One Simple Reform Could Save U.S. Homeowners Billions

(Bloomberg Opinion) -- Homeownership has become increasingly unaffordable to working families in recent years, a trend worsened by the coronavirus pandemic. There’s a way the government can ease some of that burden, particularly for first-time buyers, who are disproportionately minorities: Do what’s needed to reduce the unnecessarily high cost of mortgage insurance.

For homeowners who can’t afford big down payments, mortgage insurance has become a fact of life. Fannie Mae and Freddie Mac, the government-sponsored enterprises that guarantee about one of every two new home mortgages, are required by law to have some kind of credit enhancement on loans that exceed 80% of the purchase price. This is almost always obtained from a specialized mortgage insurer. About one in five of their mortgages have it.

Such mortgage insurance is unduly expensive, due in large part to the way the market is structured. Regulations prohibit Fannie and Freddie from employing their buying power to negotiate directly with the handful of private mortgage insurers. Instead, hundreds of mortgage lenders individually choose the insurers on the loans they sell to Fannie and Freddie — a process that generates quite large marketing and selling costs for the insurers as they compete against each other. For the most part, homeowners directly pay the inflated premiums needed to cover those costs, with no practical ability to shop for better pricing.

For all its expense, the insurance doesn’t deliver the level of protection it should. During the 2008 financial crisis, almost all of the seven mortgage insurers then operating ran into trouble: Regulators put three into liquidation, and three others saw their credit ratings drop deep into junk territory. The companies also denied very large numbers of claims, a controversial action that few in the industry believed fully legitimate. Taxpayers and lenders then had to absorb billions of dollars in losses that the insurers would otherwise have covered.

In 2016, Fannie and Freddie proposed to their regulator, the Federal Housing Finance Agency, a limited pilot program to test a different approach where they would obtain mortgage insurance directly, on a competitive, low-cost, wholesale basis, eliminating the need for those large marketing and sales expenses. The pilot began in 2018. One major insurer, which is interested in entering the business, estimates that the program reduced the cost to borrowers by as much as 30%. For a typical 5%-down-payment loan, that’s about $600 to $800 annually. If applied to all insured mortgages in 2019, the total savings over the life of the loans would exceed $2 billion. These savings would accrue to the first-time and minority homebuyers who disproportionately use mortgage insurance, consistent with the two companies’ mission of enabling homeownership among low and moderate income families.

As a fringe benefit, aside from being more affordable, the insurance purchased through the pilot program is more likely to make its payments in full. It comes from diversified insurance firms, which generally have stronger credit ratings, and which also provide partial collateral to back their promises to pay future claims. Amazingly, traditional “monoline” mortgage insurers provide zero collateral to stand behind some $270 billion of claims exposure to GSE mortgages.

Yet two years later — much longer than normal — the program remains a pilot. Given the obvious benefits, it’s hard to understand why. The result is to protect the profit margins of entrenched mortgage insurers at the expense of homeowners.

The FHFA should immediately take a clear pro-consumer and pro-competition stance by approving the pilot for full implementation, making inexpensive and more reliable mortgage insurance available to all borrowers who need it. It’s good for homeowners and taxpayers, as well as for the stability of the broader financial system.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Donald H. Layton was chief executive officer of Freddie Mac from 2012 to 2019. He is a former vice chairman of JPMorgan Chase & Co. and a former chairman and CEO of E*TRADE Financial Corp. He is a senior industry fellow at Harvard's Joint Center for Housing Studies.

©2020 Bloomberg L.P.