The federal government wants to support the goal of home ownership. But that goal will not be achieved if government subsidies lead home purchasers to default more on their mortgages. So a second goal is to minimize the defaults on home mortgages.
The tension between these two goals is being played out in the proposed rules for home mortgages under the Dodd Frank Act. To prevent another blow-up in the housing market, Congress generally required mortgage originators to retain 5% of the risk of loss of any mortgage they sold.
However, in a display of ambivalence, Congress then allowed three major exemptions from this risk retention requirement — for mortgages insured by the federal government, sold to Fannie Mae or Freddie Mac or otherwise meeting the criteria for high-quality mortgages.
Congress was right to impose a risk retention requirement. If a bank or broker sells mortgages soon after they are originated and no longer has any risk of loss, that bank or broker has little incentive to determine whether the borrower is likely to default on the mortgage.
If the mortgage originators are exempt from the risk retention requirement, the main protection against a mortgage default is a substantial down payment by the borrower. With low down payments, borrowers have an incentive to walk away from a mortgage if they encounter difficulty making the monthly payments.
Unfortunately, the rules proposed for home mortgages in late August contain three broad exemptions from the risk retention requirement for lenders — without requiring the borrowers to make substantial down payments in these situations.
The first exemption is for home mortgages insured by a federal agency. These are primarily mortgages issued by banks and then 100% insured by the Federal Housing Administration ( FHA ). Why should a bank do due diligence on a borrower’s ability to make monthly payments on a home mortgage that is 100% insured by the FHA?
Yet the minimum down payments for FHA insured mortgages is only 3.5%. And even that low down payment can be subsidized through a number of housing programs described on the FHA website.
The second exemption from risk retention is for mortgage originators who sell their mortgages to Fannie Mae and Freddie Mac.
These mortgages are turned into mortgage-backed securities, which are 100% guaranteed by either institution and sold to investors. So again what incentive do these mortgage originators have to assure that the borrowers are like to make their monthly payments?
Yet Fannie Mae and Freddie Mac will buy home mortgages with as little as a 10% down payment. Any losses on these mortgages will be borne by US taxpayers, since both institutions became insolvent and were placed in federal conservatorships.
These two exemptions cover roughly 85% of the new home mortgages in 2012. Most other home mortgages will be exempt from the risk retention requirement under the proposed definition of QRMs — qualified residential mortgages.
In 2011, the regulators initially proposed a definition of QRMs with 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 of the borrower ( including the monthly mortgage payments ) not exceed 36% of the borrower’s income.
Because of a barrage of criticism by the housing industry, the regulators recently proposed a revised definition of QRMs. Most notably, the latest proposal required no down payment by the borrower and increased the allowable debt-to-income ratio of the borrower from 36% to 43%.
If these re-proposed rules are adopted, I predict that almost every home mortgage in the US will be insured by a federal agency, sold to Fannie Mae or Freddie Mac, or will meet the definition of a QRM. In other words, there will be no risk retention requirement for the lenders on almost all home mortgages, and the borrowers will make down payments of 10% or less on these mortgages. This combination is a recipe for another housing crisis.