Federal Reserve Board Governor Elizabeth A. Duke strongly endorsed the Board's current monetary policy in a speech to the Mortgage Bankers Association on Friday.   Duke, in a speech devoted primarily to outlining current status and the future outlook of housing and housing finance said that this policy "has clearly set the stage for a revival of the housing market."

She said the record low interest rates have sparked interest in homebuying and monetary policy has contributed significantly to improvement in the labor market, easing one of the main sources of weak housing demand. It may also have supported investor demand for purchasing houses, as the expected return on an investment in housing is better than other investments and households may be making that same determination.  

The interest-rate-sensitive housing market is affected by all of the tools of monetary policy, but purchases of agency MBS have the same downward effect on the general level of long-term interest rates as purchases of other longer-term securities while also reducing the spread between Treasury and MBS yields.  Thus, compared with purchases of Treasury securities, purchases of MBS have somewhat larger effects on mortgage rates. This was especially true in the first round of purchases in 2009 when investor uncertainty about the degree of government support for agency MBS was quite high.  These purchases also influence yields by affecting the cost of hedging the risk (known as convexity risk) that mortgages prepay more quickly when rates decline or more slowly when rates increase because the Federal Reserve does not hedge such risk. 

Lower MBS yields result in lower mortgage rates, which can spur the economy through elevated home-purchase and refinancing activity. But this effect is not yet fully transmitted to the economy, as the difference between MBS yields and mortgage rates is still somewhat wide and, tight credit has prevented many households from accessing the low rates. Any improvement in credit conditions would thus act to improve the efficacy of MBS purchases. Similarly, policies that constrain mortgage lending or increase its cost would reduce efficacy.

Duke said she considers the additional impetus to housing from MBS purchases is appropriate for at least three reasons; first because the housing market has suffered such extraordinary damage.  Second, housing investment has contributed far less to economic growth than in a typical recovery. And, third, even as other types of credit have eased, standards for mortgage credit remain quite tight.

Duke said that the peculiarities of the MBS market itself present some potential market functioning issues that bear monitoring.  It is not as deep or as liquid as the Treasury market, and the total size of the market is not growing as quickly. As refinancing activity slows, the gross pace of new MBS issuance could slow as well, and Federal Reserve purchases at the current level could leave an even larger footprint in the secondary mortgage market. So it is entirely possible that it might be appropriate at some point to adjust the pace of MBS purchases in response to developments in primary or secondary mortgage markets.

Finally, the statement of exit strategy principles provided in the June 2011 FOMC minutes contemplates the sale of MBS once the Committee has begun to remove policy accommodation in order to return the System Open Market Account to an all-Treasury portfolio.  As the Fed's holdings of MBS become larger in both absolute terms and in relation to the overall supply of agency MBS outstanding, a point might come where market functioning concerns begin to outweigh the efficacy of such purchases or that sales of MBS in volumes sufficient to meet the parameters of the exit strategy principles might create significant market disruptions.

Duke said that it is pretty clear that a recovery in the housing market is finally under way, with house prices, construction activity, and home sales all improving over the last year.  The open question is whether this positive trend is sustainable.  The factors driving recent improvement lead her to conclude that recent gains will continue and perhaps even strengthen but she continues to be concerned with tight mortgage credit conditions for many would-be borrowers and that these conditions will only ease slowly and gradually.  While demand will probably come from a pickup in new household formation as the economy increases these households may be the very ones to face especially tight credit conditions.  

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

Home Mortgage Disclosure Act (HMDA) data indicate that in 2011, purchase mortgage originations hit their lowest level since the early 1990s and remained near these subdued levels in 2012 even as mortgage rates hit historic lows.  This drop, although widespread, has been most pronounced among borrowers with low credit scores and originations are virtually nonexistent for borrowers with credit scores below 620.

Whether this pattern stems from tight supply or from weak demand among borrowers with lower credit scores, it has disturbing implications for potential new households. Younger individuals--who have seen the greatest drop in household formation--have, on average, credit scores that are more than 50 points lower than those of older individuals, a difference that existed even before the recession. 

Why are conditions still so tight for these potential first-time homebuyers, and when might they return to normal?  The mortgage market is reacting to a variety of economic, market, and regulatory issues that may not be present in other lending markets.  Part of the tightening in credit standards is a reaction to fears about the economy and the trajectory of house prices.  As the economic recovery continues, lenders should gain confidence that mortgage loans will 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.

Capacity constraints also play a role.  Although purchase originations have been subdued, refinancing originations have more than doubled from mid-2011 to the end of 2012 and the ratio of refinance applications to the number of real estate credit employees has been at levels near those seen during the record 2003 refinancing boom. At the same time, each loan takes longer to process and lenders for various reasons are unable or unwilling to expand capacity.

Lenders often manage capacity constraints by holding mortgage rates high relative to funding costs. Also, when MBS yields drop sharply the rate may take time to adjust as a result of both capacity issues and the need to process loans with rate locks in place.

Furthermore, when refinancing demand is high, lenders have less incentive to pursue harder-to-complete or less profitable loan applications.  Repeat refinance applications by high-credit-quality borrowers are likely the easiest to complete as are refinances under the revised Home Affordable Refinance Program which require substantially less documentation.  It is possible that these applications may have had the unintended effect of crowding out borrowers with lower credit scores. 

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."

As Graham alludes, Lenders may also be responding to other market forces such as the risk that they will be required to repurchase defaulted loans from the government-sponsored enterprises (GSEs). Mortgage servicing standards are more stringent than in the past due to settlement actions and consent orders which increase the cost of servicing nonperforming loans.  Combine that with uncertainty about the ultimate regulatory environment, and lender caution is that much more of a possibility.  It will be up to policymakers to find the right balance between consumer safety and financial stability, on the one hand, and availability and cost of credit, on the other.

The new Qualified Mortgage (QM) rule issued by the Consumer Financial Protection Bureau (CFPB) in January and the Qualified Residential Mortgage (QRM) Rule being fashioned by other regulators along with other prudential rules will further shape the economics of mortgage lending.   Duke said that loans outside the QM box may become more costly for lenders and borrowers for at least three reasons.  First, the possible increase in foreclosure losses and litigation costs, although expected to be small, will become known only after the initial round of ability-to-repay suits are settled by the courts.  Second, mortgages that do not meet the QM definition by definition will not meet the future QRM standard, and so lenders will be required to retain some of the risk if these loans are securitized which may increase costs and limit the size of the market. Third, investors may be wary of investing in non-QM collateralized securities because it is difficult to gauge the risks.  Investors may respond to this information asymmetry by requiring a higher risk premium or by refusing to purchase these securities altogether. For all of these reasons, the non-QM market could become small and illiquid, which would further increase the cost of these loans.

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