In the rush to correct the plethora of mistakes made by the mortgage lending industry during the real estate boom, Congress has proposed many reforms. Most of these proposals have to do with creating a more stable buyer pool that is less-likely to default on a loan in the future. Requiring higher down payments, higher credit scores, more thorough income verification, more transparent appraisal evaluations, and other sensible-sounding approaches have been posited by a number of groups.
When we look at the actual data on which homeowners default, however, some of that "common sense" logic doesn't hold up. There are really just two major factors that influence the majority of defaults: borrowers can no longer afford their payments, or the home is so far underwater that borrowers don't believe it's worthwhile to hold on. Creating a requirement of increased down payments to reduce defaults has been proposed, but the statistics, surprisingly, rebut that idea's effectiveness.
Our focus in righting our lending standards should be on fixing these two main problems and, as much as possible, preventing their recurrence in the future.
I. Borrowers can no longer afford to make mortgage payments.
The inability to make mortgage payments stems from many issues--reduced employment, job loss, increasing adjustable-rate mortage payments, etc., but the root cause is always a lack of sufficient income. A large number of the defaults we've seen in previous years were from No-Doc, Stated Income, and other questionable loans that didn't verify a borrower's income or their ability to repay an increasingly-adjusted mortgage payment. The so-called "liar loans" that were underwritten during the boom will continue to default for a few more years, but lenders have already corrected this mistake and income verification has been stepped up significantly. Requirements for credit scores, reliable indicators of responsible credit use, have been significantly increased. Lenders stopped allowing new stated income loans years ago. Going forward, as the number of these defective loans starts to dwindle, we will see very few defaults based purely upon shoddy income verification.
Job loss is a larger problem, not one that the lending or real estate industry can correct on its own. A real estate recovery, however, would certainly put thousands of Americans back to work in construction, lending, appraisal, remodeling, and dozens of other real estate-related occupations. That recovery depends on stable home sales and stable home prices.
II. Homeowners feel they are too far underwater and "walk away".
The mindset of an underwater homeowner is delicate. There are certainly portions of the U.S. where many homeowners are 30% underwater or more, and don't see a the likelihood of a full recovery. There are far more areas, however, where a large percentage of homeowners are only 10% underwater, and these households can turn the tide. A couple that feels they will regain their equity within five years and continue raising their family in their home will likely continue to pay their mortgage on time and protect their credit and investment. That same family, if presented with a likelihood of years of further reduction in their home's value, becomes a much more likely candidate for default. These homeowners can create a downward spiral effect when their home goes into foreclosure, further reducing their neighbors' home values.
Down payments do not alleviate a significant amount of default risk. While this might seem counter-intuitive after the discussion of equity, the facts bear it out. Home buyers who put down very small down payments are almost exactly as likely to default as those with a 20 percent or higher down payment. It seems that those who put down very little on their homes understand the risk/reward that comes with their investment and are willing to ride out the down market for the potential of larger upside gains. From Corelogic Inc:
- Raising down payments from 5 percent to 10 percent would decrease borrower default rates a mere 0.2 to 0.3 percent. At the same time, it would eliminate 7 percent to 15 percent of buyers.
- Raising down payments to 20 percent would still only decrease defaults by 0.8 percent, and it would exclude 20 percent to 25 percent of all buyers.
If nothing else, this should make any policymaker stop short and analyze their goals. If we exclude anywhere near 20 percent of buyers from the market, there will be far fewer homes sold, creating another significant downturn in real estate--no discussion. Knowing that these borrowers are injecting money and jobs into the economy, and that their default rates are almost exactly the same as the population as a whole, there is no sensible reason for the restriction.
Real estate, much like the stock market, is sometimes susceptible to self-fulfilling prophecies. Consumers see falling prices, predict future decreases, and decide not to buy even when prices are low. Consumers see rising prices, predict future gains, and join the scramble to buy even when prices are high. It's a reality of our market. Our number one goal should be to create consumer confidence in the real estate market, which requires the support of healthy sales and home prices.
Homeowners don't want to default. Consumers want to buy homes. Both of these groups need to be confident that even though their investment may fluctuate, in the long-term owning a home in America is the right choice. As we make decisions about regulating real estate lending going forward, we must always be aware that this massive sector of our country's consumer spending needs to be encouraged, not restricted. Responsible lending makes sense, but squeezing out responsible buyers with smaller down payments will only exacerbate our problems in the real estate market and our economy as a whole.
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