Are banks refusing to make loans unless buyers put up a big down payment? Apparently so. Will this hurt the recovering housing market? Maybe. Is this all due to restrictive Dodd-Frank rules that ought to be discarded? Nope. Read on for the real story.
It turns out that Dodd-Frank allows banks to make any kind of loans they want. What it does say, though, is that if a loan fails to conform to its rules—one of which is a 20 percent down payment—then the issuing bank can't just bundle up the entire loan and immediately sell it off. It has to keep a 5 percent stake. Felix Salmon comments:
The question about high down payment mortgages is a relatively arcane backwater of financial underwriting, and we can leave it to the statisticians and bond investors to decide just how much, if at all, such down payments reduce defaults. Instead, we should be concentrating on the banks here, the institutions which seem to be entirely unwilling to underwrite any mortgage at all, unless and until they’re allowed to flip the entire thing, 100%, to bond investors, for a quick, risk-free profit.
This violates common sense. If the bank is underwriting the loan, the bank should retain at least a tiny amount of the risk in that loan. Indeed, if I were a bond investor, I would as a matter of course require extra yield on any loans which were sold by a bank without any skin in the game at all. After all, there’s not much point in being assiduous about your underwriting if you’re just going to sell the entire loan anyway.
Right. The whole point here is not to prevent banks from making whatever kind of loans they want. The point is to force them to have some skin in the game. If they want to lower their underwriting standards, that's fine. But if they do, they have to keep some of the risk for themselves. This acts as an incentive to be careful about who they make loans to, instead of returning to the Wild West of the aughts, when underwriting standards went completely to hell and fraudulent loans were made by the millions. That happened because the loan issuers didn't care: they were just going to bundle up the loans and sell them off anyway. Now they can't. As Felix says, if banks don't like this, we really ought to be asking, "Why not?"