To lure private capital to the mortgage market, interest rates must rise

Everyone says they want private capital to form the basis of housing finance, but nobody is willing to accept the consequences of attracting this money: higher interest rates. Right now, the US taxpayer is on the hook for over 90% of the residential mortgage market through the FHA and GSEs. These entities are packaging mortgage-backed security pools, guaranteeing them, and selling them to investors. Without this government backing, investors would demand better returns, and the only way returns improve is if mortgage interest rates rise.

Of course, rising interest rates is the last thing lenders and housing bulls want to see. Higher interest rates would reduce mortgage balances, make housing even less affordable, and ultimately will either halt appreciation or cause prices to decline again. Since the banks are still exposed to hundreds of billions of mortgages without collateral backing, they need prices to rise back to peak levels to prevent billions in losses. As long as the banks have so much exposure, any plans to wind down the GSEs will be put on hold until the banks are solvent again.

The Housing Market Is Still Missing a Backbone

By GRETCHEN MORGENSON — Published: August 10, 2013

IN a speech in Phoenix last Tuesday, President Obama finally entered the debate over the future of United States housing policy. But his talking points offered few details about how to reduce the government’s giant footprint in the mortgage market.

Mr. Obama vowed to keep mortgage costs affordable for first-time home buyers and working families, pleasing those who think that the government should have a large role in this arena. His call for investment in rental housing was a welcome change from past mantras that focused solely on increasing homeownership across the country.

It was good to hear a President give lip service to renters. Unfortunately, no policy initiatives actually help them.

Playing to taxpayers who are angered by the government’s takeover of Fannie Mae and Freddie Mac in 2008, Mr. Obama said he wanted to wind these companies down. That’s an important goal.

But as if to prove how hard this will be, both companies later in the week announced enormous profits for the second quarter of this year, most of which go to the government in the form of dividends. Together, the companies reported $15 billion in profits; with Treasury on the receiving end of this lush income stream, it will be tempting to keep the mortgage finance giants in business.

Politicians will drag their feet on winding down the GSEs for two reasons. First, they are making money, and the government needs the revenue, and second, as long as the banks need super-low interest rates, the government guarantee will remain in place.

Yet with the government backing or financing nine out of 10 residential mortgages today, it is crucial to lure back private capital, with no government guarantees, to the home loan market. Mr. Obama contended that “private lending should be the backbone” of the market, but he provided no specifics on how to make that happen.

This is a huge, complex problem.

Actually it’s not. All the problems Ms. Morgenson discusses below would be solved by higher interest rates. If investors were allowed to properly price in the risks, the market would find its own equilibrium.

In fact, there are many reasons for the reluctance of banks and private investors to fund residential mortgages without government backing.

For starters, banks have grown accustomed to earning fees for making mortgages that they sell to Fannie and Freddie. Generating fee income while placing the long-term credit or interest rate risk on the government’s balance sheet is a win-win for the banks.

While this is true, it would also be true of a private securitized mortgage market. Banks would still originate loans and collect fees and sell these loans to private investors. The government guarantee just makes the price higher (and interest rates lower). Banks and originators would make money whether or not a government guarantee were in place.

A coming shift by the Federal Reserve in its quantitative easing program may also be curbing banks’ appetite for mortgage loans they keep on their own books. These institutions are hesitant to make 30-year, fixed-rate loans before the Fed shifts its stance and rates climb. For a bank, the value of such loans falls when rates rise.

All investors are hesitant to lock in long-term rates when they know inflation is coming. That’s why interest rates must rise. Duh.

This process has already begun — rates on 30-year fixed-rate mortgages were 4.4 percent last week, up from 3.35 percent in early May. This is painful for banks that actually hold older, lower-rate mortgages.

This is painful for everyone. Why should the US taxpayer feel this pain?

Private investors, like mutual funds and pension managers, aren’t hurrying back to the residential mortgage market, either. Deep flaws remain in the mortgage securitization machine, and it needs to be retooled before investors will begin buying these securities again.

The private market would solve this if given the chance. Any intelligent entrepreneur would examine the flaws and fix them because they knew the investors would pay a premium, and the entrepreneur would make more money.

Perhaps the largest problem for investors who might otherwise be willing to return to the mortgage market is the lack of transparency in privately issued securities. Investors interested in mortgage instruments are not allowed to analyze the loans going into these pools before they buy them.

The banks putting together the deals typically provide some data, like borrowers’ incomes and credit scores, as well as whether the loans backed primary residences or second homes. But investors don’t get access to actual loan files that can tell them what they need to know about the quality and types of the mortgages packed inside the deals. …

If an investor discounts a security for lack of transparency, then securitizers would naturally respond by increasing transparency to get a better price. What is the dilemma here?

Then there’s another issue. Investors are also unlikely to take an interest in mortgage securities because serious conflicts of interest are still embedded in the process.For example, in the aftermath of the crisis, investors learned that they could not rely on the trustee banks charged with overseeing these loan pools to do their jobs. The trustees are supposed to make sure that firms administering the loans treat investors fairly. These duties include taking in and distributing payments as well as foreclosing on borrowers.

Even though the trustees are supposed to work for investors, these watchdogs are actually hired by the big banks that not only package the mortgage securities but also provide administrative services for them. So it was perhaps not surprising that the trustees failed to make the big banks buy back loans that didn’t meet the quality standards set out when the securities were originally sold. Such buybacks could have prevented billions in losses for investors, and the trustees’ inaction indicated where their allegiances lay.

This bad behavior on the part of bank servicers will also be corrected by the markets. If investors discounted securities serviced by a bad bank, securitizers would look to other servicers who wouldn’t behave badly in order to get a better price.

Yet another reason for investors around the country to steer clear of mortgage securities is the recent action by Richmond, Calif., to seize underwater home loans and reduce the amount of debt outstanding on the properties. Many of the loans that the city officials want to restructure are held by mutual funds and pensions.

This will go nowhere. (See: Richmond, CA, moves to seize mortgages through eminent domain)

Mr. Obama’s views on the path forward for housing finance are welcome. But much work needs to be done before private capital will come back to this market. Eliminating conflicts of interest and increasing transparency in the securitization process will go a long way to achieving that end.

And raising interest rates will go even farther.

Gretchen Morgenson has been writing about housing and mortgage finance since I’ve been covering these issues. I’m always a little surprised by how tenuous her grasp of the subject matter is. She fails to see that these problems are readily solvable, and she completely misses the ultimate solution which is higher interest rates.

The bottom line is that mortgage interest rates must rise if private capital without government guarantees is going to be the basis of the market. Since the banks can’t afford substantially higher interest rates, I expect to see the GSEs continue in their current form until prices near peak levels and banks finally resolve their outstanding bad loans.

2008 refi leads to foreclosure

The former owners of today’s featured property bought it back in 1994 for $148,000, most of it borrowed. They didn’t Ponzi borrow during the bubble, but in mid 2008, they refinanced with a $270,000 first mortgage and extracted a lot of cash. They quit paying the mortgage shortly thereafter, and they squatted for two and a half years. Fannie Mae took this house back late last year and finally put it on the market.

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12722 VOLKWOOD St Garden Grove, CA 92840

$448,500 …….. Asking Price
$148,000 ………. Purchase Price
6/24/1994 ………. Purchase Date

$300,500 ………. Gross Gain (Loss)
($35,880) ………… Commissions and Costs at 8%
$264,620 ………. Net Gain (Loss)
203.0% ………. Gross Percent Change
178.8% ………. Net Percent Change
5.7% ………… Annual Appreciation

Cost of Home Ownership
$448,500 …….. Asking Price
$15,698 ………… 3.5% Down FHA Financing
4.32% …………. Mortgage Interest Rate
30 ……………… Number of Years
$432,803 …….. Mortgage
$120,617 ………. Income Requirement

$2,147 ………… Monthly Mortgage Payment
$389 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$93 ………… Homeowners Insurance at 0.25%
$487 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,116 ………. Monthly Cash Outlays

($521) ………. Tax Savings
($589) ………. Principal Amortization
$25 ………….. Opportunity Cost of Down Payment
$132 ………….. Maintenance and Replacement Reserves
$2,163 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$5,985 ………… Furnishing and Move-In Costs at 1% + $1,500
$5,985 ………… Closing Costs at 1% + $1,500
$4,328 ………… Interest Points at 1%
$15,698 ………… Down Payment
$31,996 ………. Total Cash Costs
$33,100 ………. Emergency Cash Reserves
$65,096 ………. Total Savings Needed
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