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Major changes ahead for mortgage system as U.S. seeks to scale back role in housing

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F undamental changes are probably ahead for the American mortgage system as the federal government pushes to unwind its unprecedented involvement in the housing market. These changes could significantly raise the down payments demanded by lenders, curtail the availability of long-term mortgages with fixed interest rates, and increase the cost of borrowing in general. The government’s effort to scale back its role in housing could show up in small ways soon. In April, the Federal Housing Administration plans to raise the annual premium it charges borrowers by a quarter of a percentage point. In October, the maximum size of loans that the federal government backs is scheduled to drop to $625,500 from $729,750. The most dramatic proposal — eliminating mortgage financiers Fannie Mae and Freddie Mac — could take five to seven years.

The thinking is that the government cannot sustain its role in the housing finance system. Federally backed loans make up an outsize share of home purchases — about 90 percent — through Fannie, Freddie and the FHA. Taxpayers have kicked in more than $130 billion to cover Fannie and Freddie losses during the housing crisis, and they could be on the hook for more if the FHA depletes its cash reserves , which are already lower than the level required by law.

All three institutions guarantee that payments will be made to mortgage investors, even when loans go bad. Those guarantees helped keep the housing market from coming to a standstill during the darkest days of the economic crisis.

“But the government is taking on a lot of credit risk,” said Mark Zandi, chief economist at Moody’s Analytics. “So if loans go bad, it’s on the taxpayer. Everyone would find it preferable if the private sector were to take more of the risk.”

Loan limits

To that end, the federal government is eager to tackle the “jumbo” loan limits.

In the District and most of its neighboring counties, a temporary federal policy allows the government to back mortgages up to $729,750. Such loans typically carry a lower interest rate than those without government backing, in part because the federal guarantee makes them a safer bet for investors.

“Investors are willing to accept a lower return if their investment is less risky,” said Keith Gumbinger, a vice president at HSH Associates.

The Obama administration has supported allowing the maximum loan limit to drop to $625,500 starting Oct. 1 , and Congress is expected to back that move. ( Loan limits may be lowered even further for FHA-insured loans, federal officials said, though no details are available.)

Once the cap is lowered, loans larger than $625,500 will fall into the “jumbo” category. Jumbos are perceived to be more risky and therefore often face tougher requirements, such as 30 percent down payments and stellar credit scores.

Standards might ease if the private sector reenters that market, said Eric Gates, president of Apex Home Loans in Rockville. But if the $625,500 cap were in place today, it could lock many potential buyers out, he said.

Among them is a borrower working with Apex who wants to buy an $850,000 home in the District. The borrower plans to take out a $680,000 loan and put down 20 percent.

At today’s average rate on a 30-year fixed-rate mortgage of that size, the borrower would be charged 5 percent interest. She would pay $3,650 a month in principal and interest.

If the lower loan limit were in place, that loan would be subject to jumbo rates, which average 5.6 percent. The borrower’s payment would jump to $3,904, a $254 increase per month.

If the borrower cannot put down more money or afford higher monthly payments, she will have to buy a less expensive house — unless the seller lowers the asking price, Gates said.

Many potential buyers with high-paying jobs could find themselves in the same situation, Gates said. “This includes lawyers and doctors who have only been practicing for a few years and also have several student loan payments that keep them from saving large amounts of money [for a down payment] quickly,” he said.

Down payments and fees

Standards are not likely to ease on the down payment front.

Borrowers looking to take out FHA loans — the mortgage of choice in recent years for cash-strapped borrowers — could see the minimum down payment requirements rise from 3.5 percent, the administration said in a report to Congress last month.

Also, Fannie Mae and Freddie Mac should gradually raise their minimum to 10 percent down, the administration suggested.

Other moves are also geared toward raising down payments for certain types of loans. A financial regulatory overhaul enacted last year requires lenders to retain at least a 5 percent stake in the loans they sell to investors. The law carved out an exception for FHA-backed mortgages — considered relatively safe — and it directed regulators to decide by late April if other types of mortgages also should be exempt.

Those regulators are close to proposing a plan that would extend that exception to all loans guaranteed by the government, including those backed by Fannie and Freddie.

Here’s where down payments come in: As part of that upcoming proposal, regulators plan also to exempt loans with down payments of at least 10 percent or 20 percent — the exact percentage to be decided after public comment is gathered.

John Taylor, president of the National Community Reinvestment Coalition, said that even a 10 percent requirement would hurt buyers and “make it even more difficult for people to sell houses.”

Community banks and mortgage banks will be at a disadvantage if either of those options is enacted, said John Courson, chief executive of the Mortgage Bankers Association. If forced to hold on to certain loans, these lenders say they would have to make fewer mortgages, raise interest rates or both.

The costs to borrowers go beyond down payments. The administration has proposed that Fannie and Freddie raise their “guarantee fees” over the next several years. When borrowers fall behind or default on their loans, Fannie and Freddie use these fees to pay their mortgage-bond holders. The fees are usually included in interest rates paid by borrowers.

The increase of one-quarter percentage point in annual premiums planned for FHA mortgages is scheduled to take effect April 18. For the vast majority of loans, the premium will rise from 0.9 percent to 1.15 percent. For a borrower who takes out a $170,000 mortgage, the average FHA loan size, the monthly payment would increase by $34 a month.

“The irony of it is that all of these policies are intended to protect consumers from bad mortgage practices,” said Guy Cecala, publisher of Inside Mortgage Finance. “The price of improving and better protecting them is to increase the cost of the mortgage.”

30-year fixed-rate mortgage

Much further down the line, if Fannie and Freddie are dismantled, the future of the popular 30-year fixed-rate mortgage comes into play.

The United State is one of the few countries where most of the mortgages are prepayable, 30-year fixed-rate loans. That means that lenders bear the risk of financing a mortgage that borrowers can then refinance without penalty if rates go down.

With Fannie and Freddie buying the loans, lenders are off the hook if the loans default. They also do not have to worry about a sharp rise in rates during the life of the loan.

“The interest rate risk is phenomenal,” Cecala said. “If [lenders] charge 5 percent interest and then the rates shoot up to 10 percent for a 30-year [loan], they are losing money on every one of the loans that they held at 5 percent.”

Lenders would be taking a risk on interest rates going the other way, too.

“If the rates drop to 2 percent, everyone refinances and that 6 percent above-market loan you have you lose to refinancing,” said Adam Levitin, a law professor at Georgetown University.

The question becomes, will lenders lose their appetite for the 30-year loan without Fannie and Freddie there to shoulder that risk?

“I don’t see that happening,” said Brent Ambrose, a real estate professor at Pennsylvania State University. “When there’s demand, people will provide it. It may cost a little more, given that the guarantee is not going to be there, but there will be institutions out there that will find a way to provide it.”

After all, Ambrose said, 30-year loans are available in the jumbo market, where loans are not federally backed.

Barry Zigas, housing policy director at the Consumer Federation of America, said that outlook may prove correct.

“But it’s a hell of a gamble,” Zigas said. “Once you set up the system without the guarantees, if you bet wrong it’s going to have heavy consequences for consumers.”

The long-term fixed-rate mortgage is an asset that lenders do not want to keep on their books, Zigas said. They would rather force consumers to take on the interest rate risk. That’s why adjustable-rate mortgages are prevalent in other parts of the world. With those loans, borrowers bear the risk of rates going up.

Levitin said the jumbo market exists only because it piggybacks on the Fannie and Freddie infrastructure.

“The 30-year fixed-rate mortgage has been the bedrock of American housing finance from the Depression up until the beginning of the housing bubble,” when borrowers went chasing after more exotic loans, Levitin said. “We have never seen a private mortgage market in the U.S. provide long-term, fixed-rate loans on a wide scale, and there’s no reason to think it will.”

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