Confirming reports in the media, our recent channel checks indicated that the federal government is contemplating a program whereby the government-sponsored enterprises (GSEs) and FHA would permit mortgage originators to underwrite new-home loans with a 30-year fixed rate of 4.5 percent, which will then be purchased by the government through the GSEs or FHA program. With prevailing 30-year fixed rates at approximately 5.5 percent, the initiative serves as a government-backed mortgage rate buydown, yet another measure being taken to address the root of the financial crisis. In my view, the government’s actions are an attempt to force mortgage spreads closer to historical levels. For example, since November 2007, the spread between the 30-year mortgage rate and the 10-year Treasury has exceeded 200 basis points, which compares to the historical median of roughly 160 basis points. The weekly spread recently peaked at 280 basis points prior to the Fed’s decision to directly purchase $600 billion of mortgage-backed securities. While the spread has tightened roughly 25 to 50 basis points since that announcement, it still remains above 200 basis points. As the free market has not reduced the risk being priced into residential real estate via mortgage rates, it appears the government is stepping in to facilitate the adjustment. The proposed 4.5 percent federally backed mortgage rate would be modestly above the 4.25 percent rate implied by historical spreads.
Mortgage contacts were mixed regarding the potential stimulus to be realized from the proposed plan. Those that believe there is pent-up demand in the channel expect the lower mortgage rate to be a substantial benefit to the market. On the other hand, the headwinds of poor credit, lack of existing-home equity, minimal sources for down payments, and near record low consumer confidence may limit the upside.
Confidence of potential home buyers that home prices are unlikely to deteriorate further is the primary factor missing in many markets, as traditional affordability metrics are back to acceptable levels. Unless the government can end the downward foreclosure spiral, I believe that consumers will be unwilling to purchase a home when there exists a high probability that their down payment could be eliminated in a short amount of time by further home price deflation. I do not subscribe to the notion that there is significant pent-up demand in the channel and thus believe that the success of initiatives aimed at lower mortgage rates will be muted in the near term. The fact that rate buydown programs recently offered by some of the national home builders have been unsuccessful in stimulating demand reinforces this opinion.
With that said, lower funding costs have to be considered an incremental positive and could further fuel purchases that have been helping to clear excess inventory from the market, largely through the purchase of foreclosures. This improvement is unlikely to halt accelerating defaults and the pipeline of foreclosures, and thus will probably not stop home price deflation in the near term. However, I believe it is a small step toward finding a floor for the housing downturn.
In addition to stimulating demand via lower mortgage rates, members of various government agencies have discussed several aggressive proposals for Congress to consider that are aimed at stemming the ongoing wave of foreclosures.
In my view, a solution to completely solve the foreclosure crisis seems highly unlikely as servicers are unable to overcome many modification impediments including delinquent borrowers that do not return phone calls. Complexities surrounding pooling servicing agreements in non-agency securitizations, second lien holders reluctant to cooperate, and a lack of income to justify modifications are also issues. Furthermore, moral hazard risks are surfacing and the risk of re-default on modified loans is currently running at approximately 35 percent after six months and nearly 60 percent after eight months.
Nevertheless, I expect policymakers to continue their aggressive attempts to reduce incremental foreclosures and pressure the private sector to step up its efforts to supplement several modification programs.