's final rule, the definition of a qualified mortgage is much looser than first proposed in 2011, and aligns with a definition in a separate rule by the Consumer Financial Protection Bureau.

The exemption is now so broad that the "same economic incentives" for the banks that existed prior to the financial crisis "may persist," SEC economists said in a study gauging the rule's impact.

SEC Commissioner Luis Aguilar, a Democrat who voted in favor of the rule, on Wednesday acknowledged some outstanding concerns with the scope of the exemption.

But, he said, the rule contains a safeguard that allows regulators to periodically review how it defines a qualified residential mortgage, and has asked SEC staff to provide annual updates.

(Reporting by Sarah N. Lynch; Additional reporting by Douwe Miedema; Editing by Susan Heavey, Jeffrey Benkoe and Alan Crosby)