(Adds Kraninger, Calabria comments, details, background)
By Pete Schroeder and Katanga Johnson
WASHINGTON, July 25 (Reuters) - U.S. regulators said on Thursday they plan to end an exemption for Fannie Mae and Freddie Mac that permits them to back risky mortgages, a move that would reduce the government's footprint in the housing market, potentially increasing borrowing costs.
The Consumer Financial Protection Bureau will allow that exemption to expire at the beginning of 2021 but may extend it for a short time "to facilitate a smooth and orderly transition," the agency said.
CFPB Director Kathy Kraninger said ending the exemption would ensure fair competition across the mortgage market. While she said she was seeking a smooth transition, the change could make it more difficult for some borrowers to obtain loans at affordable rates by limiting the ability of Fannie and Freddie to guarantee certain mortgages.
About 19 percent of loans backed by Fannie and Freddie from 2014 to 2018 were made under the "patch" exemption, and those loans were disproportionately made to minority borrowers, according to the Urban Institute.
The CFPB is seeking public comment on how to amend the underlying "qualified mortgage" rule, which was written after the 2008 financial crisis to identify high-quality mortgages that are likely to be repaid.
Established in 2014 in an effort to prevent risky lending, the rule sets parameters for what mortgages regulators believe would be repaid.
The rule requires banks to verify a borrower's income and debt levels, and limit fees and other risky features. In exchange, lenders are protected from lawsuits borrowers might file charging that banks saddled them with unfair mortgages.
When it was written, the CFPB created the patch or exemption for government housing agencies and Fannie and Freddie, allowing them to back loans with looser underwriting standards.
The patch was intended to be temporary, set to expire at the beginning of 2021 or when Fannie and Freddie exited from government control. Some industry insiders had expected a possible extension, but Kraninger said on Thursday the agency was not seeking to continue it.
"The patch is going to expire, but we are amenable to some input on what a transition would look like," she told reporters.
Mark Calabria, director of the Federal Housing Finance Agency overseeing Fannie and Freddie, said the impact on the market could be relatively small as borrowers and lenders adjusted and other government agencies helped fill the gap. He added the law did not allow the patch to persist indefinitely.
"Adverse economic impact is not a legal justification for ignoring statute," he said. (Reporting by Pete Schroeder; Editing by Susan Thomas and Peter Cooney)