Mortgages with as little as 5 percent down would still be allowed under a Senate proposal for replacing Fannie Mae and Freddie Mac, with first-time homebuyers allowed to put down as little as 3.5 percent.

The proposal, which is being put forward by the top Democrat and Republican on the Senate Banking Committee, provides a blueprint for winding down Fannie Mae and Freddie Mac in order to replace them with a new federal agency to be called the Federal Mortgage Insurance Corporation (FMIC).

Among the plan's key goals are to encourage an expanded role for private capital in the housing market while shielding taxpayers from liability in the event of another downturn. It also seeks to ensure the continued availability of affordable, 30-year fixed-rate mortgages, a key feature of the U.S. housing market.

Johnson-Crapo proposal

The proposal, which is being put forward by Sen. Tim Johnson (D-SD), chair of the Senate Banking Committee, and Sen. Mike Crapo (R-ID), the committee's ranking Republican, must still win approval in both the Senate and House of Representatives. However, members of both parties have been expressing their support and the administration has commended the initiative, which are positive signs for its chances.

"There is near unanimous agreement that our current housing finance system is not sustainable in the long-term and reform is necessary to help strengthen and stabilize the economy," said Sen. Johnson. " This bipartisan effort will provide the market the certainty it needs, while preserving fair and affordable housing throughout the country."

The need to replace Fannie Mae and Freddie Mac with a new mortgage finance system is one of the few things both Democrats and Republicans have agreed on in recent years. But working out an approach acceptable to both sides has been a time-consuming challenge.

Investors would absorb initial losses

The new insurer, the FMIC, would help shield mortgage investors against potential losses when loans go bad, the same as Fannie Mae and Freddie Mac do currently. However, under the new proposal private investors would absorb the first 10 percent in losses before the government-backed insurance would kick in.

That's different from the current model, where Fannie Mae and Freddie Mac guarantee the full returns on all mortgages they back.

Just as with the current model, the cost of the insurance would be covered by fees charged for guaranteeing the loans. Mortgages would also have to meet certain standards in order to qualify for FMIC, similar to the "conforming loan" standard now required by Fannie Mae and Freddie Mac.

Because the FMIC would be a federal agency, the government's guarantee of mortgages would be explicit, rather than implied as it was under the formerly semi-private Fannie Mae and Freddie Mac. The implied guarantee of the current system was blamed for underpricing mortgage risk during the expansion of the housing bubble a decade ago.

Higher rates likely

To be sure, mortgages guaranteed under the new program will likely be more costly than those currently guaranteed by Fannie Mae and Freddie Mac, since mortgage investors will be asked to take on more risk. The stated goal of bringing more private capital into the mortgage market also means mortgage rates will likely be higher than they would be under the present system, since higher returns are needed to attract private investment.

It's not clear what role private mortgage insurance (PMI) will play under the new system. Currently, Fannie Mae and Freddie Mac require that PMI be included on any mortgage with less than 20 percent down. In the event the loan goes into foreclosure, the private mortgage insurer is responsible for making up the difference between the actual down payment and 20 percent; so if the borrower had put down 5 percent of the purchase price, the private mortgage insurer would be liable for 15 percent in the event of foreclosure.

It's expected that congressional leaders will seek to get a vote on the Johnson-Crapo bill before the election season begins in earnest this summer.

Published on March 12, 2014