Yesterday President Obama supported the phasing out of Fannie Mae and Freddie Mac, the quasi-governmental corporations that purchase home mortgages from private lenders and package them into securities sold with a government guarantee. Similarly, the Federal Housing Administration (FHA) provides a 100% guarantee of home mortgages of moderate size, which are issued by banks and mortgage lenders.
Instead, the president endorsed a new home mortgage system where the private sector would be primarily at risk for mortgage defaults and the federal government would act as a backup guarantor.
This new system would be a significant improvement over the current situation where the federal government, rather than banks or brokers, takes most of the risk of mortgage defaults.
A bipartisan group in the Senate is supporting a mortgage bill along the lines that the president has endorsed. But the chances of that bill soon being enacted are low, because separate legislation in the House would remove the federal government entirely from much of the home mortgage market.
Meanwhile, federal regulators are close to adopting exemptions from the risk retention requirement of the Dodd Frank Act, which would undermine that Act’s efforts to give lenders some “skin in the game.”
If lenders retained the first 5% of losses on home mortgages they originated and sold, they would be highly motivated to perform careful diligence on the borrowers’ ability to pay.
However, the Dodd Frank Act contains broad exemptions from its risk retention requirement. Under these exemptions, any bank or broker that sold home mortgages to Fannie Mae or Freddie Mac, or whose mortgages were insured by the FHA, would retain no risk of loss from default on those mortgages. A borrower can obtain a FHA insured mortgage with a down payment of 3.5%, and a mortgage can qualify for sale to Fannie Mae or Freddie Mac with a down payment of 10%.
Furthermore, the Dodd Frank Act authorized federal regulators to adopt an exemption for qualified residential mortgages (QRMs). Although the initial proposal limited the exemptions to mortgages where the borrower made a down payment of 20% or more, this proposal was met by a barrage of criticism from the mortgage banking industry. Therefore, it seems that the final rule will limit QRMs to home mortgages with only a 5% or 10% down payment by the borrower.
In short, as I explained more fully in a recent article, the exemptions from the risk retention requirement will undermine the president’s efforts to shift the risk of mortgage defaults from the federal government to the private sector. Most home mortgages in the U.S. will not require the lenders to retain the risk of mortgage default, and most will not require the borrowers to make a down payment of more than 10%.