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Home Publications Blogs Beat the Press Applying Arithmetic to the Mortgage 5 Percent Retention Rule

Applying Arithmetic to the Mortgage 5 Percent Retention Rule

Wednesday, 01 June 2011 20:49

The bankers are warning of Armageddon if a rule from the Dodd-Frank bill is left in place that requires that retain a 5 percent stake in mortgages where the owner puts less than 20 percent down. In effect, that if the bank sells a loan into a security pool that had a down payment of less than 20 percent, it will be liable for at least 5 percent of the losses incurred on the mortgage if there is default.

While the bankers are portraying this as an ominous restriction that will prevent them from making loans to moderate-income homeowners, a little arithmetic suggests otherwise. Before the bubble, Freddie Mac estimated that its average loss on a foreclosed property was 25 percent of the mortgage's value.

If we assume that the mortgages in question will have the same 25 percent loss rate once the market becomes more normal, then this would imply a loss of 1.25 percent of the mortgage's value, given the bank's 5 percent stake. If one in ten of these mortgages go bad, then this implies an average loss of 0.125 percent on loans in this category.

However, this calculation assumes that the bank can sell off a mortgage with less than 20 percent down at the same price that it can sell off a mortgage with 20 percent or more down. Since this is almost certainly not true, then the loss to the bank from this provision would be somewhat less than 0.125 percent of the price of the mortgage. If this loss were fully passed on to homebuyers then the impact of this provision would at most be equivalent to raising the cost of a mortgage by 0.13 basis points, and almost certainly considerably less. Given this arithmetic, it is not plausible that this 5 percent rule will have any noticeable effect on the access of moderate-income families to mortgages.

Comments (2)Add Comment
written by Sirius...TheStarDog, June 01, 2011 9:49
"...raising the cost of a mortgage by 0.13 basis points..."

Class warfare...indeed.
I believe you misinterpret the "5% stake"
written by Bill H, June 02, 2011 9:35
The issue is not that the bank "retains liability for 5% of losses incurred," but rather that when the down payment is less than 20% when the bank sells the loan to a securities pool it may only sell off 95% of that loan and must retain 5% of it on its books. That reduces the amount of new cash that the bank can bring in to make more loans by that 5% that it is keeping on the books, and it increases the amount that it must retain on its books as "reverves against loss."

If that loan goes bad, the bank loses that entire 5%, which is the whole point of the exercise. The rule is to make sure tha banks take more care in lending money. When they were selling off 100% of the loan they didn't care whether it was paid back or not. Presumably, the risk of losing that 5% balance of the loan will make them care. I'm not convinced that it will.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.