Friday, April 11, 2008

The State of the No Down Market

by Tanta on 4/11/2008 09:05:00 AM

To summarize this MarketWatch article: the parties who are actually in first loss position--whose money is on the table if these things go south--have learned their lesson about no-down financing. The parties who just like to party haven't gotten the memo yet.

Mortgage Guaranty Insurance Corp., for example, changed its guidelines last week to exclude coverage of 100% mortgages. At a minimum, borrowers need a 3% down payment and a credit score of at least 680 to be eligible for coverage. In selected markets where home prices are declining, a 5% down payment is the minimum required. . . .

"It's obvious why they're making these changes," [Broker*] Brown said of the insurance companies. "They have to eliminate the losses they're taking." Mortgage insurance companies have been hit hard by the increasing number of defaults and foreclosures, he pointed out.

At MGIC, the changes to underwriting of low loan-to-value loans -- as well as increases to the pricing on some products -- were made due to the recent performance of loans with those characteristics, said Michael Zimmerman, senior vice president of investor relations. But the changes, he said, also reflect a return to more historically normal underwriting standards.

"The more equity that a borrower has -- or, if you will, skin in the game -- in any investment, the more likely they are to have a higher degree of responsibility toward it," he said.

Goldhaber [of Genworth] said that those in the mortgage industry also have a responsibility to put homeowners into the proper mortgage product. These days, it's irresponsible to give people a loan for 100%, he added.

"In soft markets like we have today, with declining home-price appreciation, to put someone in a zero down is really inappropriate," he said. "It's the kind of product choice that gets consumers in trouble."
Let us pause just for a moment to reflect on a distinction I haven't posted jillions of words on for a least a year, probably, but that is really crucial here: loss frequency versus loss severity. Requiring a 5% down payment from a borrower is not really about substantially lowering a lender's or insurer's loss severity, or how much you will lose if the thing defaults. It is about substantially lowering loss frequency, or how often defaults occur. This is what the concept of "skin in the game" means: it means having a borrower with a first-loss stake in the deal that is significant, in dollars, to the borrower. A borrower who does not wish to lose a 5% investment in the property, the logic goes, is less likely to "ruthlessly default" immediately should home prices drop; that borrower has some motivation to hang in there until they recover. (And if current prices are still so high that they have a long way to fall and little likelihood of ever recovering, whatever are you doing putting a borrower into such a loan with only 5% down? That's asking for "ruthless default.")

But the idea here is that the "skin in the game" is significant to the borrower, not representative of the lender's likely loss. If a 95% financed loan defaults tomorrow, even with no change in the home's value, the lender/insurer is still going to lose somewhere in the neighborhood of 20% of the loan amount. Default servicing and foreclosure and resale of REO is expensive, more expensive than that 5% down is going to cover. Down payments in this view of the world are set to "what the borrower can't afford to lose," not "what the lender can't afford to lose." Or again, it is about making defaults less frequent--because borrowers are motivated not to default "optionally"--than about making defaults less severe, although they surely do mitigate severity.

Try telling these mortgage brokers that:
That said, while the conventional no-down-payment products may have disappeared, there are still ways to buy a home without a down payment, said A.W. Pickel, CEO of LeaderOne Financial in Overland Park, Kan., and former president of the National Association of Mortgage Brokers.

"You have to broaden your definition of no-down payment," he said, adding that loan options are available, if not in the form they were in before.

A gift from a family member or a community grant can take the place of a down payment, for example, he said. And down-payment assistance programs are available to help those seeking loans backed by the Federal Housing Administration, he added. . . .

"You will see more unique products coming out," he said, as companies search for ways to help down-payment challenged buyers get into a new home.

But as of now, there are fewer options than there were before for would-be buyers who don't have ample cash reserves. And Brown sees that as an overreaction.

He believes consumers should have the option of financing their entire purchase -- even if it comes with extra fees or higher rates. Someone who doesn't have a lot of cash, but is a good credit risk, for example, should have that option, he said.
To quote Professor Krugman, "gurk." It's as if this "conversation" between mortgage insurers and mortgage brokers is happening on two different planets. I have gone on record as being a bit skeptical that "ruthless default" is as widespread as some breathless media stories want to imply--mostly because I suspect that the borrowers in question really can't afford their mortgage payments--but only a fool (which I try not to be) would claim it has never happened and won't keep happening if you put people into "free put option" contracts where there is no financial downside to just walking away from a loan.

And yet here we are, treated to brokers discussing ways borrowers can use OPM (Other People's Money) to leverage 100% financing, even in a falling market, because we can declare them "good credit risks" at the same time we put them in loans that offer no downside to default. What kind of "good credit risks" are these people? Folks who will continue, doggedly, to make mortgage payments on an upside-down property for years and years, unable to move, unable to refinance, all in the name of the sanctity of debt obligations? How, exactly, would any lender or insurer measure this kind of "willingness to repay"? With a FICO? Now that we're being told that many borrowers are keeping up the MasterCard payments--they don't want the downside of having the card cut off--while missing the mortgage payment, because there's little downside there?

There is, of course, one possibility here: we could measure "willingness to repay" by a kind of proxy measure, like, um, "willingness to put one's own money on the table in the form of a down payment." This, however, would involve all of us being on the same planet. And clearly we aren't all there yet.
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*Actual title is "a certified mortgage planning specialist"