The fallout from the 2008 mortgage crisis, prompted regulators to search high and low for solutions to their most pressing questions.
But by 2010, their findings – which led to the creation of the Dodd-Frank Act – had already become blurred by preconceived notions about the role of risky, low downpayments in the underwriting process.
Meanwhile, the market and regulators largely ignored the weighty impact of inflated home values in general.
Ed Pinto with the American Enterprise Institute, who has consistently attacked government housing policies leading up to the housing crisis, is back with what he considers to be more proof of how flawed property valuation practices – combined with leverage increases – cause boom-bust cycles in real estate.
Pinto points out that prior to the 2006 bubble, the Federal Housing Finance Agency home price index stayed relatively in line with the Bureau of Labor Statistics Equivalent Rent Index. But by 1998, the two barometers began to deviate, Pinto says.
By 4Q 2006, the HPI was 40% higher than the labor department’s ERI. The vast space between the two suggested to Pinto that housing prices ended up escalating well beyond natural levels.
After the market bust, the idea permeated throughout the market that requiring less than a 20% downpayment – or no downpayment at all – was one of the major catalysts for housing running amok.
Pinto’s data paints a picture where higher prices – and overleveraged borrowers – had more to do with the housing meltdown than exceptionally low downpayments.
First, he looked at what was once considered a “bullet proof” pool of 2007 vintage 30-year, fixed-rate loans, fully documented at Freddie Mac with downpayments in the 30% to 39% range. The FICO’s in this group fell well above the 720 mark. Unfortunately, this group didn't perform much differently than a 1999 vintage group with 720-plus FICOs and only 3%-to-9% downpayments.
"The 2007 vintage had a 1.55% failure rate by mid-2012 similar to the loans from 1999 by mid-2012. This performance similarity, notwithstanding a 30% difference in downpayment, is directly attributable to the large deviation between HPI and ERI in 2007, the result of the value in LTV being based on comparable value, not intrinsic or fundamental value,” Pinto writes.
The takeaway from Pinto’s report is that downpayments alone cannot be blamed for the toxicity of a particular loan pool. Even with high downpayments, the 2007 vintage experienced performance rates similar to loans written a decade earlier with downpayments as low as 3%.
Controlling for all factors, what caused these two very different groups to experience similar default rates? The answer lies in the value of the home – or the overinflated value – since flawed property valuations led to an escalation in the overall principal amounts borrowers were taking on after 1998.
So the 2007 borrower may have put 30% down, but that didn't save the homeowner once the devastating impact of artificial price inflation became known to the market as a whole.
Click here to read Pinto's full blog post on this subject.