Rolling the Dice with Mortgage Reform

Though the mortgage market was badly shaken by the foreclosure crisis a few years ago, there have not yet been sweeping structural changes to the mortgage products available to consumers. If anything, low mortgage rates and refinance rates actually made the post-crisis environment more attractive to consumers who were in a position to qualify for a mortgage. However, changes now in the works may have more disruptive effects on consumers in the future.

In a few instances, the role of the federal government in mortgage policy is a central issue in the discussion of these changes, and there are two sides to the debate over whether federal intervention may help consumers or hurt them.

The Risk Retention Debate

One way that banks finance their mortgage loans is by selling off groups of loans to investors after those loans have been made. This helps banks reduce their exposure to default risk, and generate fresh cash to make subsequent loans. However, what became clear in the housing boom is that the ability to pass along risk to other parties led some banks to make irresponsible loans. So, under the Dodd-Frank financial reform law, banks were required to keep some of their own skin in the game by holding onto a portion of the loans they made. This practice is known as risk retention.

Originally, an exemption to the risk retention requirement was mandated for the least risky types of loans - those with 20 percent down payments and well qualified borrowers. Now, Reuters and others are reporting that the six federal agencies charged with setting mortgage policies under Dodd-Frank (the Department of Housing and Urban Development, the FDIC, the Federal Housing Finance Agency, the Federal Reserve, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission) have floated a proposal to exempt riskier loans from the risk retention requirement as well.

This proposal is a double-edged sword for consumers. A more permissive policy could make mortgages more readily available in the short-term. However, that permissiveness could lead to the same type of abuses that blew up during the foreclosure crisis, with the result being that mortgage loans become much harder to qualify for in the long run.

The Future of Fannie and Freddie

Amid widespread calls to eliminate Fannie Mae and Freddie Mac, President Obama called for a reduced role for the federal government in backing mortgages, while also making sure that certain loans - including the popular 30-year mortgage -- continue to be available.

Fannie Mae and Freddie Mac were once private companies with government sponsorship (called GSEs), but they were taken over by the US Treasury in 2008 during the mortgage crisis. The problem was that as private entities with government backing, they had a financial incentive to take risks without having to bear the full consequences of failure.

The GSEs help make mortgages available by buying loans from mortgage lenders, bundling them into mortgage-backed securities (MBS), and selling those securities to investors. The mortgage lenders can then turn around and lend money to more consumers. This makes funding more widely accessible and keeps mortgage rates down.

In August 2013, there is growing pressure from both parties and the President on Congress to do away with Fannie and Freddie. The challenge is achieving this without killing off the popular 30-year fixed-rate mortgage. If lenders had to wait 30 years to get their money back from a mortgage, there would be less money to lend and mortgage rates would probably rise.

A bipartisan bill introduced in June by Senators. Bob Corker and Mark R. Warner would phase out the companies over five years. Fannie and Freddie would be replaced by a new government agency modeled on the Federal Deposit Insurance Corp. It would be funded by industry fees and have a much smaller market share in home lending than the mortgage giants do today.

Higher Mortgage Rates?

Perhaps the biggest impact the federal government has had on the mortgage market since the foreclosure crisis is the Federal Reserve's intervention to drive mortgage rates lower. However, once the Fed started to signal that it planned to ease back on its intervention, mortgage rates spiked. Current home loan rates in August 2013 are about a full percentage point higher than they were three months ago.

As attractive as super-low interest rates may seem, there is a silver lining to higher rates. Mortgage lenders were naturally reluctant to make long-term loans at an interest rate that roughly equals the historical rate of inflation, so they responded to low interest rates by only approving loans to the most highly-qualified borrowers. As interest rates rise, mortgage lenders have more incentive to make loans, and that makes mortgages available to a broader cross-section of the population.

At its best, the federal government can be a stabilizing force in the mortgage market, keeping a check on excesses and providing backing that helps make mortgage loans more widely available. At its worst, the federal government can also be something of an enabler, encouraging risk-taking in the name of making loans more readily available. In seeking to make the right changes to mortgage policies, the government will have to walk a tightrope between too much restriction and too much permissiveness. How successfully it performs that tightrope act will show how well the government has retained the lessons of the foreclosure crisis.

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