A few weeks ago, we invited readers to send their questions directly to our investment professionals. Answers to selected questions will be published on the blog. Feel free to continue to send in your questions — click the envelope icon on the top right of the screen to send us an email. Head of Non-Agency Mortgages, Ray McGarrigal, answers our first question below:
Since the housing market is a crucial piece of the economy’s recovery, what do you think is still needed to improve growth?
– Christina, Washington, D.C.
Finally! The housing market is improving. Mortgage rates are at an all time low and housing affordability is at an all time high. However, growth is still impeded as we are still waiting for lower tier borrowers to benefit. The majority of mortgage borrowers who had positive equity have already refinanced into these all time low rates, possibly multiple times. They tend to be wealthier households with a low marginal propensity to consume so the impact on spending has been somewhat muted. New home buyers able to meet today’s tougher standards have also benefited; however, there have not been enough of these yet to impact the overall economy. A large number of borrowers remain locked out of this potential windfall. Either they defaulted during the past few years on obligations they were unable to meet and thus are ineligible to get a purchase application approved or they are unfortunately sitting on an underwater obligation and are forced to continue to overpay. Even with mortgage rates at historic lows, more than half of the outstanding fixed rate mortgages in the United States carry an interest rate greater than 5%.
The bad news is that the Federal Reserve’s transmission mechanism to consumers is an indirect lever that relies upon a financial intermediary to underwrite a new mortgage. This intermediary must be willing to refinance these underwater, lower credit borrowers and probably won’t do so unless provided an incentive such as Home Affordable Modification Program (HAMP) or Home Affordable Refinance Program (HARP). It’s important to note that these borrowers are also the most likely to spend their marginal dollar so the impact on spending if they were able to refinance could be quite large. The Federal Reserve estimates that there was approximately $9.9trillion of residential mortgage debt outstanding as of the third quarter of 2012. If half of these borrowers paying a rate greater than 5% (let’s assume 5.5%) were able to refinance into a new 30yr fixed rate mortgage at 4% (still above current market rates), their annual savings would be more than $50 billion. This savings, now freed up for spending, would serve as a tremendous boost to the economy.
Unfortunately there is no magic wand available to make this happen instantly, but the combination of continued marginal improvement in home prices, time and possibly a slight weakening of credit standards could begin a mini-refinancing wave. As home prices have risen, more and more borrowers are moving back to a positive equity position. As a result, we are beginning to see a slight uptick in prepayment rates in some of the more seasoned non-agency RMBS deals. This is a change that could begin to gain momentum if home prices continue to rally and credit standards or alternative sources of housing finance come available.