When the secretaries of Defense and Housing and Urban Development announced the official start last week of mandatory 6 percent mortgage rates for Armed Forces reservists and National Guardsmen called to active duty, they never answered one key question: Who is supposed to pay for the difference between 6 percent and the regular rate on servicemen's home loans?

In lenders' lingo, who's going to take "the haircut" on rate reductions triggered by the activation of the Soldiers' and Sailors' Civil Relief Act of 1940 for the upcoming war against terrorism? With 50,000-plus reservists already called to duty, and the probability of more in the months ahead, that's a potentially expensive question, indeed.

For example, if a reservist has a $150,000 30-year mortgage at 9 percent, he or she would be paying the lender $1,207.50 in principal and interest a month currently. But at the 6 percent limit mandated by the 1940 law, that would drop by one-third to $900 for the duration of active duty plus a three-month grace period. That $307.50 per month differential may not seem like much, but multiplied by hundreds or thousands of loans, it begins to add up -- and immediately eliminates the profit margins for loan servicers on every affected mortgage in their portfolios.

The impact is even greater on banks holding consumer loans and credit cards on their books, where regular rates routinely range into the mid- to high-teens. Under the law, no creditor can ask a reservist to pay back the arrears after his or her service, so once the payments are reduced, the money is lost to the lender forever.

The 1940 law requiring rate reductions is silent on the subject of who ultimately pays for the subsidization -- implying that the answers must come from financial institutions themselves. And as it turns out, there are actually a range of different answers to the question -- who takes the haircut -- depending upon the type of loan, and the legal owner of the debt.

In the case of credit cards, consumer loans and similar non-secured debts, the banks or bond investors holding the notes are expected to fully absorb the cost of the rate reductions.

But for home mortgages, the situation is different. For mortgages and home equity loans owned and retained in portfolio by lenders themselves, they must take the haircut. But for home loans sold to and serviced for any of the three giant mortgage investors -- Fannie Mae, Freddie Mac, or Ginnie Mae -- those institutions have stepped forward voluntarily to take the hit.

"We will do what we have to do to help the war effort," a spokesman for Fannie Mae told Realty Times. A spokeswoman for Freddie Mac said the corporation "will absorb the losses from the reduction in interest rates and we will continue to pay the regular servicing fee" to lenders affected by the mandatory rate cuts. A spokesman for the department of Housing and Urban Development, parent of Ginnie Mae, confirmed his agency will follow suit. Ginnie Mae buys Federal Housing Administration (FHA) and Veterans (VA) mortgages exclusively. Fannie and Freddie mainly invest in conventional, non-government-backed loans.

All three institutions said that while they are aware that the potential cost to them could be significant if the war effort expands and is prolonged, they expect no serious impact on their bottom lines. Fannie and Freddie are publicly-traded corporations. Ginnie is a federal corporation tied to the federal budget.

Had not Fannie and Freddie and Ginnie stepped forward, as they did earlier in the Gulf War effort, mortgage lenders say the effects could have been painful. An official at the Mortgage Bankers Association of America said that during the Gulf War, some lenders faced income losses of $2 million or more a month in the absence of Fannie, Freddie and Ginnie.

Some large mortgage companies who specialize in "jumbo" mortgages over $270,000 and sub-prime mortgages that Fannie and Freddie cannot purchase, will still be on the line this time, and will incur losses. But not the vast majority of lenders: They can breathe easy, because Fannie, Freddie and Ginnie will take the hits.

For more articles by Ken Harney, please press here.

Published: October 1, 2001

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