When we awoke this glorious Outer Banks day, the mortgage world had changed, In fact, it took a step backwards, which is not necessarily a negative.
It is a shame that so many things affecting our daily lives are massively complicated; so much so that most of us have no idea how their inner-workings impact each of us and our ability to earn a living. As I have mentioned in prior posts, banks and mortgage lenders do not-- indeed-- cannot raise enough liquidity to fund thirty-year mortgage loans and hold them in their internal portfolios for any significant length of time. If they did, they soon would soon run out of loanable funds. Banks need to constantly replenish their stash of loan funds.
Our free market system found a solution for this dilemma--a vehicle called Mortgage Backed Securities. Simply stated, banks would hold mortgage loans to the point in time when they needed to replenish their liquidity so they were able to extend more loans. Thus, they would bundle these loans into a "package" and sell them in the "market" to institutional investors (pension funds, mutual fund managers, large banks, foreign governments) willing to take some risk (as opposed to so-called "zero risk" investments such as US Treasury bonds) in order to receive a return somewhere higher than a US bond while lacking the downside risk of the stock market.
These MBS's, in our recent past, were supposed to be composed of mortgage loans that were uniform--i.e., the loans in the bundle all went through uniform documentation and the various borrowers had similar credit scores, debt to income ratios, and objective appraisals. Rating houses such as Standard & Poor's or Moody's were supposed to audit the loans comprising these MBS bundles, and issue reliable risk ratings such that institutional purchasers of these securities were afforded some confidence in their investment.
Somewhere along the road to the Great Recession, the rating agencies failed to recognize the weakness of the individual loans comprising these MBS's, and purchasers of these instruments took a bath--not only in the United States--but the entire global market-as borrowers defaulted in unprecedented numbers.
Remember as kids when we all thought boys and girls transmitted 'cooties" to one another? Buyers of MBS's now feel the same way--mortgage loans are cootie-infested and the old maxim of "once burned, twice shy" pervades the industry. No one will buy mortgage loan securities anymore, even if the underwriting standards have become so ridiculously stringent (and they have) that it would become virtually impossible for default-probable mortgage loan to find its way into a bundled security. Trust me, the standards on credit scores, the massive documentation to verify employment and assets, even verifying income and job status has become a game where the broker or originator must prove the borrower is not a crook intent on misrepresenting their financial situation.
So, private investors, which formerly purchased the bulk of mortgage loans extended by banks, mortgage lenders, and brokers--disappeared. As part of the stimulus packages of 2009, the Federal Reserve began to supply funds to purchase mortgage loans to the two largest (and currently, the only major purchasers) mortgage purchasers-- Fannie Mae and Freddie Mac. This influx of massive government funds drove down the interest rate and yield on these securities, which kept mortgage loan rates artificially low. As recently as last week, a 30-year mortgage priced at 4.875% yielded enough return to make both the lender, the borrowers and the broker happy with the rate. One day after the expiration of government intervention, the rate has risen to somewhere between 5.125% and 5.25%.
The Fed market intervention has taken place since spring 2009. However, on March 31, the Federal Reserve ceased purchasing ten-year Treasury bonds (the standard index used to determine mortgage loan rates) and turned over to the private sector the responsibility of creating a secondary market for purchasing bundled mortgage loans. That is good news for free market advocates and libertarians.
The bad news? Institutional investors, unlike the Federal Reserve, actually care about the risk inherent in purchasing mortgage securities. And these private investors are not convinced that newly made mortgage loans will avoid default. As a result, they are demanding higher yields on those ten-year Treasuries (likewise, they don't put as much faith in the safety of T-bills given the nation's massive and growing debt-a double-whammy to risk assessment). And, mortgage rates have begun climb--from the 4.875% previously cited (in March) to 5.125 and even 5.25% in April. Simple economics--the higher the perceived risk of an investment, the higher return demanded by the investor. If the government, with its huge debt load now must sell its T-bills to investors other than the Fed, the rate on ten-year notes will rise, and the mortgage security market issues will follow suit as their instruments are perceived to carry even more risk than Uncle Sam's promise to repay his debt.
Although I personally doubt the most pessimistic prognostications from the talking heads at CNBC, Fox Business News and Bloomberg, some experts predict a 200-300 basis point increase in mortgage rates (100 basis points equals 1% in interest rates)--so it's conceivable to imagine thirty-year rates rising as high as 8.25% by December n2010.
In any event, as of today, we have reverted to a mortgage market where rates and yields will be determined by institutional investors rather than being propped up (or more accurately, tamped down) by the Fed. Given the link nationally, and especially locally to real estate sales and economic health, we are either on the cusp of yet another downturn in home sales and purchases, or we shall see a resurgence of private-sector competition in the acquisition of loan portfolios and securities. If the former takes place, the Outer Banks is in for a tough two or three years.
On the other hand, if the private sector becomes comfortable with the quality of mortgage loans (and they should given the now-below market appraised values, the full vetting of income, assets, and documents required to submit loans to investors, as well as record low home prices), we might not only be witness to a resurgence of "conforming" primary residence lending, but also a return to second home, condominium, and pure investment home loans, including the elusive "jumbo investment home"--a category that comprises 40% or more of our housing stock.
For the sake of all my friends in real estate sales, construction, subcontracting, building supplies, as well as the insurers, lawyers and others who facilitate mortgage lending, I sincerely hope the private sector puts behind them the bad experiences of the past four years and enters into a new, yet saner, approach to mortgage lending and home loan products which are notably absent from our current market.