The Future of Home Mortgages in the U.S.

Have you heard of the two terms “risk retention” and “qualified residential mortgages”? Federal regulators are reportedly close to adopting rules defining these two terms, which will largely determine the future shape of the home mortgage market.

Here is the background. The Dodd-Frank Act tried to stop mortgage lenders from issuing mortgages and then immediately selling them to a large financial institution. That institution would put together a pool of home mortgages and sell securities based on the cash flows from the pool. Before the Dodd-Frank Act, because the issuers of many home mortgages immediately sold them, the issuers had little incentive to do a good job of checking carefully whether the borrowers would be able to pay off these mortgages. In other words, these issuers had “no skin in the game.”

In response, the Dodd-Frank Act generally required mortgage lenders to retain some risk in the mortgages they sold. In specific, these lenders were required to retain 5% of the economic risk if they sold mortgages that later defaulted. At the same time, Congress was concerned that such a requirement would lower the volume of new home mortgages. So, Dodd-Frank established several broad exemptions to the risk retention requirement for mortgages that Congress believed were relatively safe.

In the future, the home mortgage market will be dominated by mortgages covered by these exemptions. Almost every firm will prefer to originate and sell these exempt mortgages, rather than retain some of the risk that non-exempt mortgages will later default.

A look at risk

Let’s review the three main types of home mortgages exempt from the risk retention requirement and whether they seem justified. In this regard, studies show that low down payments are by far the best predictor of mortgage defaults.

First, Congress exempted from the risk retention requirement all mortgages insured by the Federal Housing Administration (FHA), which currently accounts for over 40% of the new mortgages in the US. These mortgages are issued by private lenders and then insured by the FHA if they meet certain criteria. But the FHA insures mortgages where the borrower makes a down payment of only 3.5% of the home’s value. So the FHA is insuring 100% of a mortgage where the lender retains no risk and the borrower has a very low down payment. For these and other reasons, the default rate on FHA-insured mortgages has been rising and the FHA is now in serious financial trouble.

Second, Congress exempted from the risk retention requirement all home mortgages sold by private lenders to Fannie Mae or Freddie Mac. These two large institutions went bankrupt during the financial crisis and were effectively taken over by the federal government. Yet both institutions currently buy over 40% of new home mortgages from private lenders and then effectively guarantee such mortgages against default. Although Fannie Mae and Freddie Mac have stricter standards than the FHA, they both will buy home mortgages where the borrower makes a down payment of only 10% of a home’s value. Again, the federal government is not protected from loss by either risk retention by the lender or substantial down payments by the borrowers.

Third, Congress gave the regulators express authority to exempt from the risk retention requirement “qualified residential mortgages” or QRMs. In my view, the criteria for QRMs will be followed by most private lenders for most homes mortgages not insured or backed by the federal government. If a lender follows these criteria and quickly sells the mortgage, the lender will not have to retain any risk of the mortgage defaulting. Most importantly, federal regulators proposed in 2011 that QRMs have a down payment of at least 20% of a home’s value. But this proposal was met by a barrage of criticisms that a 20% down payment would unduly slow down the mortgage market and undermine the goal of home ownership, so the regulators are reportedly ready to adopt a down payment standard of 10% or even 5% for a QRM.

In fact, most private lenders in Canada insist on a 20% down payment for home mortgages. And the Canadian housing market is booming–without a tax deduction for interest on home mortgages. Indeed, the rate of home ownership in Canada is higher than that rate in the US.

Down payments are key

In short, Congress was right to require mortgage lenders to retain 5% of the default risk in the mortgages they sell. This requirement creates the incentive for these lenders to check carefully on the ability of borrowers to pay off their mortgages. If we are going to waive this risk retention requirement for a broad array of home mortgages, we should make sure that the borrowers make a relatively large down payment. A large down payment by the borrower is the best way to reduce mortgage defaults without a risk retention requirement for the lender.