Apr302013

Large down payments provide stability to the housing market

Down payments are the bedrock of the housing market. Large down payments preserve home ownership, reduce volatility in the market, and reduce the risk to our financial system. The only people who oppose them are realtors and originate-to-sell lenders who see down payments as an impediment to profits and left-wing housing advocates who see down payments as a barrier to putting unqualified borrowers into houses.

Down payments preserve home ownership because 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.

Down payments clearly have a strong impact on delinquency that cannot be ignored. Delinquency rates on high down payment loans are a small fraction of what delinquency rates are on low down payment loans.

Down payment reduce market volatility in two ways. First, as mentioned previously, large down payments reduce strategic default. Fewer foreclosures in a time of financial crisis means less pressure on house prices. Plus, large down payments serve to limit the inflation of prices during a rally. Large down payments reduces the size of the buyer pool (which is why lenders and realtors want down payments reduced or eliminated). A thinner buyer pool puts less upward pressure on prices. It takes people time to save for larger down payments, and this serves to limit price increases by the rate of savings of potential buyers.

Ultimately, down payments limit the risk to our financial system because they reduce the volatility in the housing market. Our financial system nearly crashed in 2008, which was triggered by the collapse of the housing bubble.The destabilizing impact of low down payments is far reaching. That’s why it’s particularly dangerous that a small group of self-interested parties is lobbying to reduce or eliminate down payment requirements from the new qualified residential mortgage standards.

Down Payment Rules Are at Heart of Mortgage Debate

By PETER EAVIS — April 24, 2013, 2:15 pm

It seemed an easy fix to prevent the excesses of the housing market: make home buyers put more money down.

It really is that easy. Large down payment stabilize the market because borrowers have equity. An equity cushion makes strategic default less common, and provides a buffer against loss for lenders if they must foreclose on a property.

But as the housing market starts to return and the subprime mess fades from memory, the issue is up for debate.

Lenders and consumer advocates — rarely on the same side of the issue — are now cautioning against down payment requirements. They argue that such restrictions could limit lending, and prevent lower-income borrowers from buying homes.

Down payments do limit lending because it prevents people without the fiscal discipline to save and consistently make payments from getting loans. Down payment requirements weed out the people lenders should least want to loan money to. And who said home ownership is an entitlement that lower-income borrowers should have? Lower income borrowers who can save 3.5% can buy a property that their income can support. The FHA down payment hurdle is hardly onerous.

They also contend that the new mortgage rules put in place this year will do enough to limit foreclosures, making down payment requirements somewhat superfluous.

That argument is complete bullshit. While the new mortgage regulations will prevent future housing bubbles, these regulations leave out the lynchpin of the whole system, down payments. This arguement is the kind of weak crap put out by people hiding their real agenda — making more money from originations and sales.

The arguments seem to run contrary to long-standing beliefs about homeownership. For decades, experts have emphasized the need for a sizable down payment — a rule of thumb being 20 percent — on the premise that borrowers with a sizable chunk of equity in a home are less likely to walk away when things get bad.

If our goal is to prevent foreclosures, I can’t think of anything more effective than requiring a down payment,” said Paul S. Willen, a senior economist and policy adviser at the Federal Reserve Bank of Boston. …

As I noted, large down payments prevents many from submerging beneath their debts which causes a reduction in strategic default. Fewer defaults means fewer foreclosures. However, it isn’t just the number of foreclosures that’s the problem. The losses lenders must absorb if they do foreclose is what imperils our banking and financial system. If the bubble-era borrowers all put 20% down, banks wouldn’t be sitting on a $1 trillion in unsecured debt today.

And the subprime debacle has only distorted the debate, say some analysts. “The problem with this conversation is that it’s like discussing the future of shipbuilding from the deck of the Titanic,” said Roberto G. Quercia, director of the Center for Community Capital at the University of North Carolina at Chapel Hill. “There’s a lack of perspective.” …

WTF? I think having a conversation on shipbuilding from the deck of the Titanic is the best possible perspective. We must learn from our mistakes. The subprime debacle emphasized the need for down payments and higher lending standards. The best possible time to establish these standards is in the aftermath of a disaster.

It’s a critical issue for Washington. Currently, taxpayers, through the Federal Housing Administration, backstop most of the low-down-payment mortgages. But the aim is to curb the government’s involvement in mortgages.

As that happens, policy makers are hoping a major part of the mortgage market will come back. Specifically, they need the return of private bond investors, who once bought trillions of dollars’ worth of mortgage-backed bonds with no government backing.

Other than some small bond deals, that market remains dormant. A major reason is that the banks that sell the mortgage-backed bonds are waiting for regulators to complete rules aimed at strengthening this market.

The real reason investors are staying away from the mortgage bond market is because the federal reserve has driven yields so low with it’s manipulation of interest rates that investors can’t make a good risk-adjusted return. If officials really wanted to attract private capital back to this market, they would let interest rates rise. That would take care of the problem. Perhaps finalizing the rules might reduce the risk premium a little, but the real problem with the private bond market is that yields are far too low.

This is where down payments could play a crucial role. The proposed rules require banks to hold a slice of the mortgage-backed bonds they sell to investors. Banks do not like those types of restrictions.

Banks don’t like any types of restrictions. That’s exactly why the Dodd-Frank legislation put those restrictions in. If lenders want to originate dodgy loans, they are going to have to retain some of that risk on their own balance sheets. It’s the best and only way to ensure underwriting standards won’t get compromised. Forced buy-backs only go so far.

But lenders would not have to keep a piece of the bonds if the underlying loans included features that made them less likely to default. These exempt loans would be called qualified residential mortgages. Regulators effectively proposed that these loans should have a 20 percent down payment.

The proposal prompted widespread objections from consumer advocates, bankers and home builders, who said the plan could shut many borrowers out of the housing market.

Large down payments will shut many borrowers out of the housing market — many unreliable ones.

Banks, they argued, are likely to focus heavily on making qualified residential mortgages. And if those mortgages require high down payments, lenders will be hesitant to make loans with little money down.

Good.

Consumer advocates make a nuanced case. They do not deny that down payments reduce the risk of default. But they say defaults can be reduced almost as much by applying other rules that curb lending to certain types of borrowers. …

Bullshit. If this were true, they wouldn’t object to large down payments because it wouldn’t have any impact. Obviously, large down payments will weed out the bad borrowers more than the other rules will.

Borrowers who saved up for down payments may have budgeting skills that later help them make their payments … and borrowers with equity in their homes are less likely to walk away altogether, rather than try to find a solution.

Supporters of a down payment requirement also make a broader argument. They point out that the financial sector overhaul was not just meant to protect borrowers. It was also intended to make banks and financial markets more resilient to shocks like housing busts. In other words, the legislation always envisioned a trade-off between homeownership and the stability of the financial system.

There is no reasonable argument to be made in favor of small down payments. The only people trying to obfuscate the issue are left-wing housing advocates, realtors, and originate-to-sell lenders who have their own self-serving agendas. The reality is that large down payments provide stability to housing markets and our financial system. It only remains to be seen if politicians have the courage to stand up to the special interests and do the right thing for the country.