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Is it time to cheer for aspiring home buyers or existing homeowners looking to refinance their home loans? Mortgage rates fell for the third consecutive week on February 21, to 4.35%, according to Freddie Mac, the government-sponsored enterprise that supports a secondary market for housing mortgages.
That dip in mortgage rates follows a general downward trend that began late last year, according to Freddie Mac. The agency buys and pools housing mortgages and sells them as mortgage-backed securities to investors in the open market. “Wages are growing on par with home prices for the first time in years, and with more inventory available, spring home sales should help the market begin to recover from the malaise of the last few months,” Freddie Mac predicted.
That optimistic outlook follows a period of tepid housing demand on the back of rising interest rates, high home prices and low availability of housing stock. Faced with reduced demand for their traditional home loans, mortgage lenders had begun trying to drum up more business by offering “unconventional mortgages,” where buyers who can’t provide the standard proof of income could still get loans. Such mortgages had been blamed for fanning the 2007 housing finance crisis, but they do not seem to pose a threat as yet to the current housing market. Uncertainty also looms over the continued role of the government in the mortgage finance industry, especially through Fannie Mae and Freddie Mac, and the prospects for greater private sector involvement.
Knowledge@Wharton discussed those trends with Wharton real estate professor Benjamin Keys and Guy Cecala, CEO of Inside Mortgage Finance, a trade publication focused on the residential mortgage industry. They shared their insights on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)
Blow Hot, Blow Cold
Before the current dip in housing mortgage rates, they had risen between June and November last year, ranging between 4.5% and close to 5%. “Now, with rates coming back down and potentially staying down for at least a little while longer, there’s a renewed hope for the housing market this year in terms of demand for borrowers,” said Keys.
“We’re starting to see more appetite for the type of risk [posed by] unconventional mortgages, and that fuels the willingness to fund these types of mortgages.”–Benjamin Keys
The housing markets drew cheer from remarks earlier this month by James Bullard, president of the St. Louis Federal Reserve Bank suggesting that he didn’t expect to see any interest rate increases at least in the near term. Bullard’s comments helped correct an “expectation last year that mortgage rates, and interest rates overall, were just going to rise for the foreseeable future,” said Cecala. “We’ve gotten a reprieve on that.”
However, the renewed cheer is tempered. Those hopes for a pickup in housing demand are set against the backdrop of “a booming labor market” and an “extremely low unemployment rate,” said Keys. The positive signals from lower mortgage finance rates are not yet showing up in housing construction or home-buying trends, he added. “We have to keep in mind that even in a situation where the economy is doing as well as it is, the housing market is not going to be the [driver] that’s pulling it forward. In some ways, it’s being dragged along.” Cecala pointed to “other factors that are casting a cloud” over the overall housing market, such as low inventories, lack of new construction, rising home prices and some overheated markets.
The Rise of Unconventional Mortgages
Industry insiders are keenly tracking the rise of unconventional mortgages, which help lenders broaden their demand base to include borrowers who might otherwise not qualify for home loans. Keys said unconventional mortgages become popular when households face “affordability challenges” in being able to make their monthly mortgage payments. “As we see interest rates rise, there’s a real pressure for lenders to offer products that are going to drive down that monthly price,” he said.
Keys noted that earlier housing cycles have seen “exotic products” with teaser rates that required reduced documentation. In fact, he and a couple of co-authors had documented that trend in the years leading up to the previous housing boom in a recently released working paper, “Affordability, Financial Innovation and the Start of the Housing Boom,” with the Federal Reserve Bank of Chicago.
Cecala said the rise in the issuance of unconventional mortgages is different from the “reckless lending like in the last cycle” — in the boom years preceding the 2007 subprime mortgage finance crisis that led to the 2008 Great Recession. “The non-prime mortgages that are being made now are not akin to the ones that led up to the housing crisis — at least not yet,” he added. Borrowers who sign up for those non-prime mortgages have to produce alternative forms of income or assets, and must also have some equity in the homes they buy, he explained. “They’re not the no-documentation, no-equity loans we saw leading up to the housing crisis.”
Lenders issued $34 billion in unconventional mortgages in the first three quarters of 2018, a 24% increase from the same period a year earlier, according to a Wall Street Journal report, citing data from Inside Mortgage Finance.
“With rates coming back down and potentially staying down for at least a little while longer, there’s a renewed hope for the housing market this year in terms of demand for borrowers.”–Benjamin Keys
According to Cecala, such unconventional loans account for less than 5% of the current market, compared to more than 30% in 2006 and 2007. “[However], we have the same conditions that helped grow or promote that market, which is basically a downturn in mortgage activity and drying up of refinance activity,” he said. “Most mortgage lenders are facing the prospect of reduced activity unless they can come up with a way to boost business going forward. One of those is to move into non-conventional products.”
Keys also didn’t see any cause for alarm now over unconventional mortgage products, but he did sound a note of caution. “We’re nowhere near that the types of products or the quantity of those kinds of products, but we’re taking the first steps in that direction.”
Keys pointed out that “high-quality loans with documentation of income and assets” get securitized by Fannie Mae and Freddie Mac and then sold to investors. Other loans where borrowers do not have good credit scores or have insufficient documentation don’t make the grade for Fannie Mae or Freddie Mac. While that market for those subprime loans dried up in the wake of the 2007 housing finance crisis, there are signs of a revival there, he said. “There is a pickup of interest among investors and others,” he added. “We’re starting to see more appetite for the type of risk [posed by] unconventional mortgages, and that fuels the willingness to fund these types of mortgages.”
The changed market conditions have also provided new openings for the mortgage servicing industry. Mortgage servicing had become “a liability” for most of the past decade as many homes went into foreclosure, but that has also changed now, said Cecala. It has become a stable business with relatively lower foreclosures and rising interest rates, he added. “One thing that hurts servicing is refinancing, because if you have a certain amount of mortgages you service and then half of them refinance overnight, you lose that business and have to acquire new business,” he explained. “So, a rising interest rate environment — particularly what we saw in the first part of last year — was very good for the mortgage servicing business.”
An Uncertain Road for Fannie and Freddie
Meanwhile, policy circles continue to debate the desirability of privatizing Fannie Mae and Freddie Mac. They were put in conservatorship by the Federal Housing Finance Agency in 2008 after the deterioration in the housing markets necessitated government intervention. Now, as the markets have recovered and are poised for what many see as buoyant times, there are calls to make room for increased private sector involvement in the mortgage industry.
“The non-prime mortgages that are being made now are not akin to the ones that led up to the housing crisis – at least not yet.”–Guy Cecala
“The government effectively accounts for about 80% of the [housing] mortgage market,” said Cecala. “That’s a much bigger share than you see in any other country in the world. I’m not sure that’s the best model to have. We’re talking about bringing in private sector involvement on the edges, without dealing with that fundamental issue of how big the government should be in the mortgage market.”
Keys noted that Mark Calabria, chief economist in Vice President Mike Pence’s office who is the Trump administration’s nominee to head the FHFA is an “outspoken critic” of Fannie Mae and Freddie Mac. Calabria had previously argued for putting the agencies under receivership (which the FHFA conservatorship essentially avoided), according to a Bloomberg report. His nomination was advanced in a narrow vote along party lines by the Senate Banking Committee on Tuesday.
“It’s going to be very interesting to see — despite some of [Calabria’s] toned-down rhetoric — whether he takes some steps to bring in more private actors in the market,” Keys said. He noted that as FHFA chief, Calabria will have the power to take many unilateral decisions, such as changing the parameters by which Fannie Mae and Freddie Mac provide guarantees for housing mortgage securities, and to influence activities like refinancing, purchases of second homes or investor properties, down payment requirements and the like. “Disrupting this market would be very costly to a lot of people.”