As housing returns, so do risky practices

The timing of the real estate recovery couldn’t be better. Each June, the housing industry observes National Homeownership Month, a time to reflect on the broad desire for homeownership and the enhancement it has brought to many lives.

However, we must not let the promising signs of today’s housing recovery blind us to the harsh lessons learned during the worst years of the housing downturn, encountered just five years ago. It’s true that recently, federal regulators eliminated many of the riskiest mortgage products and practices through the issuance of the Qualified Mortgage rule, which takes effect next January. However, we are beginning to see some loan originators promote the return of 100 percent financing and other imprudent products and practices that may create substantial risk to the long-term health of the nation’s financial system. We can’t afford to return to the risky practices of the past.

For example, in the run up to the recent housing crisis, many credit-worthy borrowers who couldn’t afford a 20 percent down payment were guided away from time-tested low-down payment financing options using private or government-guaranteed mortgage insurance, toward so-called “combo” or “piggyback” mortgage products specifically designed to avoid mortgage insurance altogether.

Combo loans – first mortgages of 80 percent of the purchase price coupled with a second loan to make up the difference between the first and the borrower’s down payment – typically are marketed to higher-income home purchasers. The promise of lower payments may seem appealing on its face. However, for borrowers, the second loan starts at a higher interest rate, and often is structured with an adjustable rate that inevitably will go even higher as today’s historically low interest rates begin to rise. Rising interest rates could make such loans suddenly unaffordable for borrowers. On the other hand, in today’s environment, a borrower with an insured loan could enjoy level payments until they are able to cancel their insurance altogether, usually in about five years with private mortgage insurance.

In addition, the second lien of a combo loan typically resides completely on a bank's balance sheet, increasing its risk. And we now know that many combo loans also increased risk within the nation’s financial system, resulting in a significantly higher default rate than loans with traditional insurance. According to data from CoreLogic, the 4.9 million uninsured combo loans issued between 2003 and 2007 had a cumulative default rate nearly 40 percent greater than comparable loans with mortgage insurance.

The data says that these loans perform better in part because insurers work with lenders to apply underwriting standards that help ensure the borrower can repay the loan. And insurers – including FHA – require homeowners to invest their own funds in the form of a down payment in the home, a stark contrast to 100 percent financing.

Make no mistake; a robust low-down payment market is essential for today’s housing recovery. Since 2009, approximately 40 percent of all home purchases have been made by borrowers who make a down payment of five percent or less. Many first time homebuyers otherwise would have to save for a decade or more to make the hefty 20 percent down payment preferred by most lenders. As a result, financing options must exist but must be executed responsibly, with all parties having a vested interest in the long-term performance of the loan. When every player has capital at risk, they are smarter about how they pursue profits.

Polls show that for many, owning a home remains a key component of the American Dream. We must ensure that creditworthy borrowers continue to have access to affordable low down payment financing. However, for the long-term health of the housing market and national economy, it’s also important that policymakers and regulators of the housing finance system focus on financing options that have been proven to decrease risk to the financial system and to borrowers.

Gupta is president and CEO of U.S. Mortgage Insurance for Genworth Financial.

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