June 2, 2008 | WebMemo on Economy
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 separately.
Seven Flaws of the Dodd FHA Mortgage Refinancing Plan
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 any losses.
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:
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 regulator could:
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 process.
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.
 For more information about the role of GSEs and their regulation, see Ronald D. Utt, "Time to Reform Fannie Mae and Freddie Mac," Heritage Foundation Backgrounder No. 1861, June 20, 2005, at http://www.heritage.org/Research/GovernmentReform/bg1861.cfm (May 28, 2008).
 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).