Wednesday, November 28, 2012

Will Congress offset the Fed's attempts to lower mortgage rates?

Over the past few weeks and months, the chorus of economic and financial analysts singing praises about the housing rebound has been growing. Some believe housing will come roaring back, significantly boosting GDP, as in those good old days of the early 2000’s. Others remain more subdued about the prospects, expecting stability with potentially moderate growth. It’s certainly hard to argue with those positions given recent data, as shown below:

Recently prices are clearly trending higher, but a quick glance at late 2009-early 2010 shows a similar pattern. Will house prices continue the recovery, flatten out, or take a turn towards new lows?

Supporting the bullish case:

  • Mortgage rates are at all time lows
  • The Fed is actively buying Agency-MBS to push rates lower
  • Real house prices and price-to-rent are back to late 1999 levels (Calculated Risk)
  • New and existing home sales are rebounding
  • Government support remains strong
There are certainly many other bullet points one could add, but I want to focus on the last point, which might strike some as odd.

Do you know what percent of the current mortgage market is either owned or guaranteed by the GSEs (Fannie Mae And Freddie Mac) and the FHA (Federal Housing Administration)?

If not, would you guess...
A) 50%
B) 70%
C) 90%
D) 95%

The correct answer is C - 90%.

So why does this support the bullish case? Well, the various government agencies have primarily gained market share by offering mortgages and guarantees at prices well below any private sector participant. Seemingly unphased by fallout from the recent housing crisis, the FHA is once again doling out mortgages to subprime borrowers with down payments as low as 3.5%. Similar to the previous housing boom, this cheap credit should increase purchasing power and at least place a floor under housing prices, if not drive them higher.

Turning to the bearish position, one must recall that the government’s previous efforts to accurately price mortgage loans and guarantees ended with massive losses for the taxpayers through the GSEs. While risks of further GSE losses remain high, the FHA is quickly racking up losses on bad loans and will need capital injections (a bailout) from the Treasury. In light of these outcomes, there may be some pressure to shift part of the mortgage market back to the private sector.

Walter Kurtz at Sober Look explains that In order for the private sector to step into the mortgage market, g-fees need to rise:
The only way to shift at least some of the mortgage business to the private sector (currently the GSEs and the FHA own or guarantee over 90% of the US mortgage market) is to price the risk closer to where it would be priced in the private sector. Otherwise the private sector will never enter this market - other than to sell the mortgages banks originate to the government and keep the origination fees (which is what banks do now).
The taxpayer also needs to recoup the Fannie and Freddie rescue expenses. That means the GSEs will need to raise their g-fees, which according to JPMorgan is exactly what they plan to do (chart below).
These projected increases in g-fees will, ceteris paribus, push mortgage rates higher at a time when the Fed is trying to force rates in the opposite direction. Although the magnitude of 20-30 basis points is seemingly small, it is practically equivalent to the change from the Fed’s QE programs that are believed by many to have extraordinarily powerful effects. While I remain skeptical of the potential impact from a change of this magnitude, the trend higher in g-fees presents a potential headwind for future house prices.

Whether or not the rise portrayed above occurs remains open for debate and is being fought by numerous politicians. The reality is that the direction of US housing prices, at least in the short-run, lies primarily with the actions of the US government. Continuing the current practice of lending at below market prices across the credit spectrum may succeed at inducing a credit-infused rebound. In all likelihood the outcome will be no different than recent experiences around the globe, as the debt burden will overwhelm income and savings, leading to housing price declines and massive taxpayer losses.

1 comment:

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