Sep102013

How will a reduced loan limit impact Coastal California?

When policymakers are considering a change, they like to float trial balloons in the mainstream media to gauge the reaction. Recently, the FHFA proposed lowering the conforming limit on GSE loans. As you might expect, the industry insiders dependent upon real estate transactions are not excited by the idea. Today, I want to take an objective look at the impact of lowering the conforming limit nationally, and its specific impact on Coastal California real estate.

The conforming loan limit is designed to provide government-subsidized loans only to lower and middle income Americans. Loans above the conforming limit are provided by private lenders in what’s known as the jumbo market. During the housing bubble, the conforming limit rose as high as $417,000, but when the housing bubble burst, this limit was raised to $729,750 in markets like Coastal California that needed the most government support to maintain peak prices. The GSEs in concert with the FHA now insure over 90% of the loans in the residential housing market.

In 2011, the conforming limit was lowered from $729,750 to $625,000 ($546,250 in San Diego). Surprisingly, the FHA loan limit was not reduced when the conforming loan limit was brought down. This was done intentionally to push high wage earners into the FHA system and boost their revenues (See: To prevent an FHA bailout, lower the conforming limit on GSE loans). The desire to push performing loans out of the GSEs and into the FHA may be part of this move. The FHA would rake in enormous fees if the limit is lowered at the GSEs and the FHA limit remains in place. Since the GSEs are making money and the FHA is losing money, this is a reasonable step.

If the FHA also lowers it’s limits, the rally in Coastal California real estate will abruptly end. As it stands, people can buy houses up to $750,000 with as little as 3.5% down. If the FHA limit drops, the limit of bids for anyone with less than 20% down will drop along with it.

With so many still underwater, the equity to support a viable 20% down move-up market simply does not exist. The last time the conforming limit was dropped, Irvine, CA witnessed an 84% decline in sales volume in the price range no longer financeable with GSE loans.

What seems most likely to me is that the GSE loan limit would be dropped while the FHA loan limit remains in place. The costs of FHA loans push the effective interest rate up over 6%, so it will have an enormous impact on affordability. The $600,000 to $750,000 price range will be decimated as first-time homebuyers will no longer be able to afford these homes.

The rest of the country’s markets will see a similar phenomenon, but it won’t be as acute as the problems in Coastal California because the rest of the country doesn’t deal with such inflated house prices. A reduced loan limit will impact high wage earners everywhere the most. When combined with the likely curtailment of the home mortgage interest deduction on the way, and high wage earners will feel a real squeeze.

Loan Size to Be Cut for Fannie, Freddie

By NICK TIMIRAOS — September 8, 2013, 7:32 p.m. ET

Federal officials are preparing to reduce the maximum size of home-mortgage loans eligible for backing by Fannie Mae and Freddie Mac, a move that is likely to face resistance from some lawmakers in Congress and the real estate industry.

The proposed move is designed to wean the mortgage market off government support and allow the market for non-government-guaranteed mortgages to take a bigger role. But critics argue that any such move will shrink the pool of eligible home buyers, stunting the nation’s housing recovery.

It will shrink the pool of potential homebuyers at price points above the conforming limit. These buyers will either need to take out an expensive FHA loan or be subject to the higher loan standards of the private mortgage market. Right now that means a 20% down payment and a 720 FICO score.

That being said, it won’t reduce the size of the buyer pool at all. It will simply mean that sellers must adjust their prices to the amounts potential buyers can finance. Of course, nobody wants to acknowledge that obvious fact, and with cloud inventory being unable to lower their price, it will contribute to the Mexican standoff in the housing market.

“It would be counterproductive to make changes to the loan limits before private capital is fully engaged,” said Gary Thomas, president of the National Association of Realtors.

What does that mean? Private capital is fully engaged, it’s just too expensive and too restrictive to support efforts to reflate the housing bubble. Further, that isn’t likely to change. The NAr isn’t going to want to see any subsidies removed from housing, and all subsidies should be removed because housing subsidies are detrimental to America.

Currently, Fannie and Freddie Mac can back mortgages that have balances as high as $417,000 in most parts of the country and up to $625,500 in expensive housing markets, including parts of California and New York, and as much as $721,050 in Hawaii. Mortgages within the limits are called “conforming” loans; mortgages that exceed them are called “jumbo” mortgages.

The Federal Housing Finance Agency, which regulates Fannie and Freddie, hasn’t announced how far it will drop the loan limits, which would take effect Jan. 1, 2014, and a spokeswoman declined to elaborate on specifics. But in a statement, the agency said a “gradual reduction in loan limits is an appropriate and effective approach to reducing taxpayers’ mortgage-risk exposure…and expanding the role of private capital in mortgage finance.”

That’s the dilemma of our current regime of government supports. Everyone knows we need to get rid of them, but nobody is willing to endure the pain required to make it happen.

The FHFA says it doesn’t need congressional approval given broad powers it enjoys, so long as Fannie and Freddie remain under government control. The policy change illustrates a key challenge facing federal housing officials, who have taken extraordinary steps to keep mortgage credit flowing since the housing market crashed six years ago.

Home prices have rebounded due partly to record low interest rates. But with nine in 10 new loans receiving some form of government backing, officials are trying now to engineer a retreat without upending the recovery.

Think of how far we’ve moved toward the centrally planned pricing of the old Soviet Union. We are now discussing how to engineer the housing market, and the government insures 90%+ of the loans made. This is madness. What happened to the capitalist society we once embraced?

Any fight over loan limits “shows why it is going to be hard” to reduce the government’s role in the mortgage market, said Paul Miller, a banking analyst at FBR Capital Markets. “A lot of people who talk about having more private capital, they’re not ready to walk the walk,” he said.

That’s an understatement.

Lenders say they are eager to fill any gap left by a decline in the loan limits. Already, banks have been competing to make loans to the most creditworthy jumbo borrowers by offering rates that are in some cases lower than conforming-loan rates. Before the crisis, jumbo rates were at least a quarter of a percentage point above conforming loans, and until last year, jumbo loans were more than 0.5 percentage points higher.

Given where banks are pricing jumbo mortgages, it seems like a relatively small risk on the part of the government to take the next step,” said Michael McMahon, managing director at Redwood Trust Inc., a Mill Valley, Calif., investment firm that securitizes jumbo mortgages. …

One of the main arguments made against removing the government props has traditionally been the increased cost of private mortgage. With the turmoil caused by the recent dramatic increase in interest rates, and the stealthy increase in government guarantee fees, the cost of private money is now on par with government-backed loans.

Still, some jumbo borrowers could be locked out, particularly those who don’t have at least a 20% down payment or a credit score below 720. “There will be a hole left,” said Mr. Blackwell.

It will be a big hole. It’s the main reason I don’t foresee the FHA reducing its limit. They are the only plug that hole has. Realistically, this will drive up the the costs of borrowing significantly for those with less than 20% down.

In San Rafael, Calif., where home prices are up by more than 17% from one year ago, a reduction in loan limits could make it more difficult for borrowers like Christine Gironeto find a home that they can afford and find desirable. She and her husband closed last month on a 1,700 square-foot four-bedroom home built in 1961. They borrowed the maximum—a $625,500 loan—and made a 20% down payment in order to get a 4.6% rate. “It’s by no means a mansion. It needs a lot of work,” said Ms. Girone, 45 years old and a mother of three. While $625,500 may sound like a lot of money in most parts of the country, it doesn’t buy much in the San Francisco Bay area, said Ms. Girone.

It doesn’t buy much anywhere in Coastal California. As buyers like Ms. Girone get priced out due to the increased cost of using FHA financing, prices for houses in the affected price range will weaken.

Arbitrary changes in borrowing limits are “only going to harm the first-time home-buyer,” said Richard Redmond, the mortgage broker in Larkspur, Calif., who arranged their loan. “An across-the-board cut is easy to sell in the heartland, but it’s going to hurt the coasts.” …

That’s exactly what it will do. The impact will be hardly felt in most of the country, but the impact will be particularly harsh in Coastal California.

Reducing the limits for Fannie and Freddie—but not for the FHA, which has different ones—could simply shift more business to that agency, which has among the most liberal terms. The FHA allows borrowers to make down payments of just 3.5% and has limits that vary by county, from $271,050 up to $729,750.

As I pointed out above, I think that’s part of the motivation behind this move (See: To prevent an FHA bailout, lower the conforming limit on GSE loans). Diverting these fees to the FHA will help increase it’s revenues and rapidly replenish the fund being depleted by the bad loans the FHA made during the bust. In that way, high wage earners in Coastal California get to bear a disproportionately high burden for covering the FHA losses on loans made during the bust. We should all take that one for the team, right?

Why the move-up market will remain weak

A viable move-up market requires equity. People are supposed to make money on the sale of a previous home and use that equity to increase the down payment on their next property. But what happens to a move-up market when a significant number of market participants spend that equity instead? Obviously, the move-up market suffers. And that’s exactly what happened during the housing bubble.

The former owners of today’s featured property should be sitting on $350,000 in equity they could use to buy their next house. Instead, they are broke and living in a rental.

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6 LOS PICOS Rancho Santa Margarita, CA 92688

$479,900 …….. Asking Price
$202,000 ………. Purchase Price
6/2/1999 ………. Purchase Date

$277,900 ………. Gross Gain (Loss)
($38,392) ………… Commissions and Costs at 8%
============================================
$239,508 ………. Net Gain (Loss)
============================================
137.6% ………. Gross Percent Change
118.6% ………. Net Percent Change
6.0% ………… Annual Appreciation

Cost of Home Ownership
——————————————————————————
$479,900 …….. Asking Price
$16,797 ………… 3.5% Down FHA Financing
4.67% …………. Mortgage Interest Rate
30 ……………… Number of Years
$463,104 …….. Mortgage
$134,918 ………. Income Requirement

$2,393 ………… Monthly Mortgage Payment
$416 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$100 ………… Homeowners Insurance at 0.25%
$521 ………… Private Mortgage Insurance
$55 ………… Homeowners Association Fees
============================================
$3,485 ………. Monthly Cash Outlays

($626) ………. Tax Savings
($591) ………. Principal Amortization
$30 ………….. Opportunity Cost of Down Payment
$80 ………….. Maintenance and Replacement Reserves
============================================
$2,378 ………. Monthly Cost of Ownership

Cash Acquisition Demands
——————————————————————————
$6,299 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,299 ………… Closing Costs at 1% + $1,500
$4,631 ………… Interest Points at 1%
$16,797 ………… Down Payment
============================================
$34,026 ………. Total Cash Costs
$36,400 ………. Emergency Cash Reserves
============================================
$70,426 ………. Total Savings Needed
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