Nominal Mortgage Rates Never Lower

The AP details:

Fixed mortgage rates have fallen to historic new lows for a fourth straight week and are likely to fall further.

The average on a 30-year fixed mortgage fell to 4.01 percent this week, Freddie Mac said Thursday. That's the lowest rate since the mortgage buyer began keeping records in 1971. The last time long-term rates were lower was in 1951, when most long-term home loans lasted just 20 or 25 years.

The average on a 15-year fixed mortgage, a popular refinancing option, ticked down to 3.28 percent. Economists say that's the lowest rate ever for the loan.

Mortgage rates tend to track the yield on the 10-year Treasury note. The 10-year yield has risen this week to around 2 percent. A week ago, it touched 1.74 percent -- the lowest level since the Federal Reserve Bank of St. Louis started keeping daily records in 1962. As recently as July, the 10-year yield exceeded 3 percent.

Source: Federal Reserve

What Mortgage Payment?

TransUnion (hat tip Calculated Risk) details:

A new study developed by TransUnion confirms that the "new" payment hierarchy -- where consumers pay their credit cards prior to their mortgages -- is continuing, with the trend occurring more readily than ever before.

"Conventional wisdom has always been that, when faced with a financial crisis, consumers will pay their secured obligations first, specifically their mortgages," said Sean Reardon, the author of the study and a consultant in TransUnion's analytics and decisioning services business unit. "However, a recent TransUnion analysis has found that increasingly more consumers are paying their credit cards before making mortgage payments. This analysis reaffirms the results of a previous TransUnion study that examined data between the third quarter of 2006 and the first quarter of 2008."

This response has been even more pronounced in areas that have suffered more on a relative basis (i.e. Florida and California).



These numbers are astounding.

Source: Transunion

Agency Mortgage Bonds are RICH

Bloomberg (via Calculated Risk) details Meredith Whitney's latest concern:

The Federal Reserve has begun slowing purchases in the $5 trillion market for so-called agency mortgage-backed securities after announcing in September that it would extend the timeline for its $1.25 trillion program to March 31 from year-end. Whitney said that banks are only originating home loans that they can sell to Fannie Mae and Freddie Mac.

“If Fannie and Freddie can’t sell to an end buyer, i.e. the U.S. government steps back, the mortgage market at minimum contracts, rates go higher, and banks are poised with more writedowns,” said Whitney, founder of Meredith Whitney Advisory Group. “This is probably the issue that scares me most across the board.”

The chart below shows the option adjust spread "OAS" of Agency Mortgages to Treasuries. This is model driven (the below utilizes Barclays model) to estimate for pre-payments by borrowers and a number of alternative models suggest the OAS is now NEGATIVE to Treasuries (the power of subsidies!).



The question is who is buying mortgages at these levels besides the Fed? Easy... any investor in the Barclays Aggregate index (think pension plans, 401k participants, etc...) .

Source: Barclays Capital

A Home on the Cheap(er)

SF Gate reports:

Rates on 30-year mortgages fell slightly last week but remained just ahead of record lows posted this month, Freddie Mac said Thursday.
Real Estate

Average rates on 30-year fixed mortgages dipped to 4.8 percent from 4.82 percent the previous week, Freddie Mac said. Last year at this time, the average rate on a 30-year mortgage was 6.03 percent. It has been below 5 percent for six straight weeks.

The all-time low of 4.78 percent was recorded the week of April 2. Freddie Mac's survey dates back to 1971.

Freddie Mac also said the average rate on a 15-year fixed-rate mortgage was 4.48 percent last week, unchanged from the previous week.

Rates on five-year adjustable-rate mortgages fell to 4.85 percent from 4.88 percent - the lowest since Freddie Mac began tracking it in January 2005.

The below chart shows the importance of these low rates... a reduced mortgage payment. Assuming a $160,000 loan (a $200,000 home with 20% down), the monthly payment has now dropped to a little more than $850 per month, down from $1000 last Fall.



Source: Freddie Mac

Bailout the Shelter. Not the Investment.

What is a Speculative Investment?

In addition to the reduced interest rate subsidies announced last week, the Chicago Tribune reports:

Congress is poised to give bankruptcy judges more power to modify primary home mortgages in an attempt to halt the foreclosure crisis, a move Democrats and housing advocates have been pushing for two years in the face of stiff opposition from Republicans and the mortgage industry.

So even if the contract of the loan states the bank can take over the home if the buyer doesn't pay (i.e. THEY ARE COLLATERALIZED LOANS), a judge can cram down the loan to an "affordable" level not necessary based on market price.

Besides a HUGE transfer of wealth from those taxpayers / investors that will fund this to those receiving the benefit, who else does it help? The NY Times reports Obama's view:

Mr. Obama said pointedly that it would not help “speculators who took risky bets” or “dishonest lenders who acted irresponsibly” or “folks who bought homes they knew from the beginning they would never be able to afford.”

I couldn't possibly disagree more.

Definition #1 for speculator:

To engage in a course of reasoning often based on inconclusive evidence.

Definition #2 for speculator:

To buy securities or property in the hope of selling them at a profit

Combining definition #1 and #2 we get definition #3 for a speculator:

Engaging in the purchase of property, with the inconclusive evidence that it can be sold at a profit

Or in an EconomPic form, we get the speculative investor "circle of life".



Real Life Mortgage "Moral Hazard" Plan

Not surprising, the AP reports real life sentiments as predicted by the Mortgage "Moral Hazard" Plan Matrix below:

Click for larger image



A quote by someone from the bottom right quadrant:

"I feel like I'm doing the right thing paying my mortgage, and now apparently I have to pay my neighbor's mortgage, too. People are really angry," said Kim Guymon, a stay-at-home mom who bought a three-bedroom home with her husband in suburban Seattle in 2001 and has watched it drop $150,000 in value since last summer.

And the top left:

"It's just rewarding crooks," said the 38-year-old single mother, who said she turned down a bank's $100,000 mortgage offer five years ago because she knew she couldn't afford it.

Personally, I'm in the bottom left quadrant. I was able to purchase a home that I could afford, but it would have been a significantly smaller place, in a less ideal location, and more expensive than what I was able to rent, thus it didn't seem like a good investment. I don't think many people would argue with this statement that a home is an investment; purchasing a home with an expectation that it will increase in value turns a house from just shelter (i.e. renting) into an investment. Furthermore, if someone buys a home and is not able to make monthly mortgage payments based upon the initial value of the home, then the home is not only an investment, it is a speculative investment (i.e. the buyer could only afford the home based on speculating that the value of the home would rise).

To get a better idea of someone in the top right quadrant of the matrix, lets go back to the AP article:

Rosa Valdez, a resident of Coachella, Calif., hopes it's not too late for her family to be helped. The native of Mexico saved enough to buy a new $380,000 home in 2006 in the Lennar development of La Morada, where foreclosures are rampant. She fears her home could be next without federal help.

While the current price of a home is related to willingness of the owner to pay, it has nothing to do with the ability to make those payments unless that home was purchased as a speculative investment and in need of appreciation to make due. Lets use Rosa's $380,000 home purchase as an example (a price that was almost twice the 2006 national median home value at the time). Just three years after the home was purchased, she and her family can no longer afford to make the monthly payments without federal help. Thus, at initiation there were two distinct possibilities:

• Home prices rise = Rosa would have sold the home for a profit or refinanced the home to tap into the new equity to make monthly payments
• Home prices fall = Rosa defaults and walks away

In other words, paying the mortgage down for life was never a possible outcome, which means the entire transaction was pure speculation...

If the government wants to help individuals stay in their homes... fine, but please give the taxpayer ownership of those assets if it involves taxpayer money.


But, Will the Plan Work?

It better for the cost of the plan. Unfortunately, I only see the benefit as being 'on the margin' and we need more than an 'on the margin' benefit for the size of the bailout, which is huge when broken down. The basic details of the plan are as follows:

The mortgage plan is hoping to help 9 million individuals at a cost of $275 billion. This comes out to $30,000 PER BAILOUT or 20% of the current value of the median home PER BAILOUT! While I don't question the government's ability to spend $275 billion, I do question the 9 million figure based upon my hypothesis that home prices NEED to eventually reach their natural price level (use the chart below to determine the cost per bailout based upon whatever estimate you want to use).



The question I've asked myself (as a non-homeowner who is looking to purchase); would I be willing to pay $200,000 for something I believe is worth $150,000, even if my monthly payments are the same due to subsidized financing? Of course not! What if I want to move in the next 5, 10, or even 15 years? In that case the house gets marked to market and I lose my $50,000 relative excess. Thus, my theory is that regardless of this plan, home prices still have room to fall.

It is clear the administration believes that solving the housing problem is more important than the moral hazard being introduced. If that's the case, here is my alternative... reduce the principal owed on these mortgages IF they are already taxpayer owned (i.e. a Fannie / Freddie mortgage - leave private loans out of taxpayers hands). If they want to blow $275 billion for 9 million people, then reduce the principal by that 20% per bailout amount.

In other words, if prices are going to fall anyway, why prevent the inevitable? Renowned investor Wilbur Ross seems to echo these sentiments (Housing Wire via Naked Capitalism):

“The price of housing needs to be cleaned out. The Obama administration could right-size every underwater home and reduce principal to fit the current market value of the home. If they are going to deal with it they have to deal with it in a severe way,” Ross told HousingWire. “They also really need to consider all borrowers who are underwater, and not just the ones that have gone into default.”

The Homeowner Affordability and Stability Plan does some of that, but doesn’t go far enough, Ross suggested. “The have to reduce the principal amount of loans, not just nonperforming loans, but also performing ones,” he told CNBC. “Why should a guy who’s not paying benefit, while some poor citizen who’s struggling to make the payments gets stuck with the mortgage?”

Mortgage "Moral Hazard" Plan

Click for larger table

Source: Homeowner Afford Ability and Stability Plan Fact Sheet

Fixed Mortgage Rates at Less than 4.5%

Update: Tom O points out in the comments that EconomPic is slacking with regards to timely info, which I will agree with (meant to post this last week...)

A little behind the time. Conforming fixed 30-year mortgage rates in CA for prime borrowers have been around 4.5% at a point (under 4.7 APR)for the last week or so.

Per Bloomberg:

The largest U.S. banks are starting to offer fixed home loans below 5 percent after the government began buying mortgage securities to bolster the housing market.

JPMorgan Chase & Co. is advertising 30-year mortgages as low as 4.75 percent on its Web site, Wells Fargo & Co. has an offer for 4.875 percent and Bank of America Corp. has rates at 5 percent. The offers are for borrowers with excellent credit who put 20 percent down.

Felix of Market Movers even shows a 4.375% 15-Year rate from Chase.

Looking at historical 15-year rates and using those rates to calculate monthly payments on a 15-year $200,000 mortgage, we see monthly payments down almost $250 / month. This hope is this brings in the marginal buyer.



Too soon to tell, but it does seem like a positive sign. Of course, in an environment marked by 20-50% declines in home values there are always secondary effects to worry about.

Huge Mortgage Rally... Thanks Government!

FT reports:

The Federal Reserve on Monday kick-started its latest unconventional programme to boost the US economy, this time targeting mortgage-backed securities to help the slumping housing market, reports Reuters. The Fed plans to buy back as much as a ninth of outstanding, mortgage-backed bonds sold by mortgage giants Fannie Mae, Freddie Mac, and Ginnie Mae. The aim is to encourage buyers to return to the housing market or cut payments on existing home loans. The New York Fed began buying MBS guaranteed by Fannie, Freddie and Ginnie on Monday, part of a programme of as much as $500bn.

Nice rally! Now all the government needs to do is buy equities, credit, and commodities / hire everyone currently unemployed... almost there!

In Excel this is called a Circular Reference Error

Per the MBS Purchase Program FAQ (hat tip Across the Curve):

Assets purchased under this program are fully guaranteed as to principal and interest by Fannie Mae, Freddie Mac, and Ginnie Mae, so the Federal Reserve's exposure to the credit risk of the underlying mortgages is minimal.

Click for ginormous picture

Real Mortgage Rate is Not So Nice

The below shows the daily mortgage rates less the implied 7 year inflation rate (assumes the average life of a mortgage is ~7 years). This is much less encouraging than my earlier post.

Mortgage Financing on the Cheap... Will It Work?

Bloomberg reports:

The average rate on a fixed 30-year mortgage fell to 5.18 percent last week from 6.47 percent in October, according to Mortgage Bankers Association data.

Looking at daily data, I'll go ahead and project that next week's figure will look much better. After the Fed announced Tuesday they would be buying mortgages, rates tightened another 60-70 bps to a rate of ~4.4% (according to Barclays)!



Funny thing is... at this point the rate cut to prop up housing feels an awful lot like OPEC oil cuts to prop up the price of oil, with the obvious difference being trying to stimulate demand vs. halt supply?

My question... will either work in the short run?

New "Bailout" Liabilities = Existing Publicity Traded Debt of U.S.

FT (HT Credit Writedowns):

The two mortgage companies have between them $5,400bn in liabilities, equal to the entire publicly traded debt of the US, alongside mortgage-related assets of about equal value. These will now all be accounted for by the CBO, although public accounting rules mean that its tally of US government debt may not necessarily increase by $5,400bn.

Fannie Spreads WAY In...

IN A PERFECT WORLD: BAILOUT = END OF CREDIT CRISIS

Over the past few weeks there has been much criticism over the potential (now actual) Government Sponsored Agency “GSE” bailout due to the potential cost to taxpayers, the moral hazard it would encourage, etc... I do not disagree with most of these criticisms, but the cost of NOT doing anything would be much greater. To show the potential benefits of the bailout on both housing and credit markets, which in turn will benefit the economy, below is how the bailout will unfold in a “best case” scenario. While I do not believe it will solve all of the problems detailed below (or even a fraction of them) in this manner, I do believe it is important to look at the bail-out in terms of a "glass half full" and how it can help alleviate the liquidity problems associated with today’s credit markets.

I) BAILOUT DETAILS
Specific features of the bailout that impact the outcome to the credit market include the Feds new liquidity facility, the goal to increase Fannie and Freddie's mortgage-backed security portfolios through the end of 2009, the right for the Treasury to actively purchase MBS in the open market to reduce spread (and cost to future homeowners), and the future goal to reduce the GSE balance sheet by 10% annually starting in 2010. In the first part of my "perfect world" analysis, I predict that these features (and others – go here for 10 key features) will help put a floor on housing prices.

II) RATES MATTER

Homeowners that already qualify for high quality prime loans will not be as impacted directly by the new moves by the Fed. Why? Agency spreads are near historic wides, but absolute levels are already near historic lows.

HOWEVER, borrowers that do not currently qualify for these low rates should see their rates drop dramatically. Why is this important? If a homeowner that qualified for a 9.5% rate can access a 7% government “subsidized” loan, their buying power increases by almost 25% (all else equal).

These “subsidized” loans will prop up the housing market as the size of the payment made is what truly matters for a homeowner (specifically one that intends to live in that home for the foreseeable future). Importantly, these rates are not “teaser” rates that reset, but more manageable fixed rates for the life of the mortgage.

III) THE IMPORTANCE OF ATTRACTING THE MARGINAL BUYER TO THE MARKET
The goal is to entice the marginal buyer to come to the market / have “bad loans” refinance at more manageable rates. In the past 6-12 months potential homeowners have been sitting on the sideline as prices continue to make new lows (nobody wants to catch a falling knife). With the new “bailout” limited time horizon (increasing balance sheet through 2009), this SHOULD bring a sense of urgency for new homeowners (expect emphasis on the "limited time offer" aspect).

If these low rates do put a floor on home prices sooner than later, this should benefit the owners of subprime / Alt-A securities that have priced down as delinquencies have risen at historic levels. If the market bottoms and these owners are able to refinance at the new lower rates, get who gets off the hook? THE EXISTING MORTGAGE OWNERS who get paid back at PAR for all loans refinanced.

IV) BANKS FINALLY ABLE TO DELEVER AND MAKE NEW LOANS
Banks own a lot of these mortgage securities that have priced down and in response, over the past 6-9 months banks have attempted to delever as their equity has been written down / capital has been so difficult to come by. This system wide delevering only caused these entities to be more levered. How is this possible?

Well, if one bank attempted to delever, they’d be successful. When every bank attempts to do so at the same time, it only makes the problem worse! Let’s take a look…

As these banks all sold off assets at the same time, these assets sold priced down in value as the entire market was selling into a distressed AND illiquid market. This in turn reduced the price of assets remaining at the banks. When that happened, they were forced to write down even more assets / equity, resulting in leverage HIGHER THAN WHEN THEY INITIALLY BEGAN.

If these assets snap back even partially in value, the reverse happens. In fact, I expect a portion (maybe a tiny portion) of the underlying mortgages in securities marked as low as 60 cents on the dollar to repay at PAR when homeowners sell to new owners at the “subsidized” rate or are able to refinance themselves. In addition, liquidity injected into the market through the Treasury’s outright purchase of mortgages should bump up the price. The result will be improved leverage ratios at banks, which will slow the asset selling process we've seen from banks. In fact, expect well funded banks to actively buy securities in the market in the coming weeks / months.

It's also important that the bailout makes banks much more attractive for outside investment (think Sovereign Wealth Funds). Once new capital is injected and their balance sheets are improved, new loans can be made. This should result in improved (lower) rates for non-government mortgages.

V) THE CREDIT CRISIS ENDS?
If this all works out as I detailed in the above best case scenario, a functioning credit market at no cost to taxpayers results. What likely will happen? After everything that has transpired over the past 12+ months, I have no idea though I do expect credit markets to more accurately reflect the actual economy and not the lack of liquidity in markets. The result of which might scare investors just the same...

Outstanding Mortgages: Agency vs. Non-Agency

Source: Pioneer Investments

Agency MBS: Cheap or "Mispriced" Options?

Fannie MBS (as defined by 30 Year current coupon TBA), is historically cheap on an option adjusted spread "OAS" to Fannie's Agency Debt (as defined by its 5 year CDS spread) basis, widening even further since last month when I asked "Are Fannie Mortgages Cheap or is its Debt Expensive?"

In researching the topic I came across an interesting post over at Accrued Interest challenging this relative cheapness:

But times are anything but typical. Various conditions are coming together which will keep homeowners in their current residence far longer than historic norms. There is a large number of homeowners currently underwater on their mortgage, and an even larger number with less than 20% equity. Given that getting a mortgage with less than 20% down payment is difficult and very expensive right now, homeowners who currently have less than 20% equity would have to come up with a lot of cash in order to move to another home.

So the housing turnover element of mortgage principal payments is set to plummet. In addition, the same factors will prevent many refinancings. A borrower underwater on his current mortgage will not be able to refinance his loan just because rates fall 50bps.

This means that the average life of a mortgage is longer than is currently being assumed.

For example, a Fannie Mae 30-year 6% mortgage security currently has a nominal yield of 6.19% and an average life of 5 years. The average life is the median of a Bloomberg survey on prepayment estimates. That calculates to a nominal yield spread of 271bps.

Note that a 6% mortgage security is typically made up of borrowers with a 6.5% mortgage. Currently mortgage borrowing rates are 6.26%, according to Freddie Mac. Under normal conditions, one would assume that a 6.5% borrower is relatively close to a refinancing opportunity. Hence Wall Street prepayment models are assuming that this mortgage will pay principal slightly faster than this time last year.

More likely is that mortgages will prepay at historically slow rates. Cutting Wall Street's estimated prepayments in half, the mortgage's average life goes from 5 years to 9 years. Because the yield curve is so steep, that results in the yield spread falling to 219bps. If you cut Wall Street's estimate by a third, the spread falls to 202bps.

As investors come to terms with the extending average lives, prices are likely to fall rather than yield spreads contract. Holding the 271bps yield spread constant but extending the average life to 9 years causes the price to drop by over 3%.

Why didn't I think of that?

Source: Accrued Interest

The Fed's (Lack of) Impact on Rates

Source: Jim Bianco of Bianco Research via Naked Capitalism.