By Robert Freedman, senior editor, REALTOR® Magazine

A banking reform rule proposed by the FDIC and Federal Reserve earlier this month to require 20 percent minimum down payments on residential mortgage loans is based on the idea that loans with higher down payments perform better than those with lower down payments. As recently as last week, FDIC General Counsel Michael Krimminger told a House Banking subcommittee that his agency’s studies show “a significant relationship between higher loan-to-value ratios and increased risk of default.”

The Fed and FDIC’s 20-percent minimum-down proposal isn’t for all residential mortgages; it’s just for mortgages that get included in securities and sold to investors. If lenders don’t want to require a minimum 20 percent down, they just need to hold at least 5 percent of the value of the loan on their books. If they don’t want to retain that 5 percent, then they would have to require that minimum 20 percent down.

Source: Community Mortgage Banking Project

It’s hard to argue with the regulators that, in an ideal world, households would put down 20 percent when taking out a mortgage to buy a house. And indeed, the FDIC isn’t the only entity to find a relationship between high down payments and loan performance. The Community Mortgage Banking Project, a coalition of independent mortgage bankers, points to its own work showing a small correlation between down payment amount and performance—but with the emphasis on small.

In an analysis of the performance of loans made between 2002 and 2008, loans on which the down payment is increased from 5 percent to 10 percent showed improvement of between 0.1 percent and 0.5 percent. No, those aren’t typos. The gains are that small.

There was a little bit better improvement when down payments were increased from 5 percent to 20 percent. Performance improved between 0.3 percent and 1.6 percent.

Any time you can improve loan performance it’s a good thing, but to get these small levels of improvement, the market for home sales would have to shrink enormously, between 6.6 percent and 14.7 percent in the case of requiring a minimum 10 percent down, and between16.7 percent and a whopping 28.8 percent in the case of requiring a minimum 20 percent down. The market would shrink that much because requiring those higher down payments would drive huge numbers of households out of the market.

In other words, what the FDIC and Federal Reserve want to do is lop off almost a third of the home sales market to get up to 1.6 percent improved loan performance.

What’s ironic is that residential mortgage loans made over the last two years, most of which have down payments far below 20 percent and even below 10 percent, are among the best performing vintages ever, according to Fannie Mae and Freddie Mac data.

The key? Sound underwriting. As NAR and other organizations have been saying for months, it’s not high down payments that lead to good loan performance; it’s common-sense underwriting: limiting loan amounts to what people can reasonably afford, looking at borrowers’ credit payment history and their other existing debt, and setting terms that make sense for them. As is well known by now, it was the exotic loans originated by lenders without sound underwriting (or even verifying the information loan applicants submitted in many cases) that led to the mortgage debacle.

Common-sense underwriting, in fact, is what Congress had in mind when it passed banking reform last year and included that 5-percent risk requirement for banks along with the exemption for “safe” mortgages—that is, the qualified residential mortgage (QRM). As Sen. Johnny Isakson (R-Ga.) told the Washington Post about two weeks ago, high down payments “was not what we intended.” Rather, he told the paper, lawmakers decided against imposing a minimum down payment requirement on the understanding that it wasn’t necessary and out of a concern that too many households would get pushed out of the market.

The FDIC and Federal Reserve published their proposed rule about two weeks ago. Other regulators who have jurisdiction over parts of the mortgage finance market, including HUD, are joint authors of the rule (even though internally there are differences among the regulators over the amount of down payment requirement, according to reports).

The proposed rule is open for public comment until June 10. After that, the banking regulators must consider the comments prior to publishing a final rule, at which time the requirement would take effect. There’s no set time frame between when the comment period closes and when the final rule is published. It could be a few months or it could be much longer than that.

NAR has made clear getting the down payment requirement taken out of the rule is one of its priorities. When REALTORS® come to Washington in mid-May for the REALTORS® 2011 Legislative Meetings & Trade Expo, letting members of Congress know about how badly this minimum down payment requirement will hurt the housing market will be at the top of the list during REALTORS®’ visits to lawmakers’ offices on Capitol Hill.

Of course, many lawmakers already know about the issue and are champing at the bit to get that minimum down payment requirement out of the rule. As Sen. Isakson told the Washington Post a couple of weeks ago, “the regulators have hot heard the last of me.”

Past coverage.

Video on QRM

Robert Freedman

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