Large mortgages quickly become more expensive

I have been writing about this sublect on my blog:
http://financial-alchemist.blogspot.com/
Sub-prime woes are showing signs of pinching the most credit-worthy borrowers as jumbo-conforming spreads on prime mortgages have sky rocketed. Mortgages are considered “Jumbo” for amounts over $417,000. Fannie Mae and Freddie Mac will only securitize mortgages with conforming loan balances into an Agency MBS which trade in a highly liquid market. The spread has generally been about 1/8 – 1/4 pt higher in rate for those High balance loans. As of this week, the spread has risen to roughly 80 bps (0.8%) according to Bankrate.com. That’s a national average, for some lenders it’s much worse. The WSJ reported last week that a broker informed them that Wells Fargo had raised their jumbo 30yr rate from 6.875% to 8% effectively suspending production for that loan program. Why? Ostensibly from an absence of demand on Wall Street.

Banks seek to match the duration or “Life” of assets and liabilities. It’s very risky to borrow short-term, i.e. deposits, CDs, etc. and lend long-term for 15-30 years. Generally, financial institutions have a mortgage company/division responsible for originating mortgages and then selling to the secondary market. The mortgage division sells short maturity adjustable-rate mortgages to the bank to satisfy their loan investment portfolio objectives. Longer maturity conforming FRM are assembled into pools that FNMA, FHLC, or GNMA securitizes into MBS which mortgage bankers then sell to Wall Street. Non-conforming mortgages: jumbo, Alt-A, zero-down etc. are bulked up and then sold to Wall Street firms who use that paper to securitize “private-label MBS” or create CMO/CDO structures they offer to investors such as hedge funds.

Agency MBS is an extremely liquid market. Non-conforming mortgages are much less liquid since they are not securitized by a quasi-government agency so finding buyers can be difficult. I worked on a mortgage-trading desk for one of the top 15 largest banks for three years beginning back in 2004. Finding buyers for non-conforming paper was not hard then. Actually, Wall Street firms, especially those in the currently in the headlines, would be beating down our door for as many mortgages they could get their hands on. Lately it appears phones on trading desks at mortgage companies are silent. Certainly the case for Wells Fargo since it’s essentially curtailing jumbo mortgage production. Lenders do not want to originate mortgages they will not be able to sell.

Since most prime jumbo mortgages are underwritten according to Fannie Mae guidelines, the credit risk between conforming and jumbo loans are the same. That’s why borrowers could usually get almost same rate on a $416k loan as they could a $418k loan. Any spread reflects the liquidity premium of the loan, not the default risk. Now, we have seen that liquidity premium spike affecting the most creditworthy borrowers.

The credit risk of conforming MBS and jumbo MBS is significantly different. Agency MBS essentially has no credit risk since they are assumed to be backed by the Federal Government. Jumbo MBS or “Private Label” are backed by whichever Wall Street firm (and mortgage insurers) securitizes them. Thus, the credit risk associated stems from the issuer of the jumbo paper not the underlying loans per se. The credit risk on the mortgages are equal, yet the MBS credit risk is quite different.

In the past, investors assumed that jumbo MBS had minimal credit risk because the financial institutions backing them had enough capital to cover any defaults and that they were “too big to fail.”
Now, given the sub-prime fears, investors worry that non-prime defaults will hamper the backing institution’s ability to cover defaults on prime mortgages. Investors are calling into question the “too big to fail” cliché. Wall Street firms will find it difficult to sell additional mortgage-backed products to investors who are already worried about the fate of the current mortgage fund holdings.

With respect to jumbo spreads, it can be said that the sub-prime mess is spilling into the prime mortgage market. Homeowners trying to sell above $417k face significant challenges opposed to selling at a lower price. Sellers who have been asking slightly higher than the conforming limit may be forced to lower their price causing further downward pressure on home values. Think about how many homes were purchased above $417 during the explosion in home prices. Think about how many of those inflated home values were beyond the actual reach of buyers, but were purchased with a non-traditional mortgage. Interest-only, option payment, and adjustable-rate mortgages with low teasers allowed borrowers to afford expensive homes due to the low payments required during the loan’s early stages. As rates reset higher and monthly payments increase, borrowers will be more likely to default. To avoid foreclosure borrowers will try to sell at the amount owed on their mortgage, but with falling home values and ubiquitous home supply, it will be challenging for sellers to get what they owe.