How to Create Another Housing Crisis

Newly proposed federal rules gut the requirement in Dodd-Frank that mortgage lenders retain some risk of loss.

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 FNMA +7.41% or Freddie Mac FMCC +9.00% 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.

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