Ailing U.S. Mortgage and Housing Markets Potentially to Get a Lift
20 Mar 08
While the GSEs now have significant new lending capacity, it is not clear that the demand for this funding will materialize to any great extent in the near future. The risk premiums on GSE borrowing need to come down, and this is problematic given the current high levels of business cycle risk.
The ailing U.S. mortgage credit market and housing market is poised to get a lift from a significant potential boost in lending activity by the GSEs (Fannie Mae and Freddie Mac). The ability of the GSEs to respond to the severe housing downturn had been severely constrained by (a) caps that have been placed on the overall growth of their retained lending portfolio; (b) the conforming loan limit of $417,000—which effectively had frozen these lending entities out of the jumbo mortgage loan market; and (c) the requirement from OFHEO (Office of Federal Housing Enterprise Oversight) to hold a 30% capital cushion over and above their usual capital minimum.
The portfolio caps were lifted (effective March 1, 2008) by OFHEO on February 27. These portfolio caps had effectively restricted the lending activity of the GSEs, with a large share of activity being shunted over into securitized loan conduits.
Conforming Loan Limit
The fiscal stimulus package, which was passed by Congress and signed into law by the president in mid-February, increased the GSE conforming loan limit for one year to $729,750 (for high-cost areas) from its current level of $417,000.
The 30% Required Capital Cushion
On March 19, OFHEO reduced the required capital cushion for Fannie Mae and Freddie Mac from 30% to 20%. This capital cushion had been put in place during an extensive review of questionable GSE accounting practices (dealing primarily with the use and valuation of derivatives contracts). The reduction of the capital cushion is in exchange for a commitment from the GSEs to raise capital. As of December 31, 2007, Fannie Mae had a capital base of about $45.4 billion, or a surplus of $3.9 billion above the required base plus 30%, while Freddie Mac had a capital base of $37.9 billion, or a surplus of $3.5 billion above the required base plus 30%.
Outlook and Implications
The reduction of the required surplus from 30% to 20% would unlock about $7.1 billion in capital in the case of Fannie Mae, and about $6.1 billion in the case of Freddie Mac. How much additional capital these two entities will be able to raise is difficult to say at this juncture, given current difficult conditions in the U.S. equities market and the fact that the market valuation of their shares has dropped sharply in the past year. If they raise an additional $5 billion jointly, then, combined with the lower required surplus, that would provide a capital base of about $18.2 billion to leverage new mortgage lending.
According to estimates from JP Morgan, Fannie Mae and Freddie Mac should be able to purchase about $35–40 billion of mortgages, or guarantee roughly $200 billion in additional loans for every $1.0 billion of new capital. New capital will be allocated between these two businesses. With about $18.2 billion of new capital at their disposition, therefore, the GSEs should be able to expand their retained portfolios by about $600–700 billion.
Given that total new mortgage credit was about $743.3 billion in 2007, the GSEs could make a significant positive impact on the flow of mortgage credit to the housing market in 2008. That being said, the cost of funding for the GSEs has seen significant pressure in the past several months due to heightened perceptions of cyclical risk in the housing market, and the economy as a whole. Therefore, while the GSEs have significant new lending capacity, it is not clear that the demand for this funding will materialize to any great extent in the near future. The risk premiums on agency borrowing need to come down, and this is problematic given the current high levels of business cycle risk.
However, a modest reduction of about 50 basis points in the risk premium on 30-year conventional mortgages, to near 200–210 basis points, would bring 30-year mortgage rates back down to a range of 5.30% to 5.50%. That could stimulate significantly more demand for mortgage loans, and the GSEs are now in a good position to meet that demand. The big question is, can the recent Fed moves to provide significant new liquidity, unlock the credit markets, and lower benchmark borrowing costs lead to such a reduction in the risk premium? We believe they can. If we pass that important watershed in the next few weeks, it perhaps could mark the beginning of the end of the crisis in the mortgage credit markets.by Brian Bethune