Expecting a Crush of Lenders for Low Down Payment Mortgages?

The most prominent obligation for federal bank regulators – the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, and the Controller of the Currency – is to avoid another taxpayer bailout as happened in 2008. The Troubled Asset Relief Program (TARP) infused $250 billion into banks to stabilize them.  The program was embarrassing to banks that did not need the help, and it infuriated some taxpayers who saw it as a handout to the rich.  All TARP funds have since been repaid, yet resentments linger and no politicians want a repeat of that mess on their watch.

Much of money that banks “borrow” is ordinary consumer deposits that are insured by the Federal Deposit Insurance Corporation (FDIC).  Since the federal government backstops the FDIC payouts, the taxpayer is at risk if a bank were to fail.

Dodd-Frank regulations limit some bank risk by blocking banks from trading securities for their own account (the Volker Rule), they strongly discourage participation in some legitimate businesses (e.g. materials warehousing),and they set a higher capital ratio that forces banks to use much more of their own capital, i.e. less leverage.

A higher capital ratio means that for any portfolio of actual loans the bank makes (e.g. consumer mortgages, car loans, small business loans) the bank must invest more of its own equity dollars than previously.  When totaling up bank assets, assets are risk-weighted (i.e. $1 million in Treasury bills accounts for more than $1 million in distressed mortgages).  Before the recession, capital ratios were often in the 6% range or less, but the current capital ratio requirement is 10%.  That 66% hike makes the process of loaning money less efficient, and the bank will need to increase the interest rate it charges on actual loans to scrape together a return for the additional funds the bank was forced to invest.   This balance sheet hardening may not cost regulators a dime, but is has strategic consequences for banks and it causes inconveniences and higher costs for consumers.

Dodd-Frank regulations have reduced credit card swipe and overdraft fees the banks relied on.  Cuts in fees and mortgage margins are leading many banks to close rural bank branches.  Citibank is also closing many suburban branches across the US, and all of its branches in some countries.  Evidently Citi hopes to transition away from being a consumer bank to become a capital markets bank.  Fewer bank branches results in consumer inconvenience and reduced competition (i.e. less innovation and less price competition).

Meanwhile Fannie Mae and Freddie MAC announced they will begin accepting mortgages for borrowers with as little equity as a 3% down payment.  This comes close to the zero down payments and liars loans that set conditions leading to the 2008 recession.  At least this time around, actual documentation of income is required.

It is ironic that banking regulators force banks to avoid a lending leverage more than 10 to 1, while federal mortgage lenders accept mortgages with 32 to 1 leverage.  Under current rules, if a mortgage slips into default, the issuing bank has to accept a big part of the loss.  So, under today’s conditions, the odds are high that a mere token number of low down payment mortgages will be issued by banks.