It's no secret that mortgage underwriting has tightened considerably since the housing bust, helping to reduce defaults.
But how tight standards should be in the future — and especially the role down payments play in judging the risk that loans will go sour — has sent a debate coursing through the mortgage and housing industries and the highest levels of the business community.
Federal regulators Wednesday backed off a March 2011 proposal that included a 20% down payment in the definition of what a low-risk loan should look like when mortgages are packaged as securities and sold to investors. They hope to set a final rule soon after a 60-day comment period.
The move signals the debate is not over, but for all practical purposes could be soon.
At issue is the not-yet-final regulation known as the qualified residential mortgage, or QRM. The original proposal met with boisterous opposition from housing and business groups, which said the down-payment rule would lock out many qualified buyers.
They wanted the QRM to resemble another regulation called the qualified mortgage, or QM, an "ability to repay" standard approved this year by the Consumer Financial Protection Bureau. The QM sets no down-payment requirement.
In their revised proposal Wednesday, the six regulators charged with issuing the final rule, including the Federal Reserve and the Federal Deposit Insurance Corp., agreed to define the QRM the same way as the QM. They will hear new comments — including a request for an alternative definition with additional underwriting standards — through Oct. 30 before making a final ruling.
The new rule would likely go into effect in January, when the QM rule takes full effect.
The National Housing Conference, an affordable-housing advocate, applauded regulators "for responding to the widespread sentiment against onerous down-payment requirements and in favor of aligning major mortgages rules.
Others weren't so pleased.
"This looks nothing like the original," said Edward Pinto, resident fellow of the conservative American Enterprise Institute. He says the QM "is not a strong restriction of credit quality. It has no mention of down payment or credit scores.
Owners of loans that meet QRM standards will be exempt from a Dodd-Frank financial-reform stipulation that they keep on their books 5% of the value of loans they securitize.
This "skin in the game" is meant to give lenders an incentive to avoid making loans likely to cause losses down the road. The exemption would be made because the loans supposedly would be less risky than others.
Is 20% Too High?
Most everyone agrees that the lower the down payment, the riskier the loan. But 20% is too high a bar, many interest groups say. They argue it would raise costs prohibitively for many worthy borrowers.
Even critics who say the federal government helped pave the way for the housing crisis by loosening mortgage standards think 10% down would be adequate.
Pinto says 10% down on a home purchase would be fine if it were accompanied by enough private mortgage insurance.
The QRM was meant to hold lenders to a higher standard than the QM, thus the 20% down and 36% debt-to-income ratio laid out in regulators' initial proposal.
The QM (and now the new QRM proposal) calls for a 43% maximum debt-to-income ratio and prohibits risky features and practices such as negative amortization, interest-only payment periods and loan terms longer than 30 years.
A QM loan could be sold to government-sponsored enterprises Fannie Mae (FNMA) and Freddie Mac or the Federal Housing Administration.
"If QRM ends up equaling QM, then the 5% retention requirement becomes a non-event," Pinto said. "Virtually all securities will end up qualifying for the exemption. We'd basically be back to a situation where loan underwriting standards will get riskier from where they are today.
Federal data show that the mortgage delinquency rate on prime loans fell from 4.4% at the end of December 2008 to 3.1% in June. For FHA loans, it eased from 14.3% to 10.2%.
"When lined up apples to apples, the newer vintages are doing much better," said Herb Blecher, senior vice president of Lender Processing Services, comparing, for example, the performance on loans originated in the first six months of 2006 vs. those originated in the first six months of 2010.
LPS tracks loan performance by original loan-to-value, which Blecher says is a key measure of default risk. Its data show that the higher the loan-to-value ratio, the greater the likelihood of a serious delinquency or default.
At the end of June, all outstanding loans with LTVs of 70% to 79%, the largest group, were 5.7% delinquent. But the rate rose to 7.6% when the LTV climbed to 80% to 89%, and 7.9% at 90% to 99%.
If standards weaken, defaults would likely creep up over time.
And what about the 5% risk-retention issue, the basis for the controversy
"Back in the day (during the housing bubble), lenders were simply not keeping any interest in the loans (they sold)," said Clifford Rossi, finance professor at the University of Maryland. "The 5% risk retention, that I get. It seems reasonable. But it can be very costly to banks in terms of the additional capital they'd have to hold. It can be the difference between a profitable and an unprofitable loan.
"But it's where you draw the line for a high-quality loan that matters," he added. "I think a 90% LTV (or 10% down payment) is a bright line for demarcating good quality from not-good quality.
Major banks and investment houses such as JPMorgan Chase (JPM) and Goldman Sachs (GS) are affected by risk-retention rules, since they pool loans and sell them in the form of mortgage-backed securities, says Alex Pollock, a resident fellow at the AEI.
Currently, risk-retention applies to the entity that owns and securitizes the loan, which may or may not be the original lender.
"Small banks that often make mortgage loans sell them to the big banks," Pollock said. "I think the ideal place for credit-risk retention is whoever makes the loan, not the securitizer. That's who knows the most about a loan.
But lender groups were pleased with the revised QRM proposal.
The Independent Community Bankers of America lauded regulators Wednesday "for developing a less restrictive credit risk-retention proposal that would minimize the negative impact of new regulations on our housing recovery.
In congressional testimony in June, Mortgage Bankers Association Chairman Debra Still said any variation between the QM and QRM, particularly the "prohibitive down-payment requirement in QRM," would "increase the cost of credit, discourage private capital and add to the complexity of mortgage finance.
Others that have been arguing for a less restrictive QRM definition include the National Association of Home Builders, the Center for Responsible Lending consumer advocacy group and the Business Roundtable, which represents CEOs of major companies.
"We think there should be a down payment, but it should be set by the lender, not by the government," said Kathleen Day, until recently a spokesperson for the CRL and now a lecturer on financial crises at Johns Hopkins University.
One big complaint about the 20% down rule is that it would keep many otherwise qualified borrowers out of the housing market at a time when the homeownership rate has dipped to its lowest level since the mid-1990s.
Home buyers with lower down payments could pay higher interest rates, more points and other extra costs.
"The down payment is the primary constraint to home ownership for many people," said Michael Fratantoni, a vice president at the MBA. "So the question is, can you make low down payments successfully without overly high default rates?
His answer: Control risk by product type and verify income, assets and debt-to-income ratios.
If 20% down seems too high now, it's a pittance compared to the past. In 1927, the down-payment rate a national bank could impose on a borrower was "loosened" to 50% down, says Pollock.
In 1990, nearly 70% of home-purchase loans acquired by Fannie Mae had a down payment of 20% or more, Pinto says.
Regulators' original QRM proposals for defining a high-quality loan were "very similar to what we had back in 1990 and which they are now abandoning," he said. "1990 was a very good year. Prime loans were the predominant form of lending."