New conforming limits - what will it do to jumbo loan rates?

In a rather erudite memo titled “New conforming loan limits ““ estimating the benefit” (pdf), SunTrust Mortgage EVP Tuck Reed details some of the potential changes to mortgage rates with the passage of pending economic stimulus package and rise in conforming loan limits. (big hat tip reader Bill) The bottom line - Mr. Reed only sees price improvements if Fannie Mae and Freddie Mac create a new mortgage backed security issuance that separates the jumbo loans from the conforming loans that current make up the GSE issuances. Tanta at Calculated Risk reported on the same with the post Traders: Don’t Put Jumbos in my TBAs.

He argues correctly that if Fannie and Freddie attempt to combine the jumbo loans in to the existing MBS issuances that the spread between jumbo rates and conforming rates will only narrow by the conforming rates RISING due to the increased risk and need for additional yield from investors.

However, even if Fannie and Freddie carve out the jumbo loans from the traditional mortgage backed securities issuances the rates on jumbo loans should drop approximately 40 basis points assuming there is adequate demand from investors of the new MBS class. In the short term though he doesn’t anticipate a drop in the rates surrounding jumbo loans until investors become comfortable with the new issuances.

As for liquidity, things get a little more complicated. (I know what you’re thinking”¦”Oh Lord, here he goes””¦but bear with me a minute.) Today, agency MBS trade with excellent liquidity thanks to very clear and highly controlled rules about what kinds of loans can be used to back “generic” agency MBS. These generic agency MBS are called “TBAs” since the actual loans that will go into the bonds are not known when the bonds are initially sold but are “to be announced” just before the investor takes ownership. These rules allow forward trading in bonds that haven’t even been created yet since investors feel certain they know what they will get once the bonds are made several months later. Certainty around the types of loans they will get in TBA securities also helps investors to get comfortable they can estimate the prepayment behavior of the bonds they’re buying. If anything happens to that certainty and our ability to sell TBA bonds for future delivery, we’ve got big problems.

The industry would seize-up; imagine last year’s liquidity crisis times ten. As you can imagine, no one’s interested in tinkering with something so important to the industry and it’s not clear yet if the larger balances will be allowed in TBAs.

If the securities dealer association that governs MBS decides to allow some or all of these larger balances to go into “TBAs”, we could expect a reduction in the spread between agency and non-agency mortgage rates ““ but mostly because today’s agency balances would be penalized. In other words, the spread between today’s agency and non-agency note rates would likely decrease, but only because today’s agency rates would increase as investors lose interest in TBAs.

On the other hand, if the bond market association decides to leave today’s TBAs alone and create special MBS for the new agency balances, we should not expect much reduction in the rates for the new conforming balances
right away.

This is a critical point that can’t be overlooked. Even with the GSE backing investors still need to buy the new MBS issuances made up of the larger loan amounts. Obviously the government backing of the GSE’s will help confidence; but Fannie and Freddie must take great care in handling the new debt issuances to ensure that investors don’t get skittish around all GSE issuances. He correctly argues that a scenario in which investors shy away from Fannie and Freddie MBS’s would make the current credit crisis look like child’s play.

Specifics of the Conforming Loan Increases

Now that we have the pricing out of the way let’s talk about specifics around the increases. Mr. Reed does a nice job with this as well.

From his paper:

The bill sets the FHA and conforming (FNMA/FHLMC) loan limits to the lesser of $729,750 or 125% of an area’s median home sales price. If 125% of an area’s median home sales price is below the current conforming loan limit of $417,000, don’t worry; the $417,000 still applies. In other words, you will not be any worse off than you are today. The area median home price is determined by HUD and is based, in part, on the National Association of Realtors data for each MSA.

• The FHA and conforming limit changes are meant to be temporary and are set to expire on Dec 31, 2008 (unless extended, which wouldn’t surprise me).
• The new limits will apply to 30 year and 15 year fixed rate, fully amortizing (sorry, no IO), and owner occupied.
• ARMs are being considered, but if allowed, the increase will likely apply to one ARM type (for example, 5/1s).
• FNMA will have other credit overlays including LTV limitations (probably 90%).
• The limits will be effective as soon as the bill is signed, FNMA determines pricing, and we can update systems.
• OFHEO, which regulates FNMA and FHLMC, is not very pleased that the bill does not include complete “GSE reform” and will most likely have the final say in its implementation schedule.

Who will benefit?

Mr. Reed continues:

Since the new FNMA limits are restricted to 125% of an area’s median home price, it’s estimated that only twenty of the larger MSAs across the country will see an increase in conforming loan limits and only six will see the limit go to $729,750 (see table below). Of the six big winners, five are in California and the other is in Hawaii (like we need another reason to be jealous). However, two MSAs within our footprint should see limited benefit:
Washington DC and Miami-Fort Lauderdale-West Palm Beach FL. However, the DC area limit will only go to approx. $550K while the benefit in FL should be even less - approx. $433K.

So thanks to Mr. Reed. He made my job a lot easier and shows some smart thinking in the process.

No Magic Bullet

This conundrum clearly shows that legislative policy can’t necessarily save the over-priced housing market. As Tanta at Calculated Risk said “Congress didn’t see this coming.”

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