I want to buy a house. Would you be willing to loan me $250,000 for 30 years at 4.25%? Your answer is crucially important. Before you answer keep in mind that you will be taxed on the interest you receive, so your net income will be more like 3%. Do we have a deal? What if I were a low-income borrower who would struggle to make the payments?
These, of course, are some of the questions that banks face when extending mortgage loans. Not surprisingly, over 90% of new mortgages over the past ten years have been either sold to Freddie Mac or Fannie Mae, or backed by the Federal Housing Administration (FHA). It makes little sense for the banks to hold onto these mortgages as long-term investments. Why? Because they don’t want to get stuck with a loan that pays 4.25% if interest rates begin to rise materially. In addition, higher capital requirements and an uncertain regulatory environment make these investments a more costly proposition. And finally, the rebound in housing is moving in fits and starts, creating uncertainty with regard to the collateral backing these loans. As a consequence of all these risks, banks have been passing along these risks to the government and ultimately back to taxpayers.
If interest rates and bonds confuse you, you’re not alone. Bond and debt semantics are counter-intuitive. If interest rates go up, the value of fixed-rate bonds (and loans) falls and vice versa. Think of it this way: you invest $10,000 in a 10-year bond that yields 5%. If rates fall to 3%, you wouldn’t want to sell your bond for $10,000 because you could get only 3% when you reinvest the sale proceeds. Therefore, you would ask more than the $10,000 you originally paid. Conversely, if rates climbed to 7%, no one would pay you $10,000 for a bond yielding just 5%. They would pay you less than $10,000.
Congress is pushing for the elimination of Fannie Mae and Freddie Mac and calling for the creation of a new entity, the Federal Mortgage Insurance Corporation (FMIC), to insure mortgages but not buy them. Under one proposal, FMIC insurance would hold the issuing bank responsible for the first 10% of any loss on a pool of mortgages sold to investors through the securitization process. While that may seem logical, the government still requires mortgage lenders to provide loans to low-income buyers with questionable credit histories. These are very unattractive terms for banks that are in business to make money.
If you are thinking that there is no way you would want to make a 30-year mortgage loan using the assumptions outlined above, you understand the hurdle facing America’s housing recovery. If the government stops buying mortgages (and therefore stops assuming all the credit risk), and the banks won’t write the loans, then prospective homebuyers have less money with which to buy, causing prices to fall. A significant drop in housing prices is crippling to the economy. Should Congress prevail in its proposed changes, the housing recovery could be delayed further. Given the importance placed on housing by the Fed, the ultimate result may be a reversal of the taper and a return to quantitative easing (bond buying).
We can debate the fairness or appropriateness of these Congressional proposals and the role of government in funding the real estate purchases of private buyers. But the consequences of any immediate, dramatic changes to our mortgage finance system are pretty clear.
Like it or not, the government’s funding of the mortgage market makes the current market and current prices possible. We have long suggested that the economic recovery, largely driven by increasing real estate and stock market prices, was and is based on government dollars. As a consequence, new regulation resulting in a decrease in mortgage lending seems an unlikely long-term remedy for an economy that is driven 70% by consumers.
As 2014 continues to unfold, stock markets are at all-time highs, and investors are feeling comfy and complacent. We are never comfy or complacent. When new highs are being made, revisit your investment discipline and make doubly sure you know what you own and why you own it. Furthermore, revisit your asset allocation. If the equity portion has exceeded your limits, it is time to trim and rebalance no matter how uncomfortable it may be to sell winners.