Whose Skin Is In The Game?

Article from First Tuesday Journal Online

This article analyzes the benefits of requiring lenders to hold a greater fiscal risk associated with the loans originated in their portfolios.

Homeowner’s hold the risk

As federal regulators, private banks and real estate professionals make their way through the rocky plateau of this economic recovery, one question keeps arising: how much skin should homebuyer’s have in the game?

The rash of foreclosures from 2008 to the present, many of which were brought on by strategic defaults, is often attributed to the miniscule (or non-existent) down payments required by lenders during the zenith of the Millennium Boom. For example, the median down payment in Q4 2006 was as low as 4% in nine major cities of the United States (four of which were in California). [For more information on strategic defaults, see the November 2010 first tuesday article, “Walking away” from the great recession.]

Stricter underwriting standards in Q4 2010 are driving median down payments up. The median down payment in 2010 was 22% — the highest recorded since 1997, which was the first of three years of rising sales volume and prices coming out of the recession of the 1990s.

The push from lenders for higher down payments comes from the classic business logic of skin in the game: the more cash a homebuyer has invested in their home the less likely they are to default. Conversely, the choice to strategically default is easily made when the homeowner has nothing (or very little) invested and thus nothing to lose.

Given that higher down payments mitigate the lenders’ risk of homeowner default, many involved in this debate are calling for a minimum down payment requirement of 20% for all conforming loans, Federal Housing Administration (FHA) and Veteran’s Affairs (VA) loans being the exception for first-time homebuyers. Opponents of the 20% minimum down payment argue that such a move would effectively kill any hopes of a real estate market recovery by limiting homeownership to those few people who have amassed sizable savings.

History does not support this argument.

The question then remains: what is best for both the real estate market recovery as well as its long term sustainability?

Lenders guide the invisible hand

The fundamentals of this question are rooted in a much older and much more contentious debate: to regulate or not to regulate, a dialogue now controlled by lenders. Again, history shows that most all deregulation of lenders goes up in smoke. Money, their claimed commodity, is artificially supplied and managed by the government who is wholly dependent on lenders to circulate cash.

Due to a massive number of defaults on highly leveraged, non-recourse paper held by lenders, the market seems to be regulating itself at the moment, in a typically self-induced reactionary response to prior improper conduct. However, when profit potential is high, the probability for risk is quickly shirked, as always occurs in a momentum market.

When risk comes home to roost during the cyclical and inevitable recession, and lenders face the threat of illiquidity due to their unbridled profit-grabbing, suddenly underwriting standards become more restrictive. [For a concise picture of notices of default (NODs) and notices of trustee’s sale (NOTS) in the California real estate market, see the first tuesday article, NODs and trustee’s deeds: grim signs of real estate’s present condition.]

The problem with this invisible-hand approach to the so-called self regulating mortgage market lies in its reactionary nature. Higher minimum down payments are not and will not be imposed by lenders until after they have suffered a loss when they are under pressure from government for having injured its institutions and peoples. If we choose to allow the market to regulate itself, we will be doomed to repeat this cycle for perpetuity.

Risk where risk is due

If further regulation (read: re-regulation) is then deemed necessary to curb the occurrence of mortgage defaults in the future, how then should it be implemented?

While requiring borrowers to have more skin in the game will certainly help (first tuesday has long advocated 20% minimum down payments), this does not go to the source. If lenders are forced to retain more risk in their portfolio (rather than be allowed to sell it off through Wall Street bankers in their typical originate-to-distribute scheme) they will in turn require their borrowers to share that risk by putting more down to qualify.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) recognizes this necessity by forcing lenders to have more skin in the game. Lenders will soon be required by Dodd-Frank to retain 5% of the credit risk associated with each residential mortgage securitizing a mortgage backed bond (MBB). [For more information on regulations of the MBB market, see the May 2010 first tuesday article, The era of reform: new regulations for bankers creating mortgage-backed securities.]

Requiring lenders to back their own loans (at least 5% of them) is an organic approach to stabilizing the MBB market, which will contribute directly to stabilizing the housing market for the long term. The residual effect of regulating how much risk originating lenders are forced to retain will cause each homebuyer’s minimum down payment to fluctuate based on the risk associated with their loan, rather than imposing an arbitrary standard applicable to every buyer, which always leads to fraud.

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