Wall Street Journal

How to Create Another Housing Crisis

Government policies to promote homeownership should aim to decrease mortgage defaults, not increase them. They can do so by requiring the lender to bear some of the risk of loss, by requiring the borrower to make a substantial down payment, or both. Yet late last month federal regulators proposed rules that would gut both requirements.

Before the financial crisis, banks or brokers would often originate home mortgages and immediately sell them to a large financial institution, which would package them as mortgage-backed securities for investors. With "no skin in the game," the originators had little incentive to determine whether the borrower was likely to default.

In response, the Dodd-Frank Act, passed in 2010, generally requires mortgage originators to retain 5% of the risk of loss on the mortgages they sell. However, exemptions built into the law—as interpreted by rules proposed on Aug. 28—would eliminate this requirement for most home mortgages. The proposed rules would also allow low down payments, although they are the best predictors of mortgage defaults.

Dodd-Frank has three main exemptions from the risk-retention requirement. One applies to the lenders of all home mortgages insured by the federal government. These are mainly loans issued by banks and then backed 100% (principal and interest) by the Federal Housing Administration.

Banks will thus have little incentive to ensure that the borrowers can make their monthly payments on these mortgages. On top of this, the minimum down payment for a FHA-insured mortgage continues to be extremely low—3.5% of the home's value.

The combination of low down payments and government backing is lethal. Due to losses on its insured mortgages, FHA reserves are already below its statutory minimum, and the agency may have to ask for a federal bailout.

Mortgage originators who sell their loans to Fannie Mae or Freddie Mac will also be exempt from retaining any risk of loss. The two government-sponsored enterprises package the loans they buy into mortgage-backed securities, which they guarantee. In 2008, Fannie and Freddie became insolvent and were placed into federal conservatorship.

Both financial institutions have recently become profitable, but thanks to an intense partisan political disagreement, it's unclear whether or when they will be taken out of federal conservatorship. As long as they remain in conservatorship, the risk of loss on these mortgages will be borne by U.S. taxpayers. Down payments? Fannie and Freddie will buy home mortgages where the borrower puts up only 10%.

These two exemptions will have a huge impact. Last year approximately 85% of all U.S. home mortgages were insured by the FHA or bought by Fannie Mae or Freddie Mac.

Most of the remaining home mortgages would be considered QRMs—qualified residential mortgages—under the recent proposals. QRMs are supposedly high-quality mortgages whose originators would retain any risk of loss if the mortgages were sold.

In 2011, federal regulators initially defined QRMs to include two critical conditions—that the borrower make a down payment of at least 20% of the home's value, and that the total debt payments not exceed 36% of the borrower's income. Both conditions were condemned by the mortgage industry, and in response, the definition of a QRM no longer requires any down payment. The new regulatory proposal also increased a borrower's debt-to-income ratio to 43% from 36%.

The mortgage industry claimed that the initial conditions for QRMs were too onerous and would undermine the American dream of homeownership. Their argument is belied by experience in Canada.

Most Canadian lenders insist on a down payment of at least 20% of the home's value (although the government provides some support to first-time and lower-income home buyers). Canadian lenders also look carefully at the borrower's ability to make monthly payments since the majority of home mortgages in Canada are retained by the originator, and not sold to packagers. Nevertheless, the homeownership rate is more than 67% in Canada and 65% in the U.S.

In short, if the U.S. wants to promote homeownership, it should learn from past mistakes. Under the proposed rules for home mortgages, most borrowers would make minimal down payments and most lenders would have no risk of loss. This is a good way to create another mortgage crisis.