Two-Month Forecast: July 31, 2008
Preface
It’s been a wild ride since our last forecast A new housing bill has been signed into law, producing new opportunities for lenders to rid their books of perhaps their worst-performing mortgages — that is, if they wish to realize those losses today, rather than ‘bleeding’ slowly over time. Fannie and Freddie’s mission will continue unabated, and new regulatory frameworks are coming into place. The FHA program will enjoy new prominence in housing markets, and some incentives to buy homes are now available.
All this, plus billions in actual and potential spending, add up to continued pressure for mortgage rates on the upside. New Congressionally-manded commitments for Fannie and Freddie for affordable housing will likely add 4.2 basis points to your next mortgage, and the need for more government-backed debt to finance these initiatives puts more bonds into a market — more supply during a period of uncertain demand. Of course, rising prices are evident almost everywhere you look, but the Fed cannot quickly act to quell inflation pressures for fear of upending fragile markets.
Recap
Our last forecast suggested that the downward pull of a slacking economy would prevail over rising price pressures, but the opposite turned out to be the case. The spiralling price of oil was largely to blame; it peaked at over $146 per barrel before backing off, which helped both the Producer and Consumer Price indexes to march higher. Coincident with that, the markets had to deal with new uncertainty about the solvency of Freddie and Fannie, prompting emergency offers of support. Home prices continued to slide, making even solid mortgage investments made over the past few years somewhat more risky. Demands for mortgage credit remained pretty stable, with home sales holding pretty steady during the period, but the supply of credit became somewhat more curtailed as investors extended their ‘buyers strike’ for mortgage-related assets.
All these pressures moved mortgage rates upward. Overall, we expected HSH’s overall Fixed-Rate Mortgage Indicator (FRMI) to range between 6.37% and 6.72%, but instead saw a differential of 6.65% to 7.10% at the close of the forecast period. For 5/1 Hybrid ARMs, we expected to see the average travel between 5.85% to 6.25%, but it ranged from 6.25% to 6.82% during the period.
Interestingly, it was conforming rates which suffered the most from the difficult market conditions. Conforming 30-year FRMs wandered in a 52-basis-point range, compared with only 39 for private-market jumbos. Five-one conforming product trended in a 68-basis-point gap, with just a 45 basis point distance for jumbo 5/1 ARMs. As impaired as jumbo markets have been, they may already be about as impaired as they can get, what with nominal interest rates already well above conforming. Since they are mostly being originated and held by portfolio investors, only concerns about inflation and changes to actual costs of funds — rather than investors turning away — seem to be influencing their rates.
Forecast Discussion
As we approach the one-year anniversary of the mortgage crisis (markets first began to crumble in July 2007 before fully breaking in mid-August), we’re still not out of the woods. Tighter access to credit has pulled all financially-marginal homebuyers out of the market, leaving a vacuum of demand. At the same time, record foreclosures have caused a swelling in the number of homes for sale. As Economics 101 taught us, too much supply combined with too little demand has pushed home prices lower. New home sales and home building seem likely to begin to show signs of improvement before long (perhaps a couple of quarters), but until then, rough times remain fully in play. Existing homes — the largest component of the market — are of course more affected by inventory increases due to foreclosures.
There are few players fully engaged in mortgages at the moment. Wachovia recently left the wholesale ranks, along with IndyMac Bank (which subsequently failed). Fewer players mean less competition among buyers for loans (less liquidity), and less competition means that demands for higher yields must be met in order to complete a sale.
But are we near bottom? Every time it seems reasonable to think that the worst of the financial losses are fading, along comes another announcement of billions of dollars of losses. Still, we are starting to be of the mind that conditions, if not actually improving measurably, have stabilized overall — or at least the rate or frequency of decline has lessened appreciably.
Our glimmer of optimism is derived from a few sources. Loan books are being improved though the origination of better quality mortgages; access to government-backed capital remains fully in force at near 0% real rates, and further substantial home price declines will probably be contained to a few deeply-troubled markets.
On the more technical side, the new ability for a lender to pull the worst performing loans off their books, refinance them into an FHA-backed loan, and take an immediate ‘haircut’ in terms of value — but be able to close out a troubled asset — could lead to lessened requirements to raise new capital and also reduce the need to hold additional loan-loss reserves.
The ability to shed bad assets means less of a need to raise new capital, which could lessen the considerable competition for those funds in the already-wary (and strained) credit and equity markets. A lessened need for new capital would serve to better balance the demand for those funds with the availability of them, and easing those pressures could help to lower market interest rates.
With less need to build and hold capital, more of the profits from operations can be used to buy and sell more loans, instead of being held as reserves.
As ‘bad’ loans are pulled off books, they can be replaced by ‘good’ loans; this will further improve loan books and may serve to increase (somewhat) demand for new mortgages by the firms whose loan books are improving.
The plan is, however, voluntary, and the process for deciding which loans to excise and which to allow to fail will be done on a one-by-one basis by lenders, so it will take time to produce any measurable results.
So we’re somewhat more optimistic than many, perhaps. Lower oil prices will hopefully be more permanent than temporary, which would lessen upward pressure on inflation and its associated influence on interest rates. So far, there’s been no corresponding increase in wage demands, and the stumbling economy and weak labor markets may serve to trim inflation pressures further.
We also think some of the pessimism surrounding housing will begin to fade once year-over-year comparisons of home sales no longer feature regular double-digit decreases. Failing any additional significant deterioration, we’re looking for that to start around September or October.
Although certain things set in motion will take time to realize, and keeping in mind that energy costs could again flare higher at any time, it still lends some hope that we may have found tenuous stability for mortgage rates. Hoping for stability isn’t the same thing as achieving it, of course.
Forecast
As we write this, conforming FRMs are near a year’s high; fixed-rate jumbos are near eight-year highs. If inflation calms, if demands for capital are diminished somewhat, and if bad assets can be shed, mortgage rates should get no worse and have a good chance to improve, perhaps considerably, from these levels. As such, we’re expecting a stable-to-downward trend for mortgage rates over the next nine-week period, where we forecast the overall average 30-year tracked by HSH’s FRMI to range between 7.15% and 6.65%, while the erratic 5/1 ARMs (20-basis-point bounds have been all too common this year) should find a home somewhere between 6.85% and 6.45%.
Here’s hoping we’re right. Refinancing and home buying could use a boost, and cheaper mortgage money would help.
Our next forecast should come in early October. The third quarter will have come to a close, Autumn will be upon us, and we’ll look back to see if our optimism was founded or unfounded.
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