In the decade before the 2008 financial crisis household debt increased greatly while the quality of the borrowers declined. Mortgage originators reduced required down payments, required less proof of credit worthiness, and approved less qualified borrowers. This worked because they made money on the volume, not quality or loans, and suffered no losses because all the loans were bundled and resold before any could go into delinquency or default.
In the aftermath, hindsight made clear that the incentives in the mortgage market were almost designed to create such a crisis. Regulators and Congress set out to prevent a recurrence of the subsequent mortgage market meltdown. Yet government completely failed to enact any meaningful reforms and the mortgage market certainly hasn’t reformed itself. It appears we are intent on repeating our recent history, costing borrowers and investors billions of dollars and a lot of anguish. The sad thing is we know the problems and the solutions.
We know down payments matter, but low down payment loans are back with a vengeance. The old, traditional, 20% down payment is amazingly effective at preventing mortgage default and any financial crisis emanating from residential mortgages. People work hard to avoid defaulting because they have considerable equity and are unlikely to end up underwater even if home prices drop. In the rare cases when lenders do have to foreclose, they either won’t lose money or will lose little because of that cushion of equity. Yet, even though we know requiring large down payments protects both borrowers and lenders, 3% down loans are rapidly returning to the mortgage market and zero down loans are likely to reappear soon.
While no documentation loans don’t officially exist anymore, the difference between the no-doc loans of 2007 and today’s alt-doc loans is pretty small. Sure, lenders must do a little more than collect a signature to demonstrate that the borrower can afford the mortgage, but it’s still a channel for people to get into trouble. While such loans have a…