The housing market is showing signs of life as home prices rise and mortgage-backed bonds return, but the revival may not gain full steam until regulators sort out one of the thorniest problems: the appropriate size of a down payment on a house.
After the housing collapse, initial reform proposals emphasized the need for buyers to put down a large chunk of money. The reasons seemed sensible and obvious. Many of the mortgages that went bad involved tiny down payments if any at all and studies have shown that borrowers with a larger amount of equity in their homes are less likely to default.
"If our goal is to prevent foreclosures," said Paul Willen, a senior economist and policy adviser at the Federal Reserve Bank of Boston, "I can't think of anything more effective than requiring a down payment."
In a surprising reassessment of the causes of the housing mess, however, many lawmakers, lenders and consumer advocates are now cautioning against rules that would require many borrowers to come up with significant down payments. Their main concern is that such efforts could end up cutting the supply of mortgages to lower-income borrowers, who simply do not have the money to put down. They also contend that the subprime debacle has distorted the issue.
"The problem with this conversation is that it's like discussing the future of shipbuilding from the deck of the Titanic," said Roberto Quercia, director of the Center for Community Capital at the University of North Carolina, Chapel Hill. "There's a lack of perspective."
Quercia studied mortgages in a special program for low-income borrowers, typically those with a minimal down payment. From 1998 through the end of last year, 5.5 percent of the mortgages ended up in foreclosure, he found. Subprime mortgages made during the last housing boom, regardless of down payment size, had far higher foreclosure rates, roughly 25 percent.
The outcome of the down payment debate has major implications for the mortgage market.
Currently, taxpayers, through the Federal Housing Administration, backstop most of the low-down-payment mortgages. The aim is to scale back the government's involvement in mortgages.
As that happens, policymakers are hoping a major part of the mortgage market will come back.
Specifically, they need the return of private bond investors, who once bought trillions of dollars worth of mortgage-backed bonds with no government backing.
Consumer advocates make a nuanced case. They do not deny that down payments reduce the risk of default, but they say defaults can be reduced almost as much by applying other rules that curb lending to certain types of borrowers.
Consider another set of mortgage rules, which were already put in place this year. These regulations emphasize the affordability of the loan. Under them, a borrower's overall monthly debt payments cannot exceed 43 percent of personal income.
In his study, Quercia found that loans that complied with those rules defaulted at a relatively low rate during the housing bust. About 5.8 percent of them went bad, irrespective of how much the borrower put down.
He then calculated the losses on loans to borrowers in the same group who had down payments of at least 20 percent. The default rate on that smaller group was lower, at 3.9 percent.
That lower rate came at a cost, though. More than half of the borrowers in his study group had to be excluded from the second calculation, because they didn't have a down payment of 20 percent or more. This shows how restrictive a down payment rule could be, Quercia said.
Some real estate analysts are skeptical of this approach. They assert that the new mortgage rules, which do not insist on down payments, may be relatively ineffective at preventing high levels of defaults.
This type of ratio is not a strong predictor of whether a loan will default, said Thomas Lawler, a former chief economist at Fannie Mae who founded Lawler Economic and Housing Consulting, a research firm. "It's not even in the top three," he said.
Also, Lawler and others who favor higher down payments argue that Quercia's analysis underestimates the psychological and practical importance of the down payment.
Borrowers who saved up for a down payment may have budgeting skills that later help them make their payments, they argue, and borrowers with equity in their homes are less likely to walk away altogether rather than try to find a solution.