MBS Buying Clearly Helping, But May Need To Be Adjusted- Fed's Duke

by devteam March 12th, 2013 | Share

Federal Reserve Board Governor Elizabeth A. Duke stronglyrnendorsed the Board’s current monetary policy in a speech to the MortgagernBankers Association on Friday.   Duke, in a speech devoted primarily to outliningrncurrent status and the future outlook of housing and housing finance said thatrnthis policy “has clearly set the stage for a revival of the housing market.” </p

She said the record low interestrnrates have sparked interest in homebuying and monetary policy has contributed significantlyrnto improvement in the labor market, easing one of the main sources of weakrnhousing demand. It may also have supported investor demand for purchasingrnhouses, as the expected return on an investment in housing is better than otherrninvestments and households may be making that same determination.  </p

The interest-rate-sensitive housingrnmarket is affected by all of the tools of monetary policy, but purchases ofrnagency MBS have the same downward effect on the general level of long-termrninterest rates as purchases of other longer-term securities while also reducingrnthe spread between Treasury and MBS yields. rnThus, compared with purchases of Treasury securities, purchases of MBSrnhave somewhat larger effects on mortgage rates. This was especially true in thernfirst round of purchases in 2009 when investor uncertainty about the degree ofrngovernment support for agency MBS was quite high.  These purchases also influence yields byrnaffecting the cost of hedging the risk (known as convexity risk) that mortgagesrnprepay more quickly when rates decline or more slowly when rates increasernbecause the Federal Reserve does not hedge such risk.  </p

Lower MBS yields result in lowerrnmortgage rates, which can spur the economy through elevated home-purchase andrnrefinancing activity. But this effect is not yet fully transmitted to therneconomy, as the difference between MBS yields and mortgage rates is stillrnsomewhat wide and, tight credit has prevented many households from accessingrnthe low rates. Any improvement in credit conditions would thus act to improvernthe efficacy of MBS purchases. Similarly, policies that constrain mortgagernlending or increase its cost would reduce efficacy. </p

Duke said she considers the additionalrnimpetus to housing from MBS purchases is appropriate for at least three reasons;rnfirst because the housing market has suffered such extraordinary damage.  Second, housing investment has contributedrnfar less to economic growth than in a typical recovery. And, third, even as otherrntypes of credit have eased, standards for mortgage credit remain quite tight. </p

Duke said that the peculiarities ofrnthe MBS market itself present some potential market functioning issues thatrnbear monitoring.  It is not as deep or asrnliquid as the Treasury market, and the total size of the market is not growingrnas quickly. As refinancing activity slows, the gross pace of new MBS issuance</bcould slow as well, and Federal Reserve purchases at the current level couldrnleave an even larger footprint in the secondary mortgage market. So it isrnentirely possible that it might be appropriate at some point to adjust the pacernof MBS purchases in response to developments in primary or secondary mortgagernmarkets. </p

Finally, the statement of exitrnstrategy principles provided in the June 2011 FOMC minutes contemplates thernsale of MBS once the Committee has begun to remove policy accommodation inrnorder to return the System Open Market Account to an all-Treasury portfolio.rn As the Fed’s holdings of MBS become larger in both absolute terms and inrnrelation to the overall supply of agency MBS outstanding, a point might come wherernmarket functioning concerns begin to outweigh the efficacy of such purchases orrnthat sales of MBS in volumes sufficient to meet the parameters of the exitrnstrategy principles might create significant market disruptions. </p

Duke said that it is prettyrnclear that a recovery in the housing market is finally under way, with housernprices, construction activity, and home sales all improving over the lastrnyear.  The open question is whether thisrnpositive trend is sustainable.  Thernfactors driving recent improvement lead her to conclude that recent gains willrncontinue and perhaps even strengthen but she continues to be concerned withrntight mortgage credit conditions for many would-be borrowers and that thesernconditions will only ease slowly and gradually. rnWhile demand will probably come from a pickup in new household formationrnas the economy increases these households may be the very ones to face especiallyrntight credit conditions.  </p

One model suggests that householdrnformation could increase to 1-1/2 million or more per year. If, as seemsrnlikely, however, many of these new households rent rather than buy their homes,rnthe effect on rental housing could be stronger than for owner-occupied homes,rnand applications for mortgages to purchase homes might recover only slowly. </p

Home Mortgage Disclosure Act (HMDA)rndata indicate that in 2011, purchase mortgage originations hit their lowestrnlevel since the early 1990s and remained near these subdued levels in 2012 evenrnas mortgage rates hit historic lows.  This drop, although widespread, has been mostrnpronounced among borrowers with low credit scores and originations arernvirtually nonexistent for borrowers with credit scores below 620. </p

Whether this pattern stems fromrntight supply or from weak demand among borrowers with lower credit scores, itrnhas disturbing implications for potential new households. Youngerrnindividuals–who have seen the greatest drop in household formation–have, onrnaverage, credit scores that are more than 50 points lower than those of olderrnindividuals, a difference that existed even before the recession.  </p

Why are conditions still so tight</bfor these potential first-time homebuyers, and when might they return tornnormal?  The mortgage market is reactingrnto a variety of economic, market, and regulatory issues that may not be presentrnin other lending markets.  Part of therntightening in credit standards is a reaction to fears about the economy and therntrajectory of house prices.  As therneconomic recovery continues, lenders should gain confidence that mortgage loansrnwill perform well, and they should expand their lending accordingly, either by decreasing the extent to which they apply their own "overlays" to existing agency guidelines, or by the loosening of the agency guidelines themselves. </p

Capacity constraints also play arnrole.  Although purchase originationsrnhave been subdued, refinancing originations have more than doubled from mid-2011rnto the end of 2012 and the ratio of refinance applications to the number ofrnreal estate credit employees has been at levels near those seen during thernrecord 2003 refinancing boom. At the same time, each loan takes longer tornprocess and lenders for various reasons are unable or unwilling to expand capacity.rn</p

Lenders often manage capacityrnconstraints by holding mortgage rates high relative to funding costs. Also,rnwhen MBS yields drop sharply the rate may take time to adjust as a result ofrnboth capacity issues and the need to process loans with rate locks in place. </p

Furthermore, when refinancing demandrnis high, lenders have less incentive to pursue harder-to-complete or lessrnprofitable loan applications.  Repeat refinancernapplications by high-credit-quality borrowers are likely the easiest torncomplete as are refinances under the revised Home Affordable Refinance Programrnwhich require substantially less documentation. rnIt is possible that these applications may have had the unintendedrneffect of crowding out borrowers with lower credit scores.  </p

This may be more than pure coincidence,” according to Matthew Graham, Rates Strategist at Mortgage News Daily.  “Lenders aren’t stupid,” Graham says.  “Throughout this era of all-time low rates, the group of borrowers with the best qualifications–including equity–have had little trouble qualifying for refinances.  From a lender’s standpoint, it only makes sense to fill capacity with the best-qualified borrowers who are least likely to remain interested if rates rise.  Now that rates are rising, it will be interesting to see if lenders start ramping up program availability to lower credit-quality, less rate-sensitive borrowers in order to fill capacity, or if lenders were legitimately backing away from higher risk files.”</p

As Graham alludes, Lenders may also be responding to otherrnmarket forces such as the risk that they will be required to repurchaserndefaulted loans from the government-sponsored enterprises (GSEs). Mortgagernservicing standards are more stringent than in the past due to settlementrnactions and consent orders which increase the cost of servicing nonperformingrnloans.  Combine that with uncertainty about the ultimate regulatoryrnenvironment, and lender caution is that much more of a possibility.  It will be up tornpolicymakers to find the right balance between consumer safety and financialrnstability, on the one hand, and availability and cost of credit, on the other. </p

The new Qualified Mortgage (QM) rulernissued by the Consumer Financial Protection Bureau (CFPB) in January and thernQualified Residential Mortgage (QRM) Rule being fashioned by other regulators alongrnwith other prudential rules will further shape the economics of mortgagernlending.   Duke said that loans outsidernthe QM box may become more costly for lenders and borrowers for at least threernreasons.  First, the possible increase inrnforeclosure losses and litigation costs, although expected to be small, willrnbecome known only after the initial round of ability-to-repay suits are settledrnby the courts.  Second, mortgages that dornnot meet the QM definition by definition will not meet the future QRM standard,rnand so lenders will be required to retain some of the risk if these loans arernsecuritized which may increase costs and limit the size of the market. Third, investorsrnmay be wary of investing in non-QM collateralized securities because it isrndifficult to gauge the risks.  Investors mayrnrespond to this information asymmetry by requiring a higher risk premium or byrnrefusing to purchase these securities altogether. For all of these reasons, thernnon-QM market could become small and illiquid, which would further increase therncost of these loans. </p

Duke said she is optimistic that thernhousing recovery will continue to take root and expand, helped in part by lowrnmortgage rates, but it will be the pent-up demand of household formationrnunleashed by improving economic conditions that will provide real momentum.  Whether those new households will find creditrnavailable will determine the mix of owner-occupied and rental housing and consequentlyrnthe level of mortgage originations might be quite different.

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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