Poor Case for Low Down Payment Loans

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Wednesday, 24 April 2013 14:15

One of the big issues left to be resolved in the debate over housing finance is the size of the down payment that homebuyers must put down in order for a mortgage to be considered a "qualified" mortgage. If a mortgage fits this definition, securitizers would not be required to hold capital against the mortgage.

NYT's Dealbook had a post discussing the topic which highlighted research by Roberto G. Quercia, director of the Center for Community Capital at the University of North Carolina at Chapel Hill, which purports to show that there is not much additional risk of default with lower down payments. In fact, the numbers presented in the piece imply that Quercia's research implies that low down payment loans have far higher risks of default. This means that lenders would either have to charge considerably higher interest rates or be subsidized for making these loans.

The NYT piece reports that Quercia found that the default rate during the years of the housing crash on a set of loans that met certain quality standards was 5.8 percent. However the default rate on loans with down payments of 20 percent or more was just 3.9 percent.

The piece reports that this higher down payment group comprised less than half of the loans in the study. If we assume that the 20 percent down payment group comprised 40 percent of the loans then this means that the default rate for home buyers putting less than 20 percent down was over 7.0 percent, more than 80 percent higher than for the 20 percent down payment group.

Furthermore, the losses for the less than 20 percent down payment group would be considerably higher on each default since there is less of a down payment cushion. If the loss for a default on a 20 percent down payment averages 25 percent, and we assume that the average down payment for the less than 20 percent group is 10 percent, then the losses for this group would average 39 percent of the amount loaned. (A 20 percent down payment is 25 percent of mortgage loan. A 10 percent down payment is just 11 percent of the amount loaned.)

Multiplying the increased probability of default (1.8) by the higher loss per default (1.6), the cost of default for the less than 20 percent down payment mortgages would be over 180 percent higher for the more than 20 percent down payment group, according to Quercia's research. That would not seem to be a good argument to apply the same lending standards for this low down payment group.

It is also worth noting that Quercia's assessment, as presented in the NYT post, that the 20 percent down payment would have excluded more than half of the borrowers does not follow from the evidence presented. If homebuyers knew that they had to put down 20 percent to get a lower cost mortgage, then they would be more likely to have a 20 percent down payment than in a context where this was not a requirement, as was true for the period examined by Quercia.