The Administration's Plans For Housing Finance: A Scale-Down Means Hard Times Ahead

March 7, 2011

The document the Administration recently sent to Congress outlining its game plan for housing finance has both scale-down and ramp-up thrusts. The scale-down thrust, comprising most of the report, involves shrinking the Federal Government’s involvement in the market. The ramp-up thrust would create a new Federal program designed to support the private market. This article is about the scale-down.

Backdrop

The point of departure for this proposal is a post-crisis housing finance system in which only about 10% of all new home loans are strictly private. The remaining 90% are either acquired by Fannie Mae or Freddie Mac, or insured by FHA.

Further, loan qualification requirements set by the strictly private market are far more restrictive than they were before the crisis, which is the reason their market share is now so low. Before the crisis, risk-based pricing was widely practiced, making loans available over a wide range of risks.  

Today, only a sliver of risk-based pricing remains. For the most part, risk-based pricing has been replaced by risk cutoffs. At many lenders, borrowers with a credit score of 800 have to put 20% down, and borrowers who put 40% down still need a 700 score to qualify. Some lenders will go to 10% at 680, but limit the loan size.

Fannie Mae and Freddie Mac have tightened their requirements, but by much less than the strictly private sector. The agencies today will accept a credit score of 620 at 20% down, and 680 at 5% down.  However, risk-based pricing is extensive and many borrowers with mediocre credit, small down payments or both, opt out. The average down payment on new loans is about 35% and the average FICO is about 765. The agencies have also tightened their documentation and appraisal requirements significantly.

FHA has the most liberal requirements, which are little changed from what they were before the crisis. FHA accepts 3% down with a credit score of 580, though many lenders require higher scores so that they won’t be tarred with originating too many loans that default. FHA has also increased its insurance premiums. 

What Scale-Down Means

The crux of the Administration’s scale-down plan is a gradual phase-out of Fannie Mae and Freddie Mac, combined with a reduction in the scope of FHA operations. The ultimate goal seems to be a system in which the strictly private market would account for about 85% of the traffic, and FHA would have about 15%.

The report suggests a number of ways of accomplishing this, including reductions in the maximum qualifying loan size at all three agencies, and increases in mortgage insurance premiums. The first reduces the number of borrowers who qualify while the second forces price increases by the agencies that would make the strictly private market more price competitive.  

Implications and Consequences

The volume of risky loans, already down sharply from the post-crisis tightening of qualification requirements, will shrink further as the scale-down proceeds. Since a large proportion of risky mortgages are generated by disadvantaged groups, this approach constitutes a reversal of what had been public policy for at least 4 decades, which was to encourage home ownership among such groups.

Sometime this year, the regulatory agencies will promulgate new rules implementing provisions of the Dodd/Frank bill that require them to define “qualified residential mortgage” (QRM). These are low-risk loans that exempt originators from having to assume 5% of the risk of loss. The split in the market following implementation of this rule will further disadvantage weaker borrowers, since non-QRM loans will carry a higher price if they are available at all.  

Softening the Blow

 

The report recognizes the need to go slow and cautiously, but offers no concrete ideas on how to soften the blow. Here are two.

The Administration ought to set up a task force to determine whether the existing regulatory structure, including the bank examination process, is unduly constraining the strictly private market. If Government wants lenders to expand into the space vacated by Fannie, Freddie and FHA, Government ought to make sure that it has not itself constructed roadblocks to such expansion.

FHA should extend its tentative steps toward risk-based pricing to a comprehensive system in which the insurance premium on every loan reflects the risk of loss to FHA of that loan. This will help keep FHA financially sound, reduce concerns if FHA is pressed to expand into some of the space vacated by Fannie and Freddie, and neutralize political pressures to liberalize terms unduly..

Thanks to Guy Cecala of Inside Mortgage Finance.

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