Applying Arithmetic to the Mortgage 5 Percent Retention Rule

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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.