The financial crisis and Great Recession began with the bursting housing bubble, and the disappointing growth in the economy since then is largely correlated with the lackluster rebound in housing.
As a result, government policymakers and central bankers have gone to unprecedented lengths to buoy the housing market. There was the $8,000 first-time home buyer tax credit. The Federal Reserve dropped its benchmark interest rate to 0% and then went a step further with quantitative easing and "Operation Twist" to move rates even lower. Government-backed housing agencies such as the FHA, Freddie Mac (NYSE: FRE-PK), and Fannie Mae (NYSE: FNM-PK) revised lending policies to make it easier for home buyers to obtain financing even as bank lending dried up.
Yet even with all these stimulus measures, the housing market has lagged.
Case-Shiller Home Price Index: Composite 20 data by YCharts.
The Federal Reserve Bank of New York thinks it might know the reason, as it explains in a report released Monday.
Down payments matter more
When it comes to home sales, the conversation usually starts with mortgages. The vast majority of Americans need a loan to buy a house. Obtaining that loan can be the most difficult hurdle to overcome in the home buying process.
The interest rate that banks charge for the loan (plus any fees) is the cost of that loan. Therefore supply and demand tells us that lower mortgage rates will boost home sales by making home ownership more affordable -- and the Fed's new research report confirms this. Using a complex survey technique, Fed researchers conclude that a 2% drop in mortgage rates will increase a potential home buyer's "willingness to pay" by 5%. "Willingness to pay" is used as a proxy for housing demand in this research.
What mattered even more, though, was the required down payment, particularly for lower-income borrowers. In the study, consumers' "willingness to pay" increased by about 15% when the required down payment decreased from 20% to 5%. For buyers who are currently renting, "willingness to pay" spiked 40% with the decreased down-payment requirement.
This suggests that the best tool to increase home ownership, particularly among individuals and families who don't currently own a home, is to reduce the down payment requirements on mortgage loans.
Pay attention, bankers and policymakers
Logically, this correlation makes sense from the perspective of potential buyers. These borrowers have monthly income and can easily gauge whether they can afford a given monthly payment. Changing the interest rate will moderately impact that affordability and cash flow.
On the other hand, it can be quite difficult to save up for a 20% down payment. That down payment could reasonably be $20,000 to $40,000 in most markets. That lump sum is clearly the a significant limiting factor in purchasing a home.
Fortunately, policymakers are paying attention. Fannie Mae and Freddie Mac are both working on programs to increase mortgage loans with down payment requirements of just 3.5%. These programs will complement existing low-down-payment mortgages available from the Federal Housing Administration.
Banks should also take heed of this research when designing products and programs. In today's mortgage market, banks originate mortgages based on underwriting guidelines provided by the FHA, Fannie Mae, or Freddie Mac. The bank collects the origination fee for that mortgage and, in most cases, then sells the mortgage into the secondary market as a mortgage-backed security. Other times the bank may hold that mortgage on its books and collect the interest payments over time as income.
Banks must balance the desire to originate mortgages, collect more fees, and grow interest income with the need to avoid making bad loans. And one of the strongest underwriting criteria for making good loans is requiring a higher down payment.
A mortgage market still in flux
Attempts by Fannie and Freddie to design lower-down-payment mortgages are an effort to balance the need for higher housing demand with the reality of common-sense underwriting.
It also highlights the problem the housing market still faces today: Demand is lagging despite interest rates that remain at generational lows, and while lower down-payment requirements are the most effective way to increase demand, loosening that requirement opens up the mortgage market to potential future problems if those loans go bad.
What we have here is a market stuck between a rock and a hard place.
For policymakers and banks alike, the challenge will be continuing to find new ways to entice individuals and families to take the plunge into home ownership without tipping the scales too far and putting the safety and soundness of the banks and broader market at risk.
