Let's say we are mortgage lenders who managed to dodge most of the bullets that killed or maimed so many of our fellow bankers last year. We want to stay in business and keep lending to qualified borrowers, so we must come up with updated lending standards for 2008 and 2009, specifically the down payment required.
The reason we focus on down payments is because research has shown that negative equity (i.e. a house worth less than the mortgage outstanding) is the single biggest factor leading to default. Most models today view mortgages as contracts with attached put options favoring the borrower: when the house value drops significantly below the loan amount the borrower can "put" the house back to the lender and simply walk away (a.k.a. "jingle mail").
In recent years, we have also become aware of shifting social attitudes: debt is no longer viewed as a "moral" obligation, a binding social contract between consenting parties, but as an adversarial relationship between borrower and lender. Therefore, as conservative businesspeople we must also account for a higher probability that borrowers will walk away from their debts, if it suits them.
(This phenomenon requires a discussion all by itself. In brief, I believe it is ultimately the product of leadership failure, the placing of inordinate emphasis on "free" markets and individualism instead of regulation and the development of cohesive social structures. Let me put it in this - admittedly extreme- way: in the jungle no one owes anything to anyone.)
In order to set the down payment percentage required, we must first predict the direction of house prices. In the past, declines were rare, isolated to specific areas and/or lasted for brief periods. Clearly, this is no longer the case; the bursting of the national real estate bubble has changed everything. We must, therefore, come up with some reliable estimate of what house prices will do over the next couple of years. So, we turn to Fannie Mae, the world's largest mortgage buyers, who predict that on top of the 2.2% decline in 2007, house prices will drop another 4.5% in 2008 and 2.6% in 2009. This means that a house we finance today will be priced at 93 cents on the dollar two years out, i.e. our collateral will be worth 7% less.
Based on the above, what down payment will we require to minimize defaults? What kind of error margin are we going to add - if any - on top of Fannie Mae's projections? Will 10% down suffice, or will we ask for 15-20% to be on the safe side? Or will we throw caution to the wind, call it a bottom and try to become the Sultans of Loans by increasing our market share with no-money down loans?
See the problem? The Sultans of Loans model is dead (just ask Countrywide) and the remaining, conservative lenders are increasingly asking for higher down payments. How many savingless Americans can today afford to plunk down 10-20% cash for a house? Let's do some more simple arithmetic:
A two-earner American household has an average disposable income of $70.000/yr. Let's assume they want to buy a $300.000 house and need to put down 15%, i.e. $45.000. Starting from zero, the couple will have to save 5% of their income for 13 years, or 10% for 6.5 years. Compare that saving rate with reality, as shown in the chart below:
Americans haven't consistently saved 5-10% of their income in decades and are currently at 0%, or even negative saving rates. How will they put together the required deposit for a house?
Ladies and gentlemen of the SuddenDebt S&L Credit Committee,
I am sorry to report that we are in for the long haul in this real estate/credit crisis. It's simple arithmetic... And on this day of hugs and kisses for our loved ones, I have to recommend that hard love is the only course we can take with our potential borrowers. Otherwise, our liaisons will become very dangerous, indeed.
P.S. I just got this from our Realtor (R) friends:
The median sale price of a U.S. home dropped 5.8 percent to $206,200 in the last three months of 2007 from $219,000 in the same period of 2006, the realtors group said today. Prices fell in 77 of 150 metropolitan areas, the most since the group began tracking values in 1979. The decline was 10 percent or more in 16 metro areas, the association said.