NEW YORK ( TheStreet) -- Coming financial reform legislation misses the point if it doesn't address the federal government's growing dominance of the mortgage market because the United States is already being set up for another bubble.

Uncle Sam's best role is to set the parameters for the industry, including sane underwriting requirements for banks and non-bank lenders, along with other rules to prevent abusive lending, while slowly weaning the mortgage market off the programs that have helped feed the boom-and-bust cycle.

But Senator Chris Dodd's "Restoring American Financial Stability" bill does nothing of the sort. In fact, the bill doesn't address the future of Fannie Mae ( FNM) and Freddie Mac ( FRE), or the explosion of mortgages guaranteed by the Federal Housing Administration (FHA) at all.

Why Third Parties Can't Compete (Forbes)

Despite being taken under conservatorship in September 2008, Fannie and Freddie still dominate the domestic mortgage market and the numbers show the government's role has increased even further since the crisis hit. The Federal Housing Administration's mortgage market share stood at about 30% as of Sep. 30, according to its Fiscal Year 2009 report. That's up from just 3% two years earlier. Total disbursements of guaranteed FHA loans for fiscal 2009 were $337 billion, up 83% from $185 billion a year earlier.

FHA Gravy and The Threat to Taxpayers

Now that the subprime market is temporarily dead, FHA loans have become, in some respects, the "new subprime," with borrowers making down payments as low as 3.5%, and qualifying for lower rates than conventional borrowers.

At TD Bank, a division of Toronto-Dominion Bank ( TD), for example, the best rate listed on its Web site for a qualified borrower taking a conventional 30-year fixed-rate mortgage, making a 20% down payment and paying no discount points, is 5.125%. For an FHA borrower making a down payment of 3.5%, the rate is 4.75%. For an FHA borrower qualified for the "low to moderate income rate," the quoted rate is 4.25%. FHA borrowers pay for government loan insurance that protects the lender, called a mortgage insurance premium, or MIP. The up-front MIP is 2.25%, and the borrower pays an additional annual MIP of 0.55%, which is based on the average loan balance after being fixed for the first five years.

Let's consider a case where a borrower wants to purchase a home in Stuart, Fla. that costs $200,000 and qualifies for FHA financing, based on TD Bank's published rates on May 12. Insurance and property taxes are not included and we're assuming the borrower doesn't pay points to lower the interest rate.

  • Conventional: The borrower will put down a $40,000 down payment and pay a total of $160,018 in interests and fees over the life of the loan.
  • FHA: The borrower only has to put down $7,000, so the base loan amount is $193,000. Assuming the up-front FHA mortgage insurance premium (MIP) of $4,342 is financed, the total loan amount will be $197,342. Total interest and fees over the life of the loan will be $179,883, plus an additional monthly MIP payment of $88.46, which will begin declining after five years.
  • FHA Low to Moderate: Same initial loan balance as a regular FHA loan: $197,342. At an even-lower rate 4.25%, the total cost of interest and fees over the life of the loan will be $158,778, plus the additional monthly MIP payment of $88.46, which will begin declining after five years.

When you boil down the numbers, it's pretty obvious why FHA loans are irresistible for many qualified borrowers. The total financing cost of $179,883 (excluding the monthly MIP amounting to less than many household cable bills) for the regular FHA loan exceeds the cost for the conventional mortgage by $19,883, but you are putting down $33,000 less at closing. And the FHA Low to Moderate is an absolute bargain, actually costing less than a conventional mortgage (again, leaving out the monthly MIP), with only a 3.5% down payment.

Meanwhile, according to FHA's most recently published Portfolio Analysis, 9.17% of the mortgages it insured were delinquent, as of Feb. 28. The Congressionally-mandated minimum capital ratio for the agency is 2%, which is rather low considering the delinquency rate. The agency has increased mortgage insurance premium fees this year in an effort to boost capital, but depending on the pace of economic recovery, this could well be another ticking housing time bomb, which, of course members of Congress will blame on others.

Political Heat, Consequences and the Next Bubble

During the years leading up to the real estate bubble, legislators pressured Fannie and Freddie to lower their underwriting standards, so community banks could make more loans and more consumers could achieve the holy grail of home ownership. This continual easing of credit certainly helped more people buy homes, but eventually got out of hand as home prices exploded and speculation became rampant.

Going back to the 1960s, the Congressional charters of the GSEs authorized the Department of Housing and Urban Development to set requirements for each of the companies to support affordable housing by purchasing loans to serve lower-income borrowers with "reasonable return to the corporation," which left room for Fannie and Freddie to set pricing according to the higher risk these loans represented.

Then the 1992 Federal Housing Enterprises Financial Safety and Soundness Act changed the game, authorizing the HUD Secretary to require Fannie and Freddie to make loan purchases to support affordable housing goals "involving a reasonable economic return that may be less than the return earned on other activities." (The italics are mine)

This was a key item in encouraging the evolution of riskier types of subprime lending. The legislation's formal requirement for the GSEs to accept lower returns on riskier loan purchases fed the housing bubble and encouraged ever-riskier loans, as Fannie and Freddie subsidized the bottom of the market.

Forcing lower pricing on some of the riskiest loans being purchased by the GSEs runs counter to the conventional wisdom that greater risk should have the potential to yield greater rewards, especially for publicly traded companies. Fannie and Freddie were perceived to have an advantage of an "implied guarantee" on their debt, but ironically, it was the government's interference that ultimately skewered their equity investors.

Fannie and Freddie grew ever-more dominant in the years leading up to the bubble and continued to be prodded by Congress and HUD to lower their credit standards. Traditionally, the GSEs mainly bought loans with loan-to-value (LTV) ratios of 80% or higher, meaning that the minimum down payment was 20%. Over the years, the GSEs relaxed this requirement, and by 2007, 26% of Fannie's annual loan purchases were loans with LTVs exceeding 95%. For Freddie, the number was 19%.

The mortgage giants were also subject to much lower regulatory capital requirements than other lenders. The minimum capital requirement of 2.5% of on-balance sheet assets is laughable, in hindsight.

With the roles of Fannie and Freddie likely to be left unresolved by the current legislation, it seems inevitable that this or later administrations will succumb to the temptation of once again encouraging the GSEs to ramp-up sub-prime mortgage purchases. After all, it's always politically attractive to support the American Dream.

A better goal would be to encourage "healthy" sustainable homeownership. Returning to the traditional 20% down payment would slow the economic recovery and probably hurt sales of luxury items as the savings rate rose, but it could very well prevent another meltdown down the line.

-- Written by Philip van Doorn in New York.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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