Despite the fact that the mortgage pays for about 90% of all housing revenue for every participant in the housing industry, we rarely see industry executives at mortgage conferences. So we are bringing the intelligence to you in this podcast. We don’t know anyone more knowledgeable on the mortgage market than Doug Duncan, Fannie Mae’s leader of the 35-person Economic and Strategic Research Group.
Doug described today’s underwriting as stable and similar to conditions in the late 1990s, when the mortgage market worked well. His group surveys lenders and consumers and is not seeing any significant shifts in the market. He is seeing “subprime-like” risks in the commercial markets (bonds to companies), but not in mortgages. While there are plenty of active debates over whether to loosen or tighten mortgages, these amount to disagreements on how much risk the government should take. Right now, Doug believes lending is reasonable.
However, the government is more involved in the mortgage industry than ever and is trying to become less involved. These changes could impact the industry significantly.
- Direct involvement. Through FHA, VA, and USDA, the government insures and guarantees payment to mortgage owners on about 25% of all mortgages. That is six times larger than the historical figure.
- Direct oversight. Fannie Mae and Freddie Mac (the GSEs) are supposed to be regulated by the government rather than owned (technically in conservatorship) as they are right now. The administration has announced their intent to put the GSEs back into the private market, where private capital rather than the federal government will take the risks if things go bad. While the intent has been announced, Doug believes the capital involved is too great for this to happen any time soon. When it does happen, mortgage rates will likely rise (relative to Treasuries) to compensate the bond holders for taking on the risk that they are not taking on today.
In the meantime, government officials know that mortgage liquidity (the ability to easily buy and sell mortgage securities) impacts mortgage rates. The more liquid the mortgage, the lower the rate. While the GSEs have been in conservatorship, the government has implemented a number of programs to lower mortgage rates, including bundling Fannie Mae and Freddie Mac mortgages together into a “single security” that presumably will improve liquidity. In other words, the GSEs are improving the industry for the future.
The Inverted Yield Curve Explained
Doug reminds everyone that the Fed Funds rate and mortgage rates are not as correlated as most people believe. The Fed controls short-term rates, while mortgage rates are long-term rates because the loans are for 30 years and on average pay off after 7–9 years when someone moves or refinances.
At the time of our recording on July 9, the 3-month Treasury and 10-year Treasury have been inverted for more than a month, meaning that the returns on a 3-month Treasury are higher than the return on a 10-year Treasury. This is known as an inverted yield curve and has historically been a precursor to a recession. Doug explains why you should be concerned:
- Bond holders see a recession coming. Usually, bond holders demand a higher rate on long-term debt to compensate for the additional uncertainty of what might happen over a long period of time. That is why long-term rates are usually higher than short-term rates. When long-term rates are lower than short-term rates, bond holders are assuming that the Fed will have to drop rates in the future when the economy slows, and thus bond holders are “pricing a recession in” today.
- Banks stop lending. The inverted yield curve also can contribute to a recession because banks lose their incentive to lend. When the banks cost of borrowing (always short-term) exceeds the revenue from loans they are making (usually longer term), the banks stop making loans, companies stop growing, and a recession ensues.
Industry executives should be more concerned than usual that a recession is near but should feel confident that the mortgage industry will not be the cause of the recession this time. Also, although the government is more involved than ever in the mortgage industry—and making noise about becoming less involved, executives should not be overly concerned. Changes are likely to come slowly and to be done with a lot of thought.
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