Credit markets have been gradually thawing, but the qualifications to get a mortgage have remained relatively constant. However, there has been extensive coverage suggesting that the standard 20% down payment requirement may be loosening. In fact, three banks in particular -- Bank of America (BAC 3.35%), Wells Fargo (WFC 2.74%), and Toronto-Dominion Bank (TD 1.47%) -- are all offering loans with down payments as low as 5%, and some can even come from gift funds.
The question is: What does this mean for the housing market and for the bottom lines of these banks?
New lending standards: It's not 2005 again
The term "bubble" gets thrown around an awful lot these days, especially in regard to the housing market. In this case, however, the term may not apply. Lending standards over the past decade have generally been at one of two extremes.
In the years leading up to 2007 or so, virtually anyone with a pulse qualified for a mortgage. There were low-doc, no-doc, nothing-down, interest only, and everything in the middle. I know someone who made $35,000 per year, had a 530 credit score, and got approved for a $175,000 loan with nothing down!
Since that time, lending has been pretty rigid. A 20% down has been a requirement for a traditional mortgage, and buyers have to demonstrate that they will easily be able to make the payments. A strong income and a 700 credit score have become the new standards.
Like most things that go to extremes, the right answer is probably somewhere in the middle. Rigidly requiring 20% down is probably excessive, but buyers absolutely need to prove their ability to pay. That's where these new loans, such as TD's Right Step mortgage, come into the picture. Not only does the loan allow for a 5% down payment but up to 2% can come from a "gift," which effectively makes the minimum down payment only 3%.
It's all about opportunity
The main reason we're seeing these types of loans pop up is supply and demand. Over the past several years, FHA loans were one of the only options available with a low down payment. Now, the FHA has begun to raise premiums and is requiring borrowers to pay mortgage insurance for the life of the loan, as opposed dropping it once the loan-to-value ratio hits 80%.
So the combination of improving real estate values, loosening credit markets, and the high demand for affordable low down payment mortgage loans has created a huge market for these types of loans. For example, Wells Fargo's Home Opportunities program not only allows for a small down payment but has flexible income and credit guidelines.
The housing market: What could low down payments mean?
So before we look at how the banks could make money, it makes sense to examine how this will affect the housing market. For the most part, the group that is most likely to need a low down payment loan are first-time buyers. Tight credit and rising fees of the only affordable option, the FHA, have reduced the percentage of first-time buyers making purchases. In September, only 28% of buyers were first-timers, compared with the historical average of 40%.
An increase in low down payment options could help banks in a couple of ways. First, and most obviously, if first-time buyers return to their average market share, this would mean a 42% increase in first-time buyers, which would be an approximately 12% increase in total mortgage volume. This would (in theory) increase banks' mortgage income by the same percentage.
A secondary effect of having 12% more buyers and the increased demand they bring will be increasing real estate values. This helps the banks' average income per loan, as a lot of fees and charges are based on the size of the loan. Also worth noting is that higher real estate prices will help to lessen the losses experienced by banks when unloading foreclosed properties from their portfolios.
How it will affect the banks
To see what kind of impact this could have on individual banks, we need to consider the percentage of the individual banks' income that comes from their mortgage businesses. This depends on each bank's exposure to mortgages, which can vary greatly between institutions.
For example, in the most recent quarter, Bank of America produced $465 million in revenue from new mortgages. If this amount were to increase by 12% from first-timers returning to the market (not accounting for rising home prices), it could mean an extra $56 million in quarterly profits, which would increase the company's annual earnings by about $0.02 per share, or by about 2.2%.
However, Bank of America has relatively low exposure to the mortgage market compared to Wells Fargo, which originated $80 billion in mortgages during the most recent quarter and produced income of $1.61 billion. The same 12% increase for Wells Fargo could add $193 million in quarterly profits, or a $0.15 per share annual earnings increase, which would mean a 4% boost in profits based on this year's earnings.
Final thoughts
With banking fundamentals improving across the board, this is yet another way that companies with substantial mortgage businesses can profit from the improving economy. Bear in mind that when you factor in the other benefits to these loan programs, such as increased home values, easier unloading of foreclosures, etc., that the impact on the banks' bottom lines could be much greater.
