What % Down Payment Should Alleviate Risk Retention?

I would like to use this opportunity to lay down some principles that should govern this debate.  It is national policy that mortgage financing should migrate from the Government Sponsored Entities “GSE” back to the markets that remain mostly closed because of investor resistance.  Providing standards that promote investor confidence are the key to accomplishing this goal.  The Congress has required that loan originators retain a financial interest in sold loans unless they meet a standard to receive the designation of “Qualified Residential Mortgage.”

I was dismayed to see this weekend that an alliance of banks, real estate agents and consumer housing advocates are lining up to oppose the proposed 20% minimum down payment to avoid risk retention and receive the designation of being a “Qualified Residential Mortgage”.

Prudent home financing is a cornerstone of American economic policy.  When we fail to adhere to that we end up with a financial crisis and a recession with higher loans losses for the banks and investors, higher unemployment and lowered wealth for all.

Those in opposition say down payment alone does not determine creditworthiness and other factors should be allowed into the determination of what is a safe loan.  However, the purpose of risk retention is not to prohibit the granting of “Non-Qualified” loans.  It is an effort to provide an environment that will allow the securitization markets to resume their financing of a substantial percentage of home purchases.

Investors are correctly distrustful of mortgage pools without substantial down payments.   There is no coupon that compensates investors for credit losses when these losses arise from systemic risks and a lack of standards in mortgage loans is a systemic risk.  So if the market for residential mortgage securitization is going to be revived, there must be standards that can be believed.

Investors do not trust purchasers of homes to buy what they can afford.  Investors do not trust mortgage originators to verify income and non-real estate assets across a large pool of mortgages.  Investors do not trust the rating agencies to perform due diligence that mortgage originators are doing what they say they will do.  Investors do not trust that the regulators will do anything to protect the investors.  The only things that investors can trust are down payments that are meaningful or risk retention by the mortgage originators.

Since it is national policy to bring some balance back to the mortgage mark with a blend of GSE and private market activity, there must be substantial risk retention or substantial down payments.

When banks starting buying receivables from companies many years ago, 20x expected loss was a rough standard for risk retention.  20% down payments were the norm when the local bank held mortgages.  There is something about the number 20 when conservative bankers are thinking about credit enhancement to protect against loss.  Why should the securities markets deserve anything less?

As for the ability to originate loans that do not meet the “qualified” standard, this does nothing to prohibit such origination.  Such “non-qualified” loans can be held on balance sheet or sold into the market with risk retention.  National policy should be that loan originators accept the risk that they deemed prudent and the securitizations should be protected from all but a remote probability loss scenario.  That is the definition of a “AAA” security.  An environment like this will keep the cost of home financing at the lowest possible price for those who put up substantial down payments.  That is as it should be.