Investors, as well as issuers of MBS with government guarantees, should take a hit if the underlying loans go bad, according to former GSE regulator James Lockhart.

Speaking at a GSE forum in Washington, Lockhart said the investors should bear "enough risk" so they pay attention to the quality of the underlying mortgages and the strength of the mortgage insurer.

Lockhart spoke at a University of Maryland forum on the future of Fannie Mae and Freddie Mac. He is now vice chairman of WL Ross & Co., a private equity firm that has made several investments in both mortgages and banking.

The former GSE regulator suggested that Congress and the Obama administration should consider the use of catastrophic insurance to replace the full guarantee on Fannie Mae and Freddie Mac MBS going forward.

In the case of severe defaults, catastrophic insurance would kick-in once all the equity in the mortgages is tapped, the mortgage insurance has been paid, and the originator/issuer along with the investor has taken a hit. He referred to the investor's portion as a "deductible."

The former director of the Federal Housing Finance Agency said the cost of catastrophic insurance could be raised over time to restart the private-label MBS market. The conforming loan limit also could be raised slowly to encourage private MBS issuance.

If the government decides to favor minimum down payments below 20%, Lockhart said private mortgage insurers should be regulated at the federal level to ensure adequate supervision.
He also stressed that the obligation to repurchase bad loans should reside with the mortgage originator, not the servicer.

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