Last December, Fannie Mae and Freddie Mac announced the reinstatement of its Declining Market policy to go, presumably in light of the fallout within the mortgage and mortgage -backed securities market. In a nutshell, this announcement reinstates a policy to reduce the maximum loan-to-value (LTV) ratio in markets Fannie deems to be “declining” by 5%. What does that mean? Well, if you were applying for a loan with a maximum LTV of 100%, it means that your maximum LTV would be 95%. You would need to put 5% down. As of June 1, the policy goes into full effect.
Seems like a reasonable and prudent idea, right? After all, it is well established by a number of lenders in both consumer lending and mortgage that “skin in the game” keeps borrowers more attached, even if things go haywire. “Skin in the game” might keep the borrower from having an upside down asset and 5% is a nice little cushion The policy also encourage appraisers to deem a market declining if it believes it to be so based on comparables through out the community, rather than succumb to the pressure of a lender client to label it stable. Lastly, from the lender’s perspective, who wants to have a lien on an asset that is 100% financed, losing value, and worse yet, ends up foreclosed and added to a growing number of REO properties in the portfolio? 
And perhaps I would agree, if it were simply, “you want to live in a declining market, you’ll need an extra 5% to protect us and you against value loss”, but it is not. It’s, albeit unintended, redlining reconstituted. If, for Fannie the issue at hand is the over-valuing of real estate and subsequent “over-lending” to borrowers, this policy doesn’t cut it.
First things first. As research from the Federal Reserve of Boston indicates, the borrowers most sensitive to price declination are borrowers with “Alt-A” loans; those with credit scores within 620-740 with low document/no document loans, ARMS, and interest-only loans—not sub-prime borrowers who don’t have as much savings. These Alt-A loans are often most closely tied to a continued increase in appreciation. When the appreciation is not realized, foreclosure is on the horizon. Those borrowers with homes that have lost value are 14 times more likely to default than those with an increase of same size. While sub-prime borrowers are more likely to default then prime borrowers, there is no loan level data that lends this default back to the primary mortgage because most loan level data shows a greater prevalence of sub-prime loans at the refinance level. Alt-A borrowers tend to have much higher mortgage notes than a sub-prime borrower—approximately $299k to $181k comparatively. Add on the fact that nearly 30% of Alt-A loans are non-home owner occupied compared to 8% amongst sub-prime borrowers, and it seems to me that this is where the problem lies.
Furthermore, the biggest problems will be areas where the rate of appreciation was so steep that an adjustment for those at the top of the market is significant and trickling downward. . For example, in San Diego, where the median home price went from $300k in 2000 to more than $500k in 2005, the fall has been a dramatic 30% decline in price. The rate of foreclosure has increased 200-fold. Yet, Cleveland which is not a declining market, per se, could be labeled as such if one were to simply look at zip codes and census tract numbers and compare to an appraisal on one block versus another. Yes, there are homes that were placed on the market in Cleveland that were above what the market would pay and they are sitting on the market and the prices have fallen. But existing homes have not seen much depreciation. As a matter of fact, the price of the average existing has generally stayed in line with inflation, and long term homeowners simply pay there mortgage down to get value. In these places, it is much less the overvaluing of real estate that is increasing foreclosures and more a decline in industry and an increase in unemployment.
Add on to this the fact that the policy inadvertently gives additional rise to the discrimination among borrowers through the cost of money. If a neighborhood is labeled declining, not only will an additional 5% down be required, but the lender can charge a greater interest spread for loans made in declining markets through Fannie’s risk-based pricing model. This will most notably affect low-income borrowers–particularly minority borrowers who historically have paid 75 to 175 basis points more than a non-minority borrower-and are more likely to be first-time homebuyers in markets that through zip code, census tract, and MSA analysis might be labeled as declining.
Fannie is understandably attempting to be prudent and protect itself from future messes in mortgage lending and packaging of securities, but this policy, seems to go against its mandate. It does not target the borrowers who will more than likely be upside down in a property first—small investors and speculators—and instead may lead to the targeting of the first-time homebuyer who simply wants to keep a roof overhead. The policy may very well lead to disinvestment which in turn may leave this 
in a neighborhood near you.
