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
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.