The invidious “down payment requirement” meme

By Felix Salmon
April 25, 2013

I feared this would happen. Peter Eavis has a column today about what his headline calls “Down Payment Rules”. Here’s his lede:

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

Read on, and you’ll find lots of talk about “down payment requirements”, “restrictions” on lenders, and whether “requiring a down payment” is a good idea or not, given that we want to both encourage homeownership and prevent systemic risk.

But the subject of Eavis’s column — something called the qualified residential mortgage, or QRM — was never designed to be “an easy fix to prevent the excesses of the housing market”. Rather, it was designed as a loophole to allow banks to wriggle out from an entirely sensible skin-in-the-game requirement.

I covered this subject in some depth back in June 2011, so go read that post if you want the details; nothing has really changed. (For even more on the subject, read Kevin Wack’s excellent treatment from a couple of months later.) But the basic story is simple: under Dodd-Frank, banks need to hold on to at least 5% of the loans that they make. The QRM is a loophole in that requirement — loans with high down payments are exempt from the law, and banks can sell the entire thing, rather than just 95%.

If low-down-payment loans are as safe as the critics of high down payments say they are, there shouldn’t be a problem. The bank will make the loan, will hold on to 5%, and will profit twice: first by selling the other 95% for a quick-flip gain, and secondly by getting a non-defaulting income stream from the remaining 5% of the loan.

Somehow, however, the loophole has expanded to encompass pretty much the entire mortgage market, so that high down payments are now considered an outright “requirement” for new loans, rather than just being a way for banks to avoid holding on to a tiny bit of the loan that they themselves are making.

Really, this whole debate is concentrating on entirely the wrong thing. The question about high down payment mortgages is a relatively arcane backwater of financial underwriting, and we can leave it to the statisticians and bond investors to decide just how much, if at all, such down payments reduce defaults. Instead, we should be concentrating on the banks here, the institutions which seem to be entirely unwilling to underwrite any mortgage at all, unless and until they’re allowed to flip the entire thing, 100%, to bond investors, for a quick, risk-free profit.

This violates common sense. If the bank is underwriting the loan, the bank should retain at least a tiny amount of the risk in that loan. Indeed, if I were a bond investor, I would as a matter of course require extra yield on any loans which were sold by a bank without any skin in the game at all. After all, there’s not much point in being assiduous about your underwriting if you’re just going to sell the entire loan anyway.

So instead of debating down payments, let’s hold the banks’ feet to the fire, a little bit, instead. “Banks do not like” rules requiring them to hold on to 5% of a loan, says Eavis. Why not? Until we get a good answer to that question, we shouldn’t even be talking about down payment “requirements” which aren’t really requirements at all.

12 comments

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Banks don’t like taking risks. The author should not fault them for taking advantage of a loop-hole in mortgage laws to reduce (or eliminate) their risk of loss in a financial transaction. I’m sure bank shareholders are happy that bank management is increasing the value of the bank in the lowest-risk-manner possible.

Posted by VirtualThumb | Report as abusive

Felix,
Would you like to retain a five percent interest in any house, condo, or co-op you sold and be responsible for five percent of repairs, taxes, etc? Why should you be allowed to make money and sell a house above value to a buyer who might default? Shouldn’t home sellers retain a five percent interest also or are individuals responsible for their actions in the housing market?

Has anyone talked to the accountants, IRS or SEC to make sure retaining a five percent interest qualifies for a sale? If it doesn’t then the entire amount of the mortgage stays on the books (and needs capital), not just the five percent, and gains and losses are not taken at time of sale.

The accounting rules for sales and revenue recognition are complicated and have caused restatements and problems for many well run public companies.

Posted by MiltonRecht | Report as abusive

The only reason the author is concerned that banks should have “skin in the game” with regards to the quality of the mortgages they fund (and subsequently sell) is probably becuase he’s determined that the funcitonality of the modern free market allow participants to “prey” on the ignorant (or the ill-informed). Hey, if the bond market is dumb enough to keep purchasing securities backed by mortgages of questionable credit quality, why should banks not continue to generate said mortgages (and the profits that come from their resale)? The free markets will ensure that the most informed will make the most money, and their relative success will be judged by the amount of money they make.

Posted by VirtualThumb | Report as abusive

@milton — The bank is mediating the transaction that would not be able to happen without bank assistance. The seller is merely transferring ownership and is not responsible for determining whether the new owner is a good credit risk. That’s the responsibility of the lender. The lender gets generously compensated for this service from both sides of the transaction and should bear some long term responsibility for making this bet on the new buyer, as the law was trying to do.

Posted by Mikey111 | Report as abusive

@milton — The bank is mediating the transaction that would not be able to happen without bank assistance. The seller is merely transferring ownership and is not responsible for determining whether the new owner is a good credit risk. That’s the responsibility of the lender. The lender gets generously compensated for this service from both sides of the transaction and should bear some long term responsibility for making this bet on the new buyer, as the law was trying to do.

Posted by Mikey111 | Report as abusive

Felix is not a bank, much less a systemically important one that’s too big to fail, and he doesn’t have his own federal deposit insurance nor credit facilities at the Federal Reserve. In short Felix doesn’t need Dodd-Frank, but banks do — and they need a stronger Dodd-Frank, actually.

Banks that want to resell 100% of their loans can write 20% down mortgages. What’s wrong with 20% down? It’s a classic lending standard that has effectively limited banking risk and real estate bubbles for decades. Individuals who cannot afford 20% down have an excellent option called renting (which requires a security deposit by the way), or they can find a bank willing to take at least 5% of the (higher) risk. This sensible rule isn’t at all controversial: it’s basic, time-tested prudence. The fact banks are complaining about such reasonable regulation is reprehensible.

Posted by TimothyS | Report as abusive

It’d be easier to force lenders to pay an equal amount of PMI required of buyers, as an originator insurance, for the life of the loan.

Posted by GRRR | Report as abusive

Sheesh MiltonRecht is utterly totally BEYOND CLUELESS!

Loans are not the same thing as a house or real property or tangible personal property. ONly a complete nitwit would try to analogize a loan to selling real or tangible personal proerty!

A loan is where Party A lends money to Party B and what A “owns” is the right to collect the amount of the loan plus interest!

The risk is whether the loan will be paid back + interest.

Having to retain 5% ownership is only retaining a 5% interest in the money that will be repaid (principal and interest.) That measn the bank that made th eloan gets back 5% of what it lent plus 5% of the interest paid.

It has no responsbilites like paying property taxes or anything else. It jsut has to wait to get back its 5% in principal and 5% of the interest!

Gawd help us all if such fools can vote!

Posted by onthelake | Report as abusive

If there exists a class of mortgage bond investors (outside the US government), then they should be willing to pay loan processors to provide mortgages which have minimal risk of default. Maybe they could even do it themselves! (oh wait, we used to call those businesses banks or savings and loans). But if the only investors willing to do this are the government, then let’s scrap the whole mortgage deal and let the housing market adjust to a new reality. Of all the things that government should do in the USA, the last one is loan me hundreds of thousands of dollars to buy an overpriced house and then give me a tax deduction that only serves to make the loan amount more expensive. (if I factor in my mortgage interest deduction I can afford a larger monthly payment.) Silly!

Posted by silliness | Report as abusive

I don’t see any value in the 5% rule and effectively it will be gamed anyway. As an investor in mortgages what I should care most about is the LTV, DTI, documentation and servicing. If the bank decides to retain 5% or not is not that interesting. As far as the non-retained loans that get sold, I believe Wall Street will turn to REITS, and have them retain the 5%, so in the end not that important.

What I find discomforting about the LTV discussion however is talk that this protects the borrower, when it really serves to protect the true lender, those that own the mortgage debt. I expect we’ll hear pleas and lobbying from the usual cast of characters in favor of lower downpayments(The NAR, National Home Builders Ass, etc in other words, those that benefit, but are not exposed to default risk and only seek to maximize sales volume)

Posted by Sechel | Report as abusive

@Sechel History has recently shown us that without some skin in the game “LTV, DTI, documentation” is quite likely to be more fairy tale than substance.
Unfortunately there is currently a shortage of real bankers, ones who can do real honest underwriting of loans. The employees of today’s megabanks are not trained as bankers, but as corporate climbers. They know that, since their employer has no skin in the game, they will never be held responsible for the quality of their loan underwriting.

Posted by QuietThinker | Report as abusive

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