This was excerpted from the Mortgage Market in Review newsletter that I distribute to my referral sources weekly. You can read this week’s issue here: December 26
Market Comment Mortgage bond prices were lower last week, which pushed mortgage interest rates a little higher. Rates came under pressure early in the week as the DOW surged higher Tuesday. Rates came under further pressure as the European Central Bank opened a long term financing facility to help ease the credit crisis in the region. Leading economic indicators and University of Michigan consumer sentiment data both came in higher than expected. The debt auctions were generally average at best. Mortgage bonds ended the week worse by approximately 1/2 of a discount point.
In years past a borrower would visit their local savings and loan to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend. Borrowers came to the S&L looking for a loan and were told to come back when a current mortgage paid off. What the bank needed was a way to sell the loans they made freeing up the capital to lend to new borrowers. This way they could lend the “same” money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.
To address this issue, FNMA and GNMA were established. The goal is to provide cheap mortgage money to prospective homeowners and a high quality bond for the investment community. The bond or Mortgage Backed Security (MBS) take mortgages with similar risk characteristics and pool them together. Investors in the MBS’s know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines.
During the past real estate boom underwriting guidelines were relaxed giving way to a whole new menu of mortgage products such as 100% financing. In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the property could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses moderated in 2006. Once the housing market began to cool and prices moderated, foreclosed homes were being sold for less than the notes. To add insult to injury, the loans underwritten to the looser guidelines did not perform as hoped. With the value of the collateral in question (falling home prices) and the future performance of the borrowers unknown, investors’ appetite for this risk waned. Unfortunately the liquidity issues associated with Alt A and subprime loans carried over to more secure AAA GNMA and FNMA loans. Sellers of AAA MBS’s found it more difficult to find buyers. Fortunately the Fed eventually stepped and purchased mortgage-backed securities in an unprecedented effort to keep rates low, the housing market from crumbling, and the entire economy afloat. For all the criticism the Fed receives, these efforts have been successful so far.
How this all plays out in the long term is still up for debate. The one thing that is certain is that rates remain historically very favorable. Now is a great time to take advantage of these low mortgage interest rates.
I hope you all have a very merry and happy holiday season. All the best.