In addition to its usual recap of economic and housing indicators and future projections this week's edition of Freddie Mac's Insights and Outlook sought to put any potential risk of its the new 97 percent mortgages in context.  The mortgages, a program Freddie Mac calls Home Possible Advantage, were rolled out last spring and a similar program was introduced by Fannie Mae the previous autumn.

The new mortgages have safeguards to limit the credit risks associated with the low down payments including solid FICO scores and require private mortgage insurance.  A key element of the program is the elimination of layered risks; a combination of multiple risky features has been found to magnify the total risk of a loan.  It was layered risk that presented a significant vulnerability to loss in loans originated prior to the Great Recession.

Building on a quote from banker Walter Wriston, "Judgment comes from experience-and experience comes from bad judgment" the article says it was some of the market's bad judgments during the housing bubble that led to the losses experienced thereafter.  Those events in turn give markets the experiences that forge better judgment behind the design of programs like those now offered by Freddie and Fannie.  

Before Freddie Mac launched the program it had to assess the magnitude of the risk of low down payments.  To do this they looked at loans funded by the company between the beginning of 2000 and June 2013 and calculated the actual losses realized between January 2003 and the end of the period, a span the includes both peak loan losses and a more typical pattern of loss.  They measured the absolute risk by the average percentage loss on groups of loans but loss are dominated by the time period i.e. absolute risk would be higher in periods of unusually high loss.  Therefore Freddie Mac looked at relative risk, the ratio of the absolute risk of two comparable groups. For example, 3/1 hybrid ARMS had an absolute risk 35 percent higher than that of 30-year fixed-rate mortgages (FRM), or an absolute risk ratio of 1.35. 

The report says that, not surprisingly, low down payment mortgages were found to be relatively riskier than loans with down payments between 20 and 29 percent but what was surprising how small the difference was.  Loans with a 95 percent or higher loan-to-value (LTV) ratio were found to be only 31 percent riskier than loans with an 80 percent LTV - in other words about as risky as a 3/1 ARM.  Further, the relative risk of other types of loans was much higher.  Hybrid 7/1 ARMs were 155 percent riskier than 30-year FRM and 5/1 ARMS carried five times the risk.

So clearly one way to control the risk of low-down payment loans is to make that option available only for fixed rate loans, avoiding the payment shocks that can lead to financial problems - and not layering on additional risk.  When only FRM were analyzed Freddie Mac found 95+ LTV loans were 68 percent riskier than 80 LTV loans. This estimate is a bit higher than the 31 percent relative risk for all loan types but still much lower than the relative risk of medium-term hybrid ARMs. And at exactly 97 LTV, the maximum allowed by Home Possible Advantage, low down payment loans were only 17 percent riskier than 80 LTV loans.

Again quoting Wriston, "All life is the management of risk, not its elimination," Freddie Mac's economists concluded that low down payments, by themselves, do not carry unreasonable credit risk compared to other well-accepted mortgage products. Thus one key to reducing risk is to avoid layering on other components of risk.