The Senate Banking Committee's housing package contains some
very important reforms and one very bad idea. Chairman Chris Dodd's
(D-CT) version of legislation to use the Federal Housing
Administration (FHA) to refinance at-risk mortgages at a lower
interest rate in return for a cash fee is still as wrong a way to
deal with the housing finance problems as the House-passed version.
Dodd has improved his FHA refinancing language by including
amendments by Senators Jim Bunning (R-KY) and Jon Tester (D-MT)
that would limit the ability of those who have lied on their loan
applications or otherwise abused the system to gain FHA-guaranteed
refinancing of their mortgages. However, the overall concept
remains bad policy that should not be approved.
The inclusion of such a flawed approach in the Senate Banking
Committee's package is unfortunate, as the rest of the bill
contains several very important provisions that would improve
housing finance and help to protect the taxpayer against the need
to bail out Fannie Mae, Freddie Mac, or the 12 Federal Home Loan
Banks. Legislators have been working to improve regulatory
oversight of Government Sponsored Enterprises (GSEs) for many
years, and the recent housing turmoil makes this improvement all
the more important. The Senate package also includes an FHA reform
that has bipartisan support and would reduce the chance that the
agency will require a taxpayer bailout of its existing programs.
Rather than packaging these needed changes with a seriously flawed
mortgage refinancing plan, Congress should consider them
Seven Flaws of the Dodd FHA Mortgage Refinancing
Chairman Chris Dodd's response to the subprime mortgage problems
is very similar to that proposed by Representative Barney Frank
(D-MA) of the House Financial Services Committee. Under the
legislation, lenders that chose to take part in the voluntary
program would agree to receive 85 percent of the current assessed
value of the house, while the borrower would receive a refinanced
loan equal to 90 percent of that new assessed value.
Refinanced loans would be 100 percent guaranteed by the FHA, and
the new lender would have no further credit exposure if the
borrower subsequently defaulted. If the homeowner subsequently
walked away from the new loan, the taxpayers would have to cover
The main difference is that while Frank's plan would be financed
with government tax money, Dodd's would be financed by imposing a
1.2 basis point (0.012 percent) fee on Fannie Mae's and Freddie
Mac's portfolios. The portfolios are the housing loans and
securitized mortgages that Fannie Mae and Freddie Mac hold for
investment purposes or use to back mortgage-backed securities. The
fee is expected to raise about $500 million annually that will
initially go to finance the new FHA program but will then go to
fund a Housing Trust Fund.
The proposal has many flaws:
- Like the Frank plan, it is essentially a government buyout of
problem mortgages disguised as a refinancing plan. It is an
extremely bad precedent, as lenders will quickly request that this
guarantee be made available for all loans to borrowers with poor
credit histories or lower incomes. Until now, the mortgage market
has operated under free market-oriented principles with a moderate
level of government regulation, but this program would be a
slippery step toward government micromanagement. As a significant
number of the loans now facing problems were made by irresponsible
mortgage brokers using inaccurate and even false data, it would
also signal that there are no real consequences for poor lending
- Many of these refinanced mortgages will be likely to default.
The Congressional Budget Office (CBO) estimates that fully
one-third of refinanced mortgages under H.R. 5830 (the Frank
legislation) will subsequently default, and those numbers have been
criticized by some as being overly optimistic. The risk of default
is historically best measured by the size of a down payment. The
smaller it is, the more likely that the borrower will walk away
from the loan. While the Dodd plan essentially gives refinanced
homeowners an amount equal to 10 percent of the current value of
the house, this is a gift, and the homeowner has none of his or her
own money at risk. Experience with similar "gift equity" programs
already causing problems for the FHA shows that these loans have a
default rate that is two to three times that of loans where the
borrower has made a cash down payment.
- The plan would reward two different groups of homeowners: those
who took out a speculative loan they never had a chance of repaying
in hopes of flipping the house in a rising market and those who
fell into trouble through no fault of their own. In doing so, it
sends a message that it is acceptable to renege on an obligation
because a government buyout will cut your losses.
- Even if legislation were passed tomorrow, it is not possible to
implement this plan rapidly. FHA says that it does not currently
have the people necessary to implement such a plan. It will take
time to hire and train them. In addition, mortgages must be
refinanced individually. It will take a great deal of time to
refinance the 1 million-2 million loans that supporters say could
benefit. While supporters talk of refinancing loans in bulk, this
is not possible under current laws or industry practice, nor is it
- The estimate for the number of homeowners who would be helped
by the Dodd-Frank plan continues to drop. First, supporters claimed
that about 2 million homeowners would have loans refinanced. Since
then, that number has steadily dropped, and now the CBO says that
only 500,000 loans worth about $85 billion would be refinanced over
the next four years.
- Borrowers with legitimate problems are already being assisted
by the voluntary Hope Now program. In the first quarter of 2008
alone, the Hope Now program assisted over 500,000 homeowners-the
same number that the CBO says the Dodd-Frank plan will assist over
the next four years. The Hope Now program is certain to help even
more homeowners than Dodd-Frank in coming quarters because it is
already up and running. Dodd-Frank merely duplicates the existing
private program at a cost of billions of dollars and transfers all
risk of default to the taxpayers.
- Dodd-Frank will not stop foreclosures, even for many who would
otherwise qualify. During the time it will take to put the program
in place, mortgage servicers will be legally bound to follow the
terms of the existing contract for fear that the refinancing might
fall through, including taking steps toward foreclosure. Further,
as CBO points out, many lenders will refuse to take part because it
would require them to accept heavy losses in order to participate.
Other lenders who hold second mortgages on the same property could
also block refinancing.
Important GSE Regulation Improvements
Government Sponsored Enterprises include entities such as Fannie
Mae and Freddie Mac. They also include the 12 Federal Home Loan
Banks. These entities have such a huge presence in the housing
finance market that the failure or severe mismanagement of any one
of them could have major consequences for the rest of the economy.
Fannie Mae and Freddie Mac alone control about 80 percent of the
mortgage-backed securities origination market.
While these companies now have private stockholders, they are
not really private-sector entities. Their special role was created
by Congress, and many investors assume that their debt is
implicitly guaranteed by the federal government. Such economic
power requires a regulator with the power to protect the economy.
After many false starts where the new regulator would be
essentially meaningless, the Senate Banking Committee package
includes two important changes to earlier bills under which the new
- Increase minimum capital standards for GSEs when the regulator
determines that such an increase is necessary for safe and sound
operation of the company. The increased capital requirement would
end when the circumstances that prompted the increase change, and
standards for imposition, rescinding, and how often the increases
will be reviewed must be established in advance.
- Regulate GSEs' portfolios so that not only is the health of the
individual GSE protected, but portfolio holdings are consistent
with the GSE's mission. This includes the ability to require that
the portfolio holdings are backed by sufficient capital. Thus, the
regulator would be able to take steps so that if the portfolio
suffers major losses, it will not affect the rest of the financial
sector. Further, the regulator would be able to restrict attempts
by the GSE to use its market power and enormous assets to dominate
other areas of the financial services industry.
As mentioned above, the legislation also imposes a fee on Fannie
Mae's and Freddie Mac's portfolios that will be used to finance
both the FHA refinancing program and then a Housing Trust Fund.
After the first years, 75 percent of that fund would be used to
help meet the housing needs of extremely low-income families. The
fund will be administered by Housing and Urban Development (HUD)
and allocated among the states according to a formula set by the
Secretary. If he or she fails to set a formula, funds would be
allocated using the formula of the HOME program. Most funds would go
to finance the construction of housing, although a small portion
would be used for down payment programs.
The fee is not really a problem, but its potential use is. As
noted, all of the GSEs are creations of government and have a lower
cost of capital than other private firms because there is an
implied federal guarantee of their bonds. The fee is a way to
recapture some of that advantage, thus making the GSEs' costs
closer to those of potential competitors. However, it is very
worrying for Congress to treat GSEs as a piggy bank that can fund
specific projects without going through the normal appropriations
The continued pressure on Congress to "do something" about the
large number of mortgages that are either in default now or at risk
of defaulting once their interest rates rise to market levels
should not be allowed to get in the way of extremely important
legislation to improve the regulation of GSEs or to improve the
FHA. Unfortunately, the Dodd-Frank refinancing program is not
likely to assist homeowners who are having trouble paying their
mortgages any more than the House-passed bill would.
Instead, Congress should focus on the other critical parts of
the package and quickly take steps to modernize and strengthen the
GSE regulator and to improve the FHA. Those are steps that will
help to ensure that future housing problems do not develop into
crises that could threaten the stability of the overall financial
system or require massive taxpayer-funded bailouts.
David C. John is
Senior Research Fellow in Retirement Security and Financial
Institutions in the Thomas A. Roe Institute for Economic Policy
Studies at The Heritage Foundation.
example, if the original loan was for $600,000 and the current
assessed value of the house has fallen to $500,000, the lender
would receive $425,000 and the homeowner would end up with a
guaranteed mortgage of $450,000. The lender would lose $175,000
from the value of the original loan.
HUD's HOME program is a federal block grant to state and local
governments that is designed to create affordable housing for
low-income households. For more information, see U.S. Department of
Housing and Urban Development, "HOME Investment Partnerships
Program," at http://www.hud.gov/offices/cpd/affordablehousing/programs/home/
(May 29, 2008).