Fannie and Freddie to Back Three Percent-Down Loans, Safely

Recently the FHFA announced that it would begin to allow the GSEs to finance loans with as little as 3% down payments.  This news was received with mixed reviews.  Some view it as an improvement in access for entry-level buyers while others see it as a step down the path of loose lending that brought down the market in the mid-2000s.  In fact, this step is only a modest change that will likely be done under common sense restrictions to augment successful lending with a small impact on market.  However, it should provide a positive signal to lenders.

In response to rising defaults and losses, the GSEs both eliminated their 3% down payment products in recent years in lieu of higher 5% minimums.  However, roughly two weeks ago, the new Director Mel Watt announced the restitution of this program.  Critics are concerned that this change would harken a renewal of the loose lending that brought down the housing finance system in the mid-2000s.

In a speech Friday at the Residential and Economic Trends Forum at the 2014 REALTORS^® Conference & Expo, the Director clarified that, "…the guidelines will require that borrowers have compensating factors — such as housing counseling, stronger credit histories, or lower debt-to-income ratios — in order to make the mortgage eligible for purchase by Fannie Mae or Freddie Mac."  As depicted below, examination by FHFA economists suggests that FICOs scores are very important in mitigating risk and that a borrower with a 740 FICO score and only 3% down payment has on average a lower foreclosure rate than a borrower with a 660 and more than 20% down payment.  What’s more, the agency’s work has shown that foreclosure rates vary by debt-to-income ratio.   The Department of Housing and Urban Development cited research for its HAWK program that found a decline in delinquency of 19% to 50% for borrowers who went through pre-purchase financial counseling.  Finally, all loans financed by the GSEs must conform to the qualified mortgage rule.  Researchers at the UNC Center for Community Capital found that loans originated between 2001 and 2008 that met the QM standard save for the 43% back-end debt-to-income requirement experienced a 5.2% 90-day delinquency rate through 2011.  This was well below the 5.8% for all QM loans and roughly 17.6% rate for all non-QM mortgages.  In short, the underwriting the GSE’s employ will act as a foil against defaults.

But the FHFA will be in crowded company as it ventures into the lower down payment portion of the market.  The FHA offered its 3.5% down payment product throughout the recovery while the VA dramatically expanded its mortgage program that requires no down payment.  Likewise, the USDA’s rural housing program and state housing finance agency programs have been important sources of low down payment funding.

FHA financing has been expensive in recent years, though, as the annual mortgage insurance premium has increased nearly 80 basis points since 2008.  The GSEs’ entrance into this portion of the market will provide a more affordable option to the FHA, but it will be priced relative to risk by both the agencies and their private mortgage insurer (PMI) counterparties.  The GSEs do not currently price for the 3% down payment product, but they do increase loan level pricing adjustments based on DTI, FICO and LTV.  Furthermore, private mortgage insurers like MGIC do price this risk charging 1.1% in annual PMI for a borrower with a 740 FICO and 3% down payment mortgage compared to just 0.71% for the same borrower putting down 5%.  The fee jumps to 1.48% for a 660 borrower with 3% down payment versus the FHA’s permanent MIP of 1.35% and UFMIP of 1.25%.  In short, as depicted below it will make financial sense for borrowers with credit scores below 720 to remain at the FHA or make larger down payments.  These borrowers could save $25 to $40 per month with this change.

This segment of the FHA’s business is significant, though.  Based on the FHA’s Quarterly Report to Congress, FHA’s production with FICO greater than 720 and down payment less than 5% was roughly 13.7% of its purchase production in the first half of 2014, down from 18.5% in all of 2013. It would comprise roughly 4% or less of the GSE’s purchase production.  Given the low default risk and high premiums that this portion of the market generates, it could impact the agency’s bottom line.  However, the high and permanent PMI structure at the FHA and low rate environment has led to an increase in run off as FHA borrowers gain equity and seek to refinance into better, non-permanent PMI rates.  Because of this existing run off, the impact of competition in the 3% space would be limited, but more permanent.

The fact that PMIs are currently pricing this segment is important as well; it demonstrates that private capital is willing to take this risk.  Thus, this shift by the FHFA has important implications for lenders as it signals the willingness of the agency to back off its extreme risk aversion, a change that should reinforce the agency’s recent overtures on repurchase agreements giving more comfort to lenders and a potential expansion of credit down the road.

While the FHFA’s recent announcement of the return of its 3% down payment program will improve affordability for a limited number of borrowers, it will be done with compensating factors that will limit risk and the size of the program.  More important may be the signal that it sends to lenders: the GSEs are following the example of private mortgage insurers and reaching out to borrowers.