Is Requiring 20% Down on Mortgages Too Much?

During the housing boom, it was relatively easy to buy a new home with little or no money down. Many experts agree, however, that this precedent was harmful, and part of the reason for the market's problems. Non-existent down payments resulted in some borrowers getting homes they couldn't really afford as well as banks and investors incurring bigger losses on defaults once prices declined. Of course, the theoretical solution to this problem is easy: just require higher down payments. This is the direction that regulators are heading. But are they going too far?

First, how large are the down payments that may be required? Reports indicate that regulators are mulling requiring borrowers putting 20% cash down for a mortgage to be considered lower-risk. That certainly sounds like a lot, particularly compared to the weak down payment requirements that Americans got used to over the past decade. But yesterday during a House Financial Services Committee hearing, the Ranking Member Rep. Barney Frank (D-MA) argued that 20% is not excessive. He explained:

First of all, I hope we will not buy into the argument that no mortgage loans will be made if they don't meet the "qualified residential mortgage" definition. The qualified residential mortgage definition gives you an exemption from having to retain 5% of the loans you make in a securitization. And the notion that no one will make loans unless they can 100% securitize is clearly false. In the first place, many of the smaller institutions never securitize in the first place. Many of the community banks don't securitize. They will be unaffected by this.

This is an important point to understand. The 20% requirement that regulators are considering would only apply to mortgages that banks seek to securitize without retaining a portion of the risk of those loans. As Frank says, banks could still create mortgages with down payments of less than 20%. They would just either simply not securitize these loans or securitize them but retain the required 5% risk exposure.

With this understood, we can consider some possible outcomes for a 20% down payment requirement for lower-risk loans. First, this needs to be taken in a context where banks are expected to take on most mortgage market risk. Currently, the government owns or guarantees most mortgages through Fannie Mae and Freddie Mac and few are privately securitized. That's bound to change, however, as the government begins to withdraw from the market to some extent.

So as Fannie and Freddie go away, banks and investors will have to begin taking on the risk for the sorts of low-risk mortgages that these companies had purchased and insured for decades. In doing so, investors will demand more protection than they did from mortgage bonds sold by Fannie and Freddie -- private bonds won't be stamped with a full government guarantee. So really, it's plausible that banks investors may only have an appetite for loans with large down payments anyway to protect them from possible future home price declines. By creating a 20% requirement for lower risk mortgages, regulars would likely doing what the market would have -- or certainly should have -- done anyway.

What you might imagine happening here is big banks that are involved in securitization become sort of mini-Fannies. They will soak up the vast majority of the prime mortgage market share, since that's what investors will likely be more interested in through securitization due to its lower risk. The fear, then, is what becomes of the mortgage operations of smaller, community banks that do not participate in securitization.

One possibility is that smaller banks will find a niche in providing mortgages with lower down payments -- they don't securitize anyway, so the 20% requirement won't really affect them. Such loans will likely be provided to lower- and middle-income borrowers some of whom may even be non-prime. Is this good or bad?

On one hand it's sensible. It has been argued that community banks are the ones who should be providing loans that banks hold in situations where additional attention needs to be paid in both origination and servicing. Large factory-like mortgage operations at megabanks might fail to capture some of the less obvious borrower characteristics that smaller institutions are better-situated to take into account. And if these borrowers run into problems, then they can work with the bank that holds their mortgages instead of some giant servicer that only sees them as a number.

On the other hand, this assumes that community banks have the sophistication and depth of staff to evaluate and maintain these potentially riskier mortgages. There could be reason to fear that smaller banks would end up taking bigger risks without fully understanding what they were getting into. This could result in big losses wiping out huge numbers of community banks the next time the housing market collapses.

Of course, this 20% down payment requirement would come in a context when a variety of other variables are also changing for housing finance policy. As a result, it's pretty hard to predict how it will all turn out. While it's doubtful that a bigger down payment requirement will cause the mortgage market to collapse, it's fairly certain that it will result in some significant changes.