Wall Street doesn't like being told what it can and cannot do. So whenever you hear big banks complaining about a new rule, it's important to consider whether this is just their usual resistance to a regulation that will impact their profits, or a change that would actually harm financial markets. One new rule that Wall Street is sure to hate came last year when the giant regulation bill ordered that banks must retain some of the risk for certain securitization transactions. One part of the proposal regulators released last week (.pdf) to satisfy this legislation has some bank analysts saying that the rule will kill mortgage securitization entirely.

This report comes from Jody Shenn and Sarah Mulholland at Bloomberg. They write that JP Morgan is not amused with a provision that would require "premium capture cash reserve accounts" (we'll get to what that means in a second):

For home-loan securities without government-backed guarantees, a market that has become "close to viable" again for the safest and largest loans, the provision "could potentially be a 'deal killer,'" New York-based JPMorgan analysts led by John Sim and Ed Reardon wrote in a report.

The reviving market for commercial-mortgage-backed securities would also be damaged, separate JPMorgan analysts led by Alan Todd wrote in another piece in the bank's report, released April 1.

"The CMBS market, as it exists currently, would shut down if the rules are enacted as written," they said.

So what is this horrible, dreadful rule? Here's a brief, simplified explanation.

Let's say you've got $1 billion in mortgages that you want to pool and sell to investors as bonds. The weighted-average interest rate on those mortgages is 5.5%. The bonds you sell to investors have an interest rate of 5.0%. Assuming no (or very low) losses, you will be collecting more interest on the mortgages than you have to pay the bondholders. This is common in securitization. It's called "excess spread."

That excess interest often covers potential losses. If there are fewer losses than there is excess interest, then some residual bond (think: money left over) will be worth something when all of the mortgages (and consequently all of the bondholders) are paid off. But in other cases, the excess interest is instead sold as a separate bond to investors, which is often an interest-only security.

Regulators aren't crazy about the possibility that banks could sell the excess interest in a deal, because the proceeds they receive could neutralize the risk that they're going to be forced to hold when they retain 5% of the deal, per the broader new risk retention rule. For example, in a $1 billion deal, if a bank must hold 5%, that's $50 million in bonds. If the excess spread produces an additional interest-only bond worth $40 million, then the bank could potentially earn $1.04 billion in proceeds by selling $1 billion in mortgages. That $40 million extra would cover 80% of its $50 million risk liability from the retention requirement.

To eliminate this possibility, regulators intend to force banks to establish a "premium capture cash reserve account" essentially equal to the size of the proceeds they receive from selling their excess interest. In the example above, they would have to fund a cash reserve of $40 million, as well as hold $50 million in risk retention. As you might imagine, banks don't want to have all that capital tied up. To make matters worse for banks, regulators want the cash reserve fund to incur any losses that other bondholders might face until the deal is paid off. So the cash reserve is tied up for the entire life of the deal and takes first losses.

In the case where a bank holds the excess interest bond instead of selling it, the rule also forces bank to forgo any gains until the deal is paid off. So again, bondholders would have some protection through the excess interest that builds up over the life of a deal. And banks would have frozen capital piling up, susceptible to losses.

It's pretty easy to see why banks don't like this. They might have expected regulators to overlook excess interest and allow them to gradually neutralize the risk they face as excess interest slowly trickles in. But now, a large portion of capital becomes unproductive as they remain exposed to significant risk. Some cash will remain tied up through the 5% retention requirement and excess interest will be frozen until the deal is paid off. In the made-up example above, this would be 9% initially. This could make securitization less attractive than traditional lending, as capital requirements on mortgage lending may become competitive with securitization retention requirements.

So is this rule really harmful to financial markets? That depends on how serious a problem you believe it would be if securitization never returned for mortgages with down payments under 20%. As the government slowly backs away from housing finance, it could serve as an important way for banks to obtain mortgage funding. Without it, mortgages with smaller down payments may only be offered by smaller banks that do not participate in securitization, as big banks might not find these mortgages worth the cost of tying up a huge chunk of capital for an extended period through the new risk retention requirements.

We want to hear what you think about this article. Submit a letter to the editor or write to letters@theatlantic.com.