Why Mortgage Rates Will Climb

Mortgage rates are up now and are driving higher in the future for two reasons, both emanating from Washington, including one that many are overlooking.

The first reason is well known: The Federal Reserve is planning to withdraw its bond-buying program. The second reason, whose impact is down the road, is the likely revamping or outright extinction of Fannie Mae and Freddie Mac, the two government-supported mortgage giants.

A lot of lawmakers are uneasy that in the post-2008 world, Fannie and Freddie are the mortgage market. The two organizations backstop almost 90% of U.S. home loans today. They buy mortgages from home lenders and package the debts into bonds; this in theory frees up lenders to make more loans. So Freddie and Fannie are linchpins in a housing recovery, which is key to a U.S. economic revival.

But while their influence is enormous, Fannie and Freddie’s weaknesses are also large. They are $187.5 billion in debt to taxpayers, a result of the 2008 bailout that rescued them from insolvency.

Upcoming fights over the federal budget and debt ceiling may lead to the restructuring or dismantling of the two behemoths, just when the market may least need the extra turmoil. President Barack Obama on Aug. 6 said: “I believe that while our housing system must have a limited government role, private lending should be the backbone of the housing market.”

Congress seems eager to make that happen. Sen. Bob Corker (R-Tenn.) and Sen. Mark Warner (D-Va.) propose transferring lending risk over to private capital. Their bipartisan bill requires private lenders to assume the first 10% of losses on individual home loans, and bolsters Fannie and Freddie so they are sufficiently capitalized to counter major losses. The Corker-Warner plan creates a new federal agency – the Federal Mortgage Insurance Corp., or FMIC – that regulates the mortgage industry and insures banks in a crisis.

The money to do this comes from assessing a fee on each mortgage issued. In the bill’s vision, the FMIC pays for itself thanks to those fees, and has enough left over to fund the construction of affordable multifamily properties and provide assistance to low-income homebuyers.

In the House, though, sentiment is building among Republicans to terminate Fannie Mae and Freddie Mac. House Financial Services Committee Chairman Jeb Hensarling (R-Texas) has a bill that abolishes them without a replacement – leaving the Federal Housing Authority as the only remaining U.S. mortgage backstop.

As Bloomberg notes, no House Democrats have emerged to support that bill – and as the Baltimore Sun finds, the bill drafted by Sens. Corker and Warner stands little chance of getting past the House. So it seems the playing field might be reshaped only after considerable compromise, and not in the short term.

Between early May and mid-July, the average interest rate on the 30-year fixed-rate mortgage rose a full percentage point. Rates on 30-year loans basically held steady since recently, around 4.51% in Freddie’s survey. But they could rise dramatically again.

All of this happened as the Federal Reserve Board’s rattled markets with intimations that it will reduce its purchases of mortgages and Treasury bonds. It makes the purchases to depress interest rates and boost economic activity. Wonder what happens if these legislative proposals on Fannie and Freddie pick up steam, too?

When mortgages become costlier, things can get a tougher for homebuyers, home sellers, homebuilders, real estate brokers, the construction industry, the labor market, the service industry and the broad economy. As housing’s comeback is a key factor in this current economic recovery, how worried should we be that home loans are growing more expensive?

Analysts are divided about the impact. A July Wall Street Journal poll of economists drew mixed opinions: 40% of respondents felt that more expensive mortgages “won’t have a noticeable effect” on the housing recovery, 35.6% thought that they “will slow sales” and 24.4% believed that they “will slow home-price gains.”

Without Fannie and Freddie, rates go up even more. The economics are pretty straightforward. Private lenders have little motivation to finance home loans the way the rules are now, and need significant incentives to bring them back into the market. As Moody’s Analytics chief economist Mark Zandi told CNBC, “It will mean higher mortgage rates. The question is how much higher.” In particular, first-time or lower-income homebuyers might find it even tougher to qualify for a loan. Loan standards are much tighter nowadays than before the housing crunch. Already according to Freddie Mac the average credit score for a Fannie and Freddie loan in 2012 was 756, compared with 720 in 2006.

Oh, and the two housing finance titans are finally profitable again – with an asterisk. Fannie and Freddie channeled $158 billion in dividends to the Treasury, but that money represents an investment gain for U.S. taxpayers. This money does not reduce the $187.5 billion owed to “us” on the Treasury’s initial bailout payments, because the bailout ensures government control of the two enterprises.  

The 30-year mortgage: endangered species? Without Fannie and Freddie around to guarantee home loans against defaults, the worry is that the standard American mortgage becomes scarce. In many other nations, 30-year home loans are unconventional. Banks could address the greater default risks of 30-year mortgages by asking for larger down payments and demanding higher interest rates.

Maybe we haven’t seen it yet. The fundamental housing market benchmarks are lagging indicators, presenting statistics a month or more old. The Case-Shiller composite home price figures are based on three-month averages ending in the latest month of the index – in other words, the May survey reflected data from March, April and May, and May is when mortgage rates began their ascent.

Also, the Census Bureau’s new home sales figures invite skepticism. The pace of new home sales reached a five-year peak in May, but here is the asterisk: The Census Bureau actually measures new home sales in terms of signed sales contracts rather than closings. So a sizable percentage of those homes are not yet constructed, and the actual closing could be months away.

As it turns out, 36% of the signed sales contracts in May were for homes still to be built – meaning they were in all probability three to nine months from completion. Most of the involved buyers were unable to lock in mortgage rates in early May, as they would have preferred.

What will Congress do? It is hard to imagine Fannie and Freddie liquidating their portfolios and going out of business soon. Reform will probably proceed gradually – very gradually indeed, despite any hyperbole from politicians.

If the economy gathers or at least maintains momentum, and that boosts consumer morale, then the housing market should see sustained demand – a desirable outcome.

Two things can’t be denied. One, consumers grew more optimistic recently (and wealthier, at least on paper). Two, home loans are still really cheap these days by historical standards.

Those two factors may maintain demand in the real estate market in the face of rising interest rates. That’s provided that lenders do not exact high down payments, shorter loan terms and markedly higher interest rates, killing the housing recovery and affordability.

Follow AdviceIQ on Twitter at @adviceiq.

Walid L. Petiri, AAMS, RFC, is chief strategist at Financial Management Strategies LLC in Baltimore. 

AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.