While the government-sponsored enterprises' move to allow down payments as low as 3% comes with some inherent risks, Fannie Mae executives are confident they can responsibly administer the new guidelines to ensure they're an effective tool for increasing access to credit.
Fannie Mae increased its minimum down payment standard to 5%, from 3%, in late 2013 (following a similar move Freddie Mac made in 2011). As they now prepare to reverse course, Fannie Mae executives acknowledge that they've faced questions about whether it's a prudent move.
It's a valid concern, particularly given regulatory restrictions on the size of the agencies' retained portfolios and capital reserves assets that would normally buffer against loan performance concerns, but have been stifled since the GSEs were placed into federal conservatorship. In addition, low down payment lending could pose a risk to guarantee fee profits at a time when G-fees are a significant source of Fannie's income; about half of total net interest income in the first nine months of 2014, up from approximately one-third in the first three quarters of 2013.
Still, Fannie Mae contends it's ensured the right counterparties, data, experience, and market conditions are in place to manage these risks. "We would not do so otherwise," Timothy Mayopoulos, Fannie's president and chief executive said during a Nov. 6 conference call with journalists to discuss third-quarter earnings.
Fannie was profitable in the third quarter, posting net income of $3.9 billion off net revenue of $6 billion, though earnings were down 55% from 3Q13. And even though the agency's post-downturn risk management isn't foolproof, improvements made to key areas of its operations would suggest Fannie Mae can safely offer lower down payment mortgages.
Due to the representations and warranties that lenders make testifying to their loans' soundness, Fannie or Freddie can, and do, require lenders to buy back problem loans.
That provides a level of protection to the GSEs and its investors, most notably the U.S. Treasury. But some public officials have expressed concerns that rep and warrant buybacks have become so severe that lenders are unwilling to make loans to a broad enough range of homebuyers.
Fannie needs loans to fuel its business and fulfill its mission to make homeownership more accessible. But it can't do that without lenders' participation. That's why in addition to lowering down payments, Fannie and Freddie have been working on making reps and warrants more palatable to originators albeit, potentially at a cost of taking on some more risk themselves.
While lowering the minimum down payments by 2% may not sound like much of a break, it can make a real difference in affordability to first-time buyers, said Marietta Rodriguez, who works on national homeownership efforts as a vice president at nonprofit group NeighborWorks America. "It's a lot easier to save 3% than it is 5%, especially in some high-cost markets," she said.
Private Mortgage Insurance
Private mortgage insurers that help cover risks on loans with down payments less than 80% will continue that role with higher loan-to-value mortgages, Mayopoulos said during the call.
One of the key reasons Fannie Mae and Freddie Mac's regulator, the Federal Housing Finance Agency, previously appeared reluctant to lower down payments was the fact that some private mortgage insurers failed to pay claims during the downturn. But the FHFA has been working on developing new capital standards for mortgage insurers as a safeguard against this issue. But the new capital standards for PMI firms could put upward pressure on borrower costs that could hinder use of the 97% LTV product.
"We are very optimistic about the direction the enterprises are going, but we want them to not make it so restrictive on the pricing and give the product a chance to really be successful," said Jason Madiedo, 2014 president of the National Association of Hispanic Real Estate Professionals and the president and CEO of the Las Vegas-based Venta Financial Group.
Risk Sharing Securities
Fannie Mae and Freddie Mac have created new securities designed to share some of the credit risk they take on in exchange for guarantee fees with the private market. Fannie also will be using these to manage the risk of higher LTV loans, Mayopoulos said.
Like the MI capital standards, this is still a work in progress, and Fannie's ability to use the risk-sharing securities is dependent on investor appetite. It would be tough to use these deals to lay off risk if investors' interest in them waned. But while early forms of risk sharing deals were explored before the mortgage crisis, they never were consistently sold in the secondary market the way they are now. And the risk-sharing deals have been much more active in the post-downturn market than private-label mortgage-backed securities, Mayopoulos said.
Home price depreciation is the key concern when it comes to higher LTV loans. During the downturn, prices in many areas fell significantly. If home prices fall, borrowers could end up with the property that has a value lower than the outstanding loan balance, particularly if their down payment was low. This can incent borrowers to stop paying for something that has become worth less than they owe and walk away from it. Home prices always have the potential to fall, and past data show declines greater than 3% are quite possible.
But loss of home equity in and of itself doesn't cause foreclosures so much as events like a job loss or steep medical bills do, said Rodriguez. In addition, Fannie won't layer the kind of multiple risk factors in loans as occurred during the downturn as this is much more likely to lead to foreclosure, Mayopoulos said. Fannie Mae also has risk-based pricing it didn't have then. Note that while 97% may sounds like a high LTV loan now, it's a far cry from the worst excesses seem in the private market in prior business cycles, when LTVs in some cases were as high as 125% or more.
Making a determination on a property's value is even more critical with a high LTV mortgage, and at least one data integrity study has shown material errors are still showing up in appraisals.
But Fannie, Freddie and now, the Federal Housing Administration, have embraced new technologies that standardize appraisal data and require lenders to electronically submit full valuation reports for review. While property valuations still rely heavily on appraisers' opinions, those determinations are now better backed by objective data.