Markets & Finance

The Fed's Mortgage Muddle


Despite the central bank's efforts, rates are rising just as the housing market struggles to find its feet

Here's a feedback loop that nobody expected: It looks like investors' expectations for an economic recovery could end up delaying that very scenario.

Fear of inflation and concerns over the long-term impact of ballooning government debt have been driving up yields on 10-year U.S. Treasury notes, which reached 3.91% on June 8 before easing back to 3.84% the next day.

But hasn't the Federal Reserve been working overtime to keep rates down? The prime reason for the Fed's commitment to buying Treasury debt was to lower mortgage rates to revive the moribund housing market. That was starting to work, but economists are now warning that rising mortgage rates will stop any rebound in the housing market in its tracks and derail the broader economic recovery.

In its Weekly Credit Outlook published on June 8, Moody's (MCO) said that the Economic Cycle Research Institute's (ECRI) leading index of U.S. economic activity is now showing the recession nearing an end, with the possibility of higher mortgage yields the only remaining hindrance to a recovery.

The results of Freddie Mac's Primary Mortgage Market Survey, released on June 4, showed a jump in the 30-year fixed mortgage rate to an average of 5.29% for the week ending June 4, compared with an average rate of 4.91% the prior week. Last week's rate was the highest since the week ending Dec. 11, 2008. With Treasury yields even higher so far this week, the 30-year mortgage rate is being quoted as high as 5.50% on bank Web sites such as Citibank's (C).

A Diluted First-Time Buyer Tax Credit

Mortgage rates should trade at a premium over 10-year Treasury notes to account for the greater risk. That premium has historically been between 150 and 200 basis points. The only reason mortgage rates have been so low is that the federal government is fully backing Fannie Mae and Freddie Mac's purchases and insuring of conforming mortgages that banks have been making. If not for Fannie (FNM) and Freddie (FRE), banks would be charging home buyers much higher rates and would be required to keep the loans on their own books, says John Burns, a real estate consultant in Irvine, Calif. who advises the major homebuilders.

"The rise in interest rates is coming at a really inopportune time, just as the stimulus was taking effect," says Mark Zandi, chief economist at Moody's Economy.com. "It will hurt the housing market. It dilutes the benefit of the tax credit" to first-time home buyers.

With much of the weakness in the banking system having been addressed, Zandi believes the housing market is becoming the primary risk to the economy. But he also believes the bond market has gotten ahead of itself in anticipating a return of inflationary pressures. It makes sense, however. that as the economy gathers strength, the Treasury yield curve should normalize, with the 10-year note returning to somewhere between 4.5% and 5.0%, he says.

If Treasury yields are simply reflecting improvement in the economy, then it follows that the Fed shouldn't do anything to keep rates low, says Ivy Zelman, chief executive of Zelman & Associates, which focuses on housing market analysis. The discourse among policy analysts and senior financing executives is increasingly concentrating on the high-wire act the Fed must pull off to ensure it doesn't keep interest rates artificially low for too long and thereby stoke hard-to-control inflation, she adds.

The Fed could rein in yields with any indication that it plans to take a lot more Treasury paper out of the system via debt purchases, but that's not likely, says Kim Rupert, managing director of fixed-income analysis at Action Economics. It's very difficult for the central bank to keep a handle on long-term interest rates since they're determined by other factors besides the amount of Treasury debt the Fed is buying.

Refinancing Activity Takes a Hit

Even if there weren't other factors, "it's a losing proposition for the Fed to try to fight an upsurge in yields via Treasury purchases" since its purchases can't keep pace with the $30 billion to $40 billion in new paper the Treasury is issuing each month to pay for the economic stimulus, Rupert says. The ultimate impact of all the stimulus is a very large inflation threat, she adds.

Although over the long run the Fed certainly wants to reduce the mortgage market's reliance on the Fed's purchasing of mortgages, in the near term it can afford to increase its mortgage purchases in order to keep rates from going higher, says Zelman.

One worrisome sign, notes Zelman: She's heard the hike in the 30-year fixed-rate mortgage to 5.50% has crippled refinancing activity. Deterioration in home values has caused many owners to lose equity to the point where they would only have positive equity in their homes if they got a rate between 4.5% or 4.875%. Rising rates appear to have boosted new home purchases, however, by pulling in people who were sitting on the fence since they're increasingly afraid of missing the window of opportunity to secure a relatively low rate.

Fannie Mae and Freddie Mac have been watching mortgages on their books decline in recent months to a combined balance of around $800 billion. Since their combined ceiling is $900 billion, the government-sponsored enterprises have the capacity to buy up to $100 billion in additional mortgage securities, which would help lower mortgage rates, says Zelman.

Persisting Depreciation, Foreclosure Worries

There are also ways to bring the effective mortgage rate down, such as the Obama Administration's tax credit of up to $8,000 for first-time home buyers, says Zandi. Anyone who hasn't owned a home in the past three years is eligible for the credit as long as their income isn't above a certain threshold. While the tax credit is slated to expire on Dec. 1, there are efforts to raise the limit to $15,000 and make it available to all home buyers, he says.

Higher mortgage rates in general are likely to exacerbate depreciation in home values, says Matthew Howlett, an analyst who covers the mortgage insurers at Fox-Pitt, Kelton Cochran Carolia Waller in New York. He expects home prices to fall an additional 15% to 20% over the next 18 months based on current mortgage rates and thinks they'll probably decline further if rates go up, causing more people to default on their mortgages.

Mortgage rates would also rise for people who can't afford to make at least a 20% down payment on homes they're buying if companies such as PMI Group (PMI) and MGIC Investment Corp. (MTG), which provide mortgage insurance, were to fail. While rising default rates and claims are making it more difficult for mortgage insurers to maintain adequate levels of capital and liquidity, Howlett doesn't believe any of them are in imminent danger of failing.

The insurers are depending on the moderate success of the mortgage modifications the Obama Administration is subsidizing in order to keep people in their homes. The Administration is targeting the prevention of 3 million to 4 million foreclosures. Any further downtrend in housing prices would hurt the chances of those modifications, says Howlett.

Mounting delinquencies of Alt-A mortgages—which are riskier than prime mortgages—will likely turn into defaults, creating a "tsunami of foreclosures" that will put the housing market under even more pressure, says Zelman. And it will be much harder to get those mortgages modified since they've been securitized and are in the hands of investors instead of the banks, she adds.

That Feedback Loop Again

Right now, the fear in the bond market is that even though the federal budget deficit is likely to moderate as the economy revives, the budget gap might stay around $800 billion for the next decade, says Rupert at Action Economics. The faster the economy can grow, the more the government will be able to boost tax revenues, and the lower the deficit will be. "For the moment, the working assumption is massive deficits as far as the eye can see, and I think that's going to be a problem for the bond market," she says.

And in classic feedback loop fashion, additional problems for the bond market will spell even more pain for the mortgage market.


American Apparel's Future
LIMITED-TIME OFFER SUBSCRIBE NOW

(enter your email)
(enter up to 5 email addresses, separated by commas)

Max 250 characters

Sponsored Financial Commentaries

Sponsored Links

Buy a link now!

 
blog comments powered by Disqus