The S-Curve

Federal Home Loan Bank of San Francisco's Innovations in Mortgage Finance Symposium

Richard Cooperstein

The Federal Home Loan Bank of San Francisco directed the Urban Institute to develop innovative and actionable ideas to close the gap between white and black homeownership rates, which is as wide today as before the Fair Housing Act, enacted 60 years ago. Homeownership is crucial to a fairer society because working and middle-class families most commonly create inter-generational wealth by owning homes with amortizing mortgages. Urban Institute’s eighteen-month effort culminated in a symposium in February in Los Angeles attended by dozens of housing experts. The Borrowers Mutual Escrow Fund (BMEF), which I developed a few years ago, was included in the Urban Institute study, and I was invited to discuss it at the symposium.

A few key themes emerged from the symposium. One centers around replacing decades-old credit scores with modern metrics that better reflect borrower financial condition as the consumer financial footprint has become increasingly digitized, especially among minority populations. These metrics generally extend beyond traditional credit profiles to include other important measures of borrower financial condition such as digitized cash flow data, telecom/utility data and others. A fair amount of evidence already shows that modernized metrics assess homeownership readiness much better than old ones. Reducing uncertainty reduces cost.

Another theme that includes the BMEF, is that when trying to expand homeownership, liquidity and cash flow stability can be more critical to the success of marginal borrowers than traditional credit scores and down payments. Conscientious borrowers generally strive to restart paying their mortgages after short delinquencies if given the chance. Empirical support for this view includes delinquency performance through repeated climate events (e.g., hurricanes and floods) and the success of generalized forbearance during the COVID-19 pandemic.

This has turned decades of loss mitigation wisdom on its head. The Massachusetts state mortgage insurance program has included unemployment benefits for almost 20 years to resounding success. This program provides borrowers with fragile liquidity and volatile income, with a few months of payment reserves between jobs (e.g., consistently succeeds in preventing delinquency even through the financial crisis of 2007 and the COVID-19 pandemic). The GSEs and FHA have now made forbearance their initial loss mitigation response to borrower delinquency.

The BMEF proposes that borrowers put 3% of their house value into an administered escrow account instead of towards a down payment. It’s well-known that reserves are crucial to borrower success and placing reserves into escrow to be used for income interruption or unexpected maintenance will make reserves even more effective. Money in such accounts will always reduce risk compared with small down payments for borrowers, servicers, mortgage insurers and guarantors. This is provably true because the escrow funds are very liquid for payments, while the liquidity value of small down payments is effectively zero. Further evidence is that reperformance rates for delinquent borrowers are higher for borrowers with lower credit scores than for those with higher credit scores.

Borrowers pay mortgage insurance and guarantee fees to compensate insurers for risk, but it does not impact borrower ability to pay. By contrast, putting aside borrower funds for financial stress reduces risk throughout the value chain. Since it is borrower money in the first place, no subsidy is needed, but risk declines because liquidity is improved. Finally, borrower escrows managed by servicers for taxes and insurance are individual. However, BMEF escrows can be combined across borrowers to generate large diversification gains. Even among traditionally risky borrowers, perhaps 75% of them will never become delinquent, so it’s likely that the benefit limit can exceed the average contribution.