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Why offering 3 percent downpayment mortgages is not a return to lax lending

(David Ryder/Bloomberg)

The government’s latest push to jump-start the housing market involves allowing Fannie Mae and Freddie Mac to accept mortgages with down payments as low as 3 percent – versus the 5 percent minimum currently required by the two mortgage giants.

Regulators said the move would help make more mortgages available to “creditworthy but lower-wealth borrowers.” Critics called it a return to lax lending standards that would lead to more loans defaulting.

But researchers at the Urban Institute – and, more recently, the chief executive of Fannie Mae – said the latter outcome is unlikely.

The researchers -- Taz George, Laurie Goodman and Jun Zhu – analyzed the performance of low down payment loans backed by Fannie Mae in the recent past. (Fannie accepted 3 percent down until late 2013.) They found that the default rate for loans with 3 percent to 5 percent down were  very similar to the default rates on loans with 5 percent to 10 percent down. They also found that very few borrowers got the lower down payment loans (peaking at 3.4 percent in 1999). And nearly all of those who did had top-notch credit.

Their analysis concluded that the proposed change would be “no big deal.”

In an earnings call with reporters Thursday, Fannie officials made a similar point. “We have substantial experience with these loans, and we have analyzed their performance,” Timothy J. Mayopoulos, Fannie’s chief executive, said. “In short, these loans have performed well.”

Fannie and Freddie do not make loans. They buy them from lenders, package them into securities and sell them to investors. For a fee, they guarantee the mortgages and then pay investors if the loans default.

Fannie and Freddie only buy loans with less than a 20 percent down payment if they carry private mortgage insurance, so even if some 3 percent low down payment loans were to default, taxpayers would not be forced to take a loss first, Mayopoulos said.

Fannie purchased these low-down loans for many years, at least dating back to 1999, and continues to accept them for mortgages made through state and local housing finance agencies. The mortgage insurance industry said it continues to insure those loans, and they’re doing well.

In fact, taxpayers are better off if Fannie and Freddie support more low downpayment mortgages, said Rohit Gupta, chief executive of Genworth US Mortgage Insurance. It might mean that fewer borrowers seek loans backed by the Federal Housing Administration, which accepts loans with as little as 3.5 percent down. With FHA, taxpayers are on the hook for 100 percent of a loan that goes bad. With Fannie and Freddie, the mortgage insurance industry would absorb most of the losses for a loan that defaults.

But the question remains: Will lenders offer loans to borrowers with an 3 percent down payment simply because Fannie and Freddie allow it? After all, the industry didn’t make many of those loans back when it could.

Since the housing bust, lenders have been forced to buy back billions in loans from Fannie and Freddie, and big banks have agreed to multibillion-dollar legal settlements tied to the crisis. In response, the industry has tightened its lending standards beyond what Fannie and Freddie require to insulate itself against more penalties and lawsuits. So it’s no wonder they’ve shied away from low down payment loans.

“From their point of view they were suffering a lot of beatings,” Mayopoulos said. “There’s a legal and regulatory environment that I think lenders are still fearful of.”

To get the industry to ease up, the regulator who oversees Fannie and Freddie recently announced that it would clarify the rules that determine when a buy back should take place. The details should be released in coming weeks. That should help allay the industry’s concerns, Mayopoulos said. “Many lenders have said to me they are encouraged by these developments and they are planning on adjusting their practices,” he added.

But Mayopoulos acknowledged that none of the steps proposed, including the low down payment loans, are a “silver bullet” in and of themselves. It remains to be seen how lenders will respond. It's also unclear how many potential borrowers will seek out such mortgages given that some first-time home buyers, who generally struggle to save for a down payment, still face many challenges in today’s tough job market, Mayopoulos said.

Fannie and Freddie have yet to announce the details of the 3 percent-down program.

“We believe that by going to a [3 percent-down loan] we will reach more credit-worthy borrowers,” Mayopoulos said. “How many more is yet to be determined.”