A federal proposal that would encourage mortgage lenders to retain more securitization risk could hurt housing sales and prices in the short run but make the housing market more stable in the long run, according to Standard & Poor’s Ratings Services.

A group of 6 federal financial institution regulatory agencies recently proposed that lenders should keep some of the default risk when they put residential mortgages in pools backing residential mortgage-backed securities (RMBS).

The agencies suggested exempting mortgage issuers from the risk retention rule in cases in which mortgages meet certain underwriting criteria.

Issuers could avoid the risk retention requirements, for example, if the maximum front-end ratio for borrowers was 28% and the maximum back-end debt-to-income ratio for borrowers was 36%, S&P says in a comment on the proposed rule.

The maximum combined loan-to-value ratio for “plain vanilla” mortgages that could avoid the risk retention requirements would be 80% in the case of a purchase transaction.

Plain vanilla mortgage borrowers might have to have credit scores of 690 or higher.

“Overall, the proposed tight underwriting standards appear to increase the credit quality of mortgage loan collateral,” S&P says in the comment.

Erkan Erturk, an S&P analyst, says in a statement about the comment that the proposed standards probably would reduce the amount of available residential mortgages and push back the recovery of the market for RMBS not backed by federal mortgage guaranty agencies.

“Fewer borrowers will meet these underwriting standards, which will reduce demand for housing and depress home prices even further,” Erturk predicts. “On the other hand, the proposed underwriting standards will likely improve the future credit performance of underlying mortgage loans and ultimately create a more stable housing market.”

Life insurers have an interest in RMBS market rules because they have been major investors in RMBS and in some cases have mortgage lending units that write residential mortgages.

Other mortgage coverage from National Underwriter Life & Health: