The minimum down payment should be at least 10%
The Dodd-Frank financial reform law required bureaucrats to draft rules for qualified residential mortgages. Loans that conform to the standards defined can be sold into the secondary mortgage market without restriction. Loans that do not conform require the lender to retain 5% of the capital risk on their own balance sheet. Fortunately, this is not the only protection in the system preventing lenders from originating bad loans and passing the risk off to others. All securitized mortgages have put-back provisions that allow the servicers to force the originating lender to buy back the loan if the borrower defaults. However, for a loan to be put-back to the lender, there must be defects in underwriting, and if the underwriting standards are lax on their face, the put-back provisions alone don’t provide a check-and-balance against the relentless pressure to lower standards to increase loan origination profits.
The qualified mortgage standards are necessary to provide a barrier against excessive risk taking in the secondary mortgage market. If buyers of mortgage-backed securities lose their minds and start buying the same toxic garbage they coveted during the housing bubble, they must find an originating lender willing to underwrite that garbage and retain 5% of it on their own balance sheet. This serves as an extra safeguard in the system, and it’s intended to prevent future housing bubbles.
I recently wrote that New mortgage regulations will prevent future housing bubbles. The main problems that inflated the housing bubble were the interest-only and negative amortization loans and unrestricted debt-to-income ratios. With those products effectively banned, mathematically, it’s very difficult to inflate a housing bubble. The loan balances necessary to inflate prices can’t be underwritten without high debt-to-income ratios or non-amortizing loans.
In July I lamented that Legislators failed to implement down payment requirements because the fact is that Large down payments provide stability to the housing market. But how large is large?
Studies have shown that a 20% down payment has significantly lower delinquency rates than mortgages with lower down payments. But why is that? Mostly, it’s due to “skin in the game.” People who’ve put down large down payments rarely default. In purely economics terms, people shouldn’t consider sunk costs like down payments in their decision making. However, homeowners do. People simply don’t walk away from properties where they’ve put a lot down, even if they’re deeply underwater. The decision is more emotional than logical, but coupled with the emotional desire to “own” these two forces prevent most people from strategic default even when that option is the best available to them.
There is no way to accurately measure how much skin in the game motivates people to stay and pay. Everyone knows it’s important, but with no way to accurately gauge how much is required, the forces demanding little or no down payment are winning — and for good reason — New down payment requirements could crash housing again. Unfortunately, completely eliminating down payment requirements leaves us with borrowers putting no skin in the game, and quite frankly, that’s a horrible idea.
ENACTED THREE years ago, the Dodd-Frank financial reform law remains a work in progress, as federal bank regulators attempt to convert its broad mandates into operational rules. Alas, special-interest groups are busily bending the rule-making process to their advantage. Case in point: the recent announcement of a proposed regulation that would weaken Dodd-Frank’s main mechanism for avoiding another meltdown in the mortgage-backed-security market.
This is very simple. Lenders want to originate loans and pass the risk on to others, including the US taxpayer. The less stringent the rules, the more loans they can originate and the more money they make. Therefore, they lobby for less stringent rules.
To the bill’s authors, a key cause of the financial crisis was that Wall Street packaged and sold securities backed by subprime, “no-doc” and other questionable mortgages. Not having to retain any of the default risk themselves, the banks fobbed off the bonds onto investors and went off in search of more loans, any loans, to package and sell. Dodd-Frank tried to discourage this business model by requiring future mortgage securitizers to put their own capital at risk — except when they package lower-risk “qualified” loans. The legislation’s co-author, former Rep. Barney Frank (D-Mass.), said this was his bill’s “most important” provision.
The risk retention rule will make any originations outside of the qualified mortgage rules both expensive and rare. It’s not just the risk retention provisions, but the lawsuits from issuing non-conforming loans that will keep these from being originated. Even if the risk retention goes away, something that’s still being considered, the threat of lawsuits won’t go away.
Two years ago, federal banking regulators proposed to require a 20 percent down payment as one of the criteria of qualified loans. This was consistent with the intent of Dodd-Frank, and with the economic literature, much of which identifies low equity as a reliable predictor of homeowner default.
See graph above.
But the requirement was quite inconsistent with the interests of a wide range of lobbies — from real estate agents to low-income-housing advocates — which protested that the rule would unduly limit access to credit and kill the housing recovery. The groups swarmed the regulators; hundreds of members of Congress from both parties wrote in support of them. And so, in the dog days of August this year, the regulators backed down, offering a revised rule that requires no down payment at all.
This is a clear victory for the myopic fools at the NAr. They are so desperate for higher prices and higher transaction volumes that they don’t care if it creates instability in the housing market.
The new proposal, modeled on a parallel regulation promulgated by the Consumer Financial Protection Bureau, is not entirely toothless. It would discourage the securitization of negative amortization, “interest-only” and other sketchy products, as well as any mortgages that exceed a 43 percent debt-to-income ratio. These standards, supporters say, would sufficiently reduce risk but would not unduly squeeze credit access, especially for traditionally disadvantaged groups and first-time home-buyers.
The real-world impact of the regulators’ capitulation is limited, at least in the short term, since there’s little private-sector securitization; government, in the form of Fannie Mae, Freddie Mac and the Federal Housing Administration, still dominates. But this turn of events is important, and discouraging, as a demonstration of the housing lobby’s power to shape the post-government future.
To the regulators’ credit, they are still holding out the possibility of reinstating a down-payment requirement in the final rule, due by 2014. We hope they’ll persist.
Their counter-proposal is a red herring. They’ve put a 30% down payment requirement out there as an option, so regulators are forced to chose between a 30% down payment and a 0% one. Since nobody advocates a 30% down payment requirement, that option will not be chosen. That leaves us with a 0% down payment requirement.
What would have happened if they had proposed splitting the difference at 10%? Well, that would have been a reasonable compromise with solid reasoning for its inclusion. Since the lobbyists didn’t want that to be a possibility, they put the red herring number of 30% out there to make it look as if they seriously considered a down payment requirement when in fact they killed it.
The transparency of this obvious ruse infuriates me. However, nobody in the mainstream media has picked up on this.
No doubt there is a trade-off between credit risk-reduction and credit availability, as the housing lobby argues — indeed, as it always argues.
I couldn’t be a lobbyist. I would have a hard time advocating for positions I know are detrimental to everyone other than a select few.
Yet recent history would seem to suggest erring on the side of safety. If the U.S. housing market suffered from anything before the crisis, it was excessive liquidity, and Dodd-Frank was supposed to remedy that.
Why is 10% the appropriate minimum number?
In order for a borrower to have skin in the game from their first day of ownership onward, the market must be stable enough for prices to slowly rise, and the initial equity must exceed the liquidation costs if the borrower needed to sell.
If a borrower lost his or her job the day after closing escrow and couldn’t afford to make payments, they would have to put the property on the market and sell. Since the buyer was the most aggressive bidder on the property, they will need to discount the property to find a new buyer, perhaps 2%. Further, as a seller they will have to pay various closing costs and fees which will cost another 2%. And last but not least, they will have to pay an agent to sell their house, so that’s another 6% gone. If you add those costs up, the total loss will be about 10% of the initial purchase price.
At any down payment level under 10%, the market is vulnerable to strategic default from underwater borrowers. At 10%, the market rests at it’s minimum level of safety. At 20%, which is what the down payment should be, the individual borrowers, and thereby the market, has a cushion in case of an economic calamity.
In short. 10% is good, 20% is better, 30% is a red herring, and 0% is dangerous.
$30,000 in, $128,000 out
The former owners of today’s featured property originally put $30,000 down when they bought the property. Just as subprime was imploding in April of 2007, they refinanced with a $280,000 first mortgage and a $28,000 second mortgage thereby extracting $128,000 from the property.
Quadrupling your investment in five years is a good deal. It’s no wonder some people like the volatility in California real estate.
[idx-listing mlsnumber=”OC13182410″ showpricehistory=”true”]
72 BIRCHWOOD Ln Aliso Viejo, CA 92656
$379,900 …….. Asking Price
$205,000 ………. Purchase Price
10/6/2002 ………. Purchase Date
$174,900 ………. Gross Gain (Loss)
($30,392) ………… Commissions and Costs at 8%
$144,508 ………. Net Gain (Loss)
85.3% ………. Gross Percent Change
70.5% ………. Net Percent Change
5.6% ………… Annual Appreciation
Cost of Home Ownership
$379,900 …….. Asking Price
$13,297 ………… 3.5% Down FHA Financing
4.55% …………. Mortgage Interest Rate
30 ……………… Number of Years
$366,604 …….. Mortgage
$115,674 ………. Income Requirement
$1,868 ………… Monthly Mortgage Payment
$329 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$79 ………… Homeowners Insurance at 0.25%
$412 ………… Private Mortgage Insurance
$299 ………… Homeowners Association Fees
$2,988 ………. Monthly Cash Outlays
($417) ………. Tax Savings
($478) ………. Principal Amortization
$23 ………….. Opportunity Cost of Down Payment
$67 ………….. Maintenance and Replacement Reserves
$2,182 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$5,299 ………… Furnishing and Move-In Costs at 1% + $1,500
$5,299 ………… Closing Costs at 1% + $1,500
$3,666 ………… Interest Points at 1%
$13,297 ………… Down Payment
$27,561 ………. Total Cash Costs
$33,400 ………. Emergency Cash Reserves
$60,961 ………. Total Savings Needed