The Curiously Large Mortgage Spread of the Moment

Posted By PK Last updated June 18th, 2012 8 Comments

Last week, my colleague Cameron gave you this nice primer on the mortgage interest deduction and who it really benefits. Today, we’re going to take this topic one step further (on the sell-side) and discuss government intervention in the mortgage market.

The Jumbo Mortgage Spread

The government has three direct mechanisms (and many indirect mechanisms) for propping up the mortgage market, especially at the bottom of the market: Fannie Mae and Freddie Mac, which are ostensibly independent Government Sponsored Entities, and the Federal Housing Administration (FHA), which makes no pretense to be independent. In all cases, that particular entity can step in and re-insure mortgages which take a certain form. There is a limit to this program – known as the conforming mortgage limit – over which all mortgages have to be originated and held in the private market.

See where I’m going on this? Because the next dollar of mortgage pushes a mortgage onto the private market, we can gauge either:

The rate of government intervention
The amount of fear in the private market

… depending on your political leanings and biases! Believe it or not, historical non-conforming mortgage loans are a tough data set to track down, so thanks for the Federal Reserve Bank of San Francisco for breaking through those paywalls for me.

Interpreting the Jumbo-Conforming Spread

So, we’re currently looking at around a .75% rate spread (the red line), which until recently was tracking around .25%… especially in the bubble run-up. The spread in early 2009 is of great interest here, since a 2% spread would strongly discourage buyers of houses to take out mortgages larger than the mortgage limit. Even today, the spread is hanging around a larger amount than what is normal. That’s right – nonconforming loans aren’t seeing as incredible deals as loans in the lower tier (which actually covers a majority of houses) today.

So… increased government intervention? Failure of the private market? Can’t decide and think it’s both? Sound off in the comments section!

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freeby50

How do you think government intervention would cause that spread to increase? What has government done to make the spread go up specifically?

Seems to me the increased spread is due to lenders being extra wary of taking on very large loans with no government backing. I’m sure back in 2006 they didn’t think twice about selling $1m home loans with no government backing but today I doubt you’ll find many banks wanting to originate those loans without a good premium rate.
- http://www.dqydj.net/ PK
  
  Specifically, I’m going to steal what the Fed paper said about Fed programs (and I know – the Fed isn’t the government) – QE1, QE2 and MEP. The last one was known affectionately as “Operation Twist”.
  
  As for the Government? FHA, Fannie, Freddie, underwriting standards, and the loan limits themselves. On that side these aren’t really new programs, per se – it’s just that these programs have a much bigger backstop than normal, and the two GSEs have recently been bailed out to the tune of millions of dollars.
  
  I think you’re making the point yourself – “Seems to me the increased spread is due to lenders being extra wary of taking on very large loans with no government backing”. I’m saying that without that backing rates would be well higher – closer to the jumbo rates, at a minimum.
http://moneymamba.com/ JT

I think there’s two factors at play:

1) Cost structure – Lower lending volumes in the jumbo market mean more fixed costs have to be priced into each loan. There was no shortage of jumbo buyers during the bubble, which makes for a better cost structure all around.

2) Income variability – Since mortgage size tends to go up with income, and income tends to be more variable/volatile as you get into the jumbo-sized income area (commissions, stock options, business profits, etc. vs. basic salary) a jumbo-sized non-conforming loan is simply more risky.

The primary-secondary spread is the banks margin on a loan. So, to see it trending higher gives me the belief that the mortgage market and rate differentials are driven by cost structure. There are just as many banks, just as many branches, and just as many fixed-costs as there were pre-bubble – the difference is the lending volumes. I attribute non-conforming spreads to the same beast, plus income variability risk.

Drop that tin foil hat.
- http://www.dqydj.net/ PK
  
  Not a third factor? Government and Fed intervention?
  
  Here’s how I’m seeing it – because there is a party willing to step in and intervene in the mortgage markets (whether a GSE, FHA, or whatever), banks are willing to make loans they wouldn’t put on their own books. It’s easy money if you merely have to issue these mortgages and simply fill out a form to have backing from FHA or a GSE. Sure, this has been going on for a while – but that doesn’t make it ‘not intervention’, heh.
  - JT
    
    I haven’t brushed up on my Basel II accounting lately, but yeah, there’s incentive to build out a book of loans where you don’t have to hold the risk. Need to look at the relative cost of holding a nonconforming loan on the balance sheet.
    - http://www.dqydj.net/ PK
      
      Pretty soon you’ll need to crack the books on Basel III!
      
      It’s not even really an accounting thing at this point, but more of a moral hazard thing. When the government (indirectly) is standing behind your loans, you have incentive to follow the rules correctly, but outside of that you don’t really care too much. So if someone is borderline but they fit the guidelines? Bam, make them a loan.
http://www.thefreefinancialadvisor.com/average-joes-money-blog/ Joe

Wouldn’t you say this correlates with the moves in the Treasury market lately? It would seem to me that the fear apparent in the Treasury market is the same fear (gov’t or not) of a deteriorating economy as is playing out in the lending market. My .02….
- http://www.dqydj.net/ PK
  
  Yes, absolutely, but I think if the treasury market sneezes that the mortgage market gets a cold. My point is more that a number of programs which are unique to America are increasing this spread. There shouldn’t suddenly be a cliff at $729,500 in San Francisco, or whatever – a market without intervention would be smoother at the top end.

The Curiously Large Mortgage Spread of the Moment

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