New Mortgage Down Payment Hike Could Make A Serious Dent In The Market

NEW YORK (TheStreet) — U.S. housing remains on life support and government plans to “fix” mortgages by increasing down payments may end up pulling the plug on housing recovery, banks fear.

As soon as next week the U.S. Treasury Department may introduce new draft rules that will increase the amount of equity borrowers will need to have in their homes in order to stand a reasonable chance of qualifying for a mortgage that does not have a government guarantee to as much as 20%.

Requiring a minimum 20% down payment for an official designation referred to as qualifying residential mortgages (QRMs) is probably the right medicine, concedes Christopher Whalen, analyst at Institutional Risk Analytics. However, he believes the U.S. housing market, and ultimately the economy, is still too fragile for such a strong dose.

“It’s hard to argue intellectually against 20%, but the market conditions right now require the same aggressive response on the housing side that the Fed has given us in terms of the market. And I really worry about that, because whatever recovery we get in the non-housing sector is going to be offset by the continued deflation in housing,” Whalen says.

In other words, policymakers should be trying to stimulate lending, not rein it in, in Whalen’s view.

“We’ve got to think about expanding the volume of available lending capacity to this market. We have 35 million households out there who haven’t refinanced who have optionality in their mortgages and as duration extends and rates go up they’re going to get crushed, so they will turn into defaults. It’s right there and yet the policymakers don’t get it,” he says.

A frequent critic of the banks, Whalen nonetheless finds himself agreeing with them on this issue. Both the American Bankers Association and the Mortgage Bankers Association told American Banker last week that a 20% down payment requirement is too onerous and will cause a serious slowdown in home buying. The trade groups did not return calls from TheStreet seeking comment.

Bank of America (BAC) and JPMorgan Chase (JPM) have not taken a public position on how they think a QRM should be defined, according to spokespeople for those banks. Spokespeople for Citigroup(C) and GMAC Mortgage had no response by the time of publication.

Wells Fargo (WFC) has been the only major mortgage lender to stake out a strong position, supporting an even higher down payment requirement of 30% for QRMs.

Not every loan needs to be a QRM, says Wells Fargo spokeswoman Vickee Adams. Lenders extending credit to borrowers who put less than 30% down would have to retain a portion of those loans on their books–probably 5%, according to the Dodd-Frank financial reform legislation passed last year.

It should be said that the law applies not to individual home loans, but rather to home loans pooled together and then sliced up and sold as securities–a process known as securitization. Securitization is what created the housing boom, because it allowed banks to move home loans off their books, thereby freeing up capital for still more loans.

But the Dodd-Frank law will now require banks to hold onto 5% of the securities they sell for at least two years after the date of issue. This “risk retention” provision of Dodd-Frank–sometimes referred to as the “skin in the game” rule–has made a few bankers hopping mad.

Richard Dorfman, head of the securitization group at the Securities Industry and Financial Markets Association, one of Wall Street’s main lobbying organisations, describes a meeting he attended recently at which “one of the very very dominating servicers and originators and issuers had seriously critical remarks about retention and the fact it had not been reduced to measure what is the cost of applying these various measures like retention and others. What is the cost of putting this into these programs and how can we plan a product program if we do not understand the cost implications?”

Those inclined to distrust such arguments from banks might be more easily convinced by Arturo Cifuentes, who has been credited with sounding the alarm early about the risks that were building up during the securitization boom. Even putting aside the cost implications, Cifuentes, a former Wachovia executive who is now a professor at the University of Chile, doesn’t believe risk retention actually works.

“A lot of people– politicians, Dodd Frank, etcetera make a big fuss about what they call skin in the game. It sounds like a good idea but in practice makes no sense. The thought is that if you have skin in the game a securitization should perform better but the evidence doesn’t support that view, ” says Cifuentes.

As an example, Cifuentes points to the monoline insurance industry. “It’s difficult to think of anyone with more skin in the game than MBIA or Ambac or ACA and they all went to the toilet,” Cifuentes says. “PIMCO on the other hand has originated several CDOs and never taken equity in them. They have performed reasonably well.”

Much of this debate is likely to prove academic if, as expected, the new rules requiring a 20% down payment exclude government-backed mortgages. Since those still make up roughly 90% of the market, its hard to get too excited about what happens to the other 10%–no matter how strict the underwriting requirements.

While the Obama Administration surely wants to bring that 90% number down, many observers expect that to be a multi-year process. According to that way of thinking, government officials and regulators will seek to avoid big surprises as they look to articulate a policy on housing finance.

“What I’ve heard from the Administration and what I’ve heard from Congress is that we have a pretty fragile real estate market out there right now, so you need to take things relatively slowly in the process,” says Nathaniel Otis, analyst a Keefe, Bruyette & Woods. “Most people think that the best course of action might be–whether they want full privatization or 20% or even 30% down there’s an element that you want to make sure there’s a smooth transition from where we are now to where we’re going to be in the future.”

This post originally appeared at The Street.

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