Regulators Close to New 'Safe' Mortgage Standard

Financial regulators are closing in on a new rules for mortgages that would toughen standards for some homebuyers but still allow others to purchase a property with a low down payment with government support, officials said Tuesday.

The compromise plan, first reported by American Banker, is designed to avoid inflicting any serious damage to the fragile housing market while at the same time limiting the type of non-traditional “subprime” mortgages that helped create the housing bubble and subsequent housing collapse, financial crisis and multi-billion dollar bailouts.

But with home lending standards already much tighter and subprime and other exotic loans largely extinct, “I don’t think the world is going to change very much under this rule,” a mortgage industry official said.

In the Dodd-Frank financial reform legislation approved by Congress in 2009, regulators are charged with writing standards for a “safe” mortgage. A government official said regulators will likely agree that a “safe” mortgage will require a 20% down payment, the common practice before the housing bubble.

But sources said regulators are also considering an exemption in the rules for loans backed by mortgage giants Fannie Mae and Freddie Mac, to continue to allow homeowners buy a property with a smaller down payment, 5% or so, as long as the buyer purchases extra mortgage insurance on the loan. The exemption would last until Congress approves a plan to close Fannie and Freddie, which could take several years.

The rules, which sources said regulators could formally propose as early as March, are likely to be welcomed by real estate brokers, banks, homebuilders and affordable housing advocates, who fear tough down payment requirements could sink the struggling housing market.

Historically, a big down payment like 20% provided a healthy financial cushion for lenders as well as borrowers in the event of a decline in the value of a property. But during the housing bubble, lenders made many loans with small or no down payments, assuming that ever-rising housing prices would protect them from defaults and losses.

In November, the nation's largest mortgage lender, Wells Fargo (NYSE:WFC), suggested down payments of at least 30%, to provide a bigger cushion with more protection against default or foreclosure. The idea was quickly shot down as too tough.

Among other regulators, Sheila Bair, the chairman of the Federal Deposit Insurance Corporation, favors a 20% down payment for “safe” mortgages. But she also has suggested new rules would allow for "non-standard" loans with smaller down payments, as not all credit-worthy home buyers can afford even 20% down.

The rulemaking also is expected to include new standards for mortgage servicers, mainly big banks that process monthly payments. They have been under fire for sloppy legal paperwork in foreclosures.

The rules are part of a larger effort to reduce the government’s role in the mortgage market and attract private investors back to it--but without as much risk.

Before the financial crisis, sales of mortgage-backed securities provided ample funding for new mortgage lending, as proceeds from sales generated fresh cash for loans. Now--between Fannie, Freddie and the Federal Housing Administration--the government is insuring more than 90% of new mortgages.

As previously reported, regulators would allow lenders to package up and sell mortgages with 20% down payments to investors in securites with few restrictions.

But for mortgages with smaller down payments, lenders would be required to retain a 5% share of the securitized loans, to give them strong incentives to monitor and manage their risk.

Asked about the possible new mortgage standards, a spokesperson for the Department of Housing and Urban Development, one of the regulators, said, “The proposed rule is not yet final."

An FDIC spokesperson declined to comment. Other regulators working on the plan include the Treasury Department, the Federal Reserve and the Securities and Exchange Commission.