Cheap Money Era That Saved U.S. Housing Seen Bottoming

The era of increasingly cheap money that fueled the housing recovery and record home-lending profits is showing signs of ending in the mortgage bond market.
Fannie Mae-guaranteed 3 percent securities, which lenders use to price new loans, tumbled last week to the lowest since Sept. 12, the day before the Federal Reserve announced plans to add $40 billion of mortgage debt to its balance sheet each month. The drop, as lawmakers struck a budget deal and the central bank signaled it may conclude the open-ended bond-buying program this year, could lead to further increases in homeowner borrowing costs from the record lows set in December.

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Contractors work at the Vicino community in San Jose, California. Photographer: David Paul Morris/Bloomberg

“It would present a test for the housing market just as we’re going into the key spring selling season,” said Mark Vitner, a senior economist in Charlotte, North Carolina at Wells Fargo & Co., the top U.S. mortgage lender. “I wouldn’t wind it down when it is poised to do its most good.”
While no one expects mortgage rates to skyrocket, higher rates could challenge the rebound in U.S. residential real estate after a five-year slump by cutting how much homebuyers can afford to pay. Rising borrowing costs may also “spoil the party” for lenders that profited from a more than 20 percent jump in mortgage originations last year, according to Deutsche Bank AG, by slowing refinancing that’s benefited firms led by Wells Fargo and JPMorgan Chase & Co. (JPM)
Bond investors should also anticipate reduced returns, according to Pacific Investment Management Co. Bill Gross, manager of the world’s biggest bond fund said in a Jan. 4 interview on Bloomberg Television that bets on mortgage securities “are over in terms of the capital appreciation.”

Mortgage Profits

Banks and savings institutions posted $25.3 billion in mortgage-banking profit through the first nine months of 2012, or 24 percent of their $106.8 billion total earnings, according to data compiled by Bloomberg from Inside Mortgage Finance, an industry publication, and the Federal Deposit Insurance Corp.
Lenders’ fattened margins appear to be already contracting as they seek to maintain volumes by absorbing some of the costs of lower bond prices rather than passing them on to borrowers, according to broker Brean Capital LLC.
Government-backed mortgage securities slumped last week as U.S. lawmakers on Jan. 1 agreed to a budget plan that averted the so-called fiscal cliff, which would have meant more than $600 billion of spending cuts and tax increases. The deal reduced tax hikes that could hurt economic growth while maintaining spending that boosts the supply of Treasuries. Bonds could slump again if Congress fails to cut “material expenses” as it continues to address the deficit, Deutsche Bank analyst Steve Abrahams wrote in a Jan. 3 report.

Lower Yields

Bond market losses accelerated after the minutes of a December meeting of Fed policy makers released Jan. 3 showed several of them saw its $85 billion in monthly bond purchases as likely to end sometime in 2013, with some divided between a mid- or end-of-year finish.
The Fed had said after its Dec. 11-12 meeting it would hold its separate target for short-term borrowing costs near zero “at least as long” as the unemployment rate remains above 6.5 percent and inflation projections are for no more than 2.5 percent.
The dissension on the outlook for the debt purchases “spooked” investors, said Jason Callan, head of structured products at Minneapolis-based Columbia Management Investment Advisers LLC.

‘Distinct Negative’

“Markets, being prescient, are going to try to get ahead of” the end of the Fed’s mortgage bond buying, said Callan, whose firm manages $165 billion of fixed-income assets. “I personally don’t think the rise in yields is all that sustainable in the short-term,” but it would be a “pretty distinct negative for the sustainability of the housing recovery,” he said.
Fannie Mae’s 3 percent mortgage bonds fell to as low as 103.7 cents on the dollar on Jan. 4, from 104.9 cents on Dec. 28, driving yields up to 2.02 percent as the prices ended last week at 104.2 cents, according to data compiled by Bloomberg. Prices were little changed today as of 9:48 a.m. in New York.
“The real kick that you mentioned in 2012 is over as perhaps is the real kick in corporate bonds,” Gross said on Bloomberg Television. “The total return from bond portfolios in 2013 to our way of thinking is a 3 to 4 percent number, it’s not a 10 to 11 percent number.”
Yields in the $5.2 trillion market for government-backed mortgage securities influence rates offered to consumers because lenders package about 90 percent of new loans into the bonds and then sell off the debt to investors.

Rates Rising

The average cost on 30-year fixed-rate mortgages climbed to 3.54 percent as of Jan. 4, from a record low 3.36 percent on Dec. 7, according to Bankrate.com data. Last week’s 0.16 percentage point rise was the biggest since 2010.
Mortgage rates may rise above 4 percent by the end of 2013 if the Fed ends its bond purchases and the economy continues to strengthen, Vitner said. Increases could damp the still-fragile housing recovery, which has had false starts in the past, and slow the rebound in new home construction, which is the real estate market’s main contributor to economic growth, he said.
A borrower able to make monthly payments of about $1,310 can afford a $275,000 30-year loan with rates at 4 percent, versus $300,000 with borrowing costs at 3.3 percent.
Bond rates are climbing even as Republican leaders in the House are vowing to exact deep spending cuts from President Barack Obama and the Democrats in exchange for raising the debt ceiling as the U.S. Treasury bumps up against its legal borrowing limit. European countries including Spain and Italy also face fiscal pressures that roiled markets last year.

‘Easing Brakes’

“Time to breathe,” George Goncalves, head of interest- rate strategy at Nomura Holdings Inc., wrote in a note to clients. The “Fed isn’t going to slam on the easing brakes when it doesn’t know how much damage the fiscal cliff and upcoming debt ceiling/spending cuts concerns will have on business activity.”
Housing, which the Fed has sought to boost to aid employment, is rebounding after a 35 percent slump in prices from mid-2006 through March. Values in 20 metropolitan areas climbed 9 percent from their trough through October, amid lower borrowing costs, diminished supply and demand from investors looking to convert homes to rentals, the latest S&P/Case Shiller index data show.
Still, challenges remain. Home sales tied to soured loans will likely rise to a record 1.7 million this year, after slowing in 2010 and 2011 and then reaching about 1.6 million last year, according to JPMorgan analyst John Sim. About 1 million transactions will stem from seized properties, and 700,000 from so-called short sales in which lenders let borrowers sell properties for less than they owe.

Rates Rising

While the number of investors buying homes with cash would temper the damage of rising mortgage rates, “the question is, do they go away on the anticipation of property values stalling as rates rise?” Joshua Rosner, an analyst at Graham Fisher & Co., said. “It really depends on the rapidity of the rise.”
Cash sales accounted for 30 percent of transactions in November, up from 29 percent in October and 28 percent in November 2011, according to the National Association of Realtors. Investors purchased 19 percent of homes in November.
Higher borrowing costs have already slowed applications by homeowners to refinance, which accounted for more than 70 percent of lending last year, according to the Mortgage Bankers Association. Applications are down 33 percent over the past four weeks and 40 percent from the more than three-year high reached in September, according to data from the trade group.

Lender Spreads

Lenders, which last year limited declines in borrowing costs to avoid being overwhelmed by demand, have reversed that trend. The gap between loan rates and mortgage-bond yields narrowed to 1.1 percentage points last week, from as high as 1.2 percentage points in December and a record 1.7 percentage points in September. The so-called primary-secondary spread averaged about 0.5 percentage point in the five years through 2007.
“The wide primary-to-secondary spreads have allowed lenders to absorb much of the initial market sell off that we have experienced this past week,” said Scott Buchta, Brean Capital’s head of fixed-income strategy.
There might not be “as much room” for lenders to continue to narrow the gap as some believe, because it’s been inflated partly by increases of about 0.2 percentage point last year in the fees that Fannie Mae and Freddie Mac charge to guarantee bonds, Callan said.

Margins Expand

Lenders earn more from making loans and selling them off with a larger spread. The largest originators last year saw their margins expand to roughly 2.5 percent, from a more typical 0.65 percent, according to a Jan. 3 report by Todd Hagerman and Robert Greene, New York-based analysts at Sterne Agee & Leach Inc.
Along with Wells Fargo and US Bancorp, the third-largest home lender, the analysts listed PNC Financial Services Group Inc. and Fifth Third Bancorp. as companies with “mortgage banking momentum” in their 2013 outlook.
Vickee J. Adams, a spokeswoman for San Francisco-based Wells Fargo, declined to comment, and Amy Bonitatibus of New York-based JPMorgan, the second-ranked lender, didn’t return an e-mail message.
If rates continue rising, originators would likely “shift their resources” toward borrowers with high-cost Fannie Mae and Freddie Mac loans taken out before mid-2009, which can be refinanced for borrowers with little or no home equity under a special initiative that was expanded last year, Deutsche Bank analyst Doug Bendt wrote.
About 40 percent of Fannie Mae and Freddie Mac borrowers are potentially eligible for the Home Affordable Refinance Program, and they’ll be a “tempting target” with higher rates cutting off refinancing opportunities for borrowers with loans taken out in recent years, he said.