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.

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