By Jody Shenn - Jan 11, 2012 12:00 PM GMT+0700
Ben S. Bernanke is signaling his willingness to double down on a three-year bet that’s failed to revive housing, showing the extent of the Federal Reserve chairman’s effort to wrest a recovery from the deepest recession.
Since the Fed started buying $1.25 trillion of mortgage bonds in January 2009, the value of U.S. housing has fallen 4.1 percent, and is down 32 percent from its 2006 peak, according to an S&P/Case-Shiller index. The central bank is poised to buy about $200 billion this year, or more than 20 percent of new loans, as it reinvests debt that’s being paid off. Some Fed officials have said they may support additional purchases that Barclays Capital estimates could total as much as $750 billion.
Even as Bernanke and fellow U.S. central bankers consider expanding their efforts, they are acknowledging their inability to turn around the housing market without help from the rest of the government. Bernanke underscored the importance of residential real estate, which represents 15 percent of the economy, in a study he sent to Congress last week that said ending the slump is necessary for a broader recovery.
“They’re definitely frustrated and disappointed,” said Stephen Stanley, chief economist at Pierpont Securities LLC and a former Federal Reserve Bank of Richmond researcher. “I’m sure they would have anticipated they would have gotten more bang for their buck.”
While the Fed has helped push mortgage rates to record lows of less than 4 percent, home-loan borrowing in 2012 is forecast to decline to the least in 15 years. Americans who might refinance and buy properties are getting shut out by stricter lending standards or avoiding transactions as values tumble amid mounting foreclosures, according to the Fed study.
Eventual Losses
Bernanke’s report urged Congress and President Barack Obama’s administration to consider steps with short-term costs for taxpayers, such as widening the role of Fannie Mae (FNMA) and Freddie Mac (FRE), the government-supported mortgage guarantors.
At the same time, the central bank’s purchases of mortgage bonds with yields at record lows is increasing the risk of eventual losses for the Fed, said Anthony B. Sanders, a professor of real-estate finance at George Mason University in Fairfax, Virginia.
So far, the Fed is reporting record profits. It said yesterday it will pay $76.9 billion to the U.S. Treasury as part of an annual dividend bolstered by its holdings. Brian Sack, the New York Fed’s markets group chief, said in October 2010 its goal in buying bonds would be to stimulate the economy not to generate profits and acknowledged it’s taking on some risk.
David Skidmore, a Fed spokesman in Washington, declined to comment on potential losses.
Remove Obstacles
Federal Reserve Bank of New York President William Dudley, Eric Rosengren, president of the Boston Fed, and Fed Governor Elizabeth Duke followed Bernanke in highlighting the need to fix housing to speed the recovery.
Dudley called on the government to remove obstacles to refinancing, saying in a Jan. 6 speech to the New Jersey Bankers Association that the Fed is no “substitute” for government measures. Rosengren said that day in Connecticut he supports buying more mortgage-backed securities. San Francisco Fed President John Williams sees a “strong case” for the move, he said yesterday.
The Fed has taken unprecedented steps to lower borrowing costs as it held short-term interest rates near zero since 2008. It acquired $1.25 trillion of government-backed mortgage securities and $172 billion of federal agency bonds from December 2008 through March 2010, as part of a process known as quantitative easing, or QE. It embarked on a second stage involving $600 billion of Treasuries through last June.
QE3 Likelihood
In October, it began recycling proceeds from the mortgage and agency debt into home-loan securities, buying $80.2 billion through Jan. 4. Reinvestment will probably total about $200 billion this year, according to Barclays, JPMorgan Chase & Co. and Credit Suisse Group AG.
Dudley’s comments and the Fed study signal a greater likelihood of QE3, according to Ajay Rajadhyaksha, a Barclays analyst in New York, who has estimated it could involve $500 billion to $750 billion of mortgage-bond purchases over a year.
“The investment community is almost regarding quantitative easing as a free good and if it’s a free good, why not just do QE10,000,” said Sanders, a former head of mortgage-bond research at Deutsche Bank AG. “If rates start going up, somebody’s going to have to pay the tab, and you know who that is: John Q. Public.”
Unemployment Easing
While central bankers are frustrated with the results of their record monetary stimulus, Sandra Pianalto, president of the Cleveland Fed, said yesterday after a speech in Wooster, Ohio that “on the margin” it’s affecting mortgage refinancing.
Last year, refinancings totaled $858 billion, according to a Mortgage Bankers Association estimate. Average rates on typical 30-year mortgages between 3.9 percent and 4 percent since early December, based on Freddie Mac data, bolster home prices by allowing property buyers to pay more. A monthly bill of about $1,430 covers a $300,000 loan at a 4 percent rate, versus $267,500 at 5 percent.
Unemployment is also easing. A Labor Department report showed that the jobless rate fell to 8.5 percent in December, the lowest since February 2009. Unemployment peaked at 10 percent that year as the financial crisis triggered the biggest economic contraction since the Great Depression in the 1930s.
Property Slump
Monetary policy hasn’t been enough to prevent house prices from continuing their more than five-year long slide, with Pacific Investment Management Co.’s Scott Simon, the bond manager’s mortgage head, forecasting further declines of 6 percent to 8 percent.
An S&P/Case-Shiller index of property values in 20 cities dropped 3.4 percent in the year through October. Existing home sales remain 18 percent below their 10-year average and Dudley estimated properties seized by lenders may rise to 1.8 million this year, and the same number next year, from about 1.1 million last year and 600,000 in 2010.
Housing’s share of gross domestic product, including household spending on related services like utilities and rent, declined to 15 percent in the third quarter from 18.6 percent in 2005, according to the National Association of Home Builders.
The Mortgage Bankers Association, based in Washington, estimates that home-loan originations declined last year to an 11-year low of $1.3 trillion and will fall to $968 billion this year, the least since 1997.
Protecting Taxpayers
Potential first-time buyers are particularly hurt by tightened credit, Bernanke’s paper said. Lenders are avoiding making risky loans for government programs on concerns that Fannie Mae and Freddie Mac may force them to repurchase the debt if there’s an underwriting error or delinquencies will prove costly for servicing departments.
Only about 85 percent of lenders are offering loans eligible for guarantees by Fannie Mae and Freddie Mac, which were seized by the government in 2008, to borrowers with 680 credit scores and 10 percent down payments, according to LoanSifter Inc. data cited by the study. Fewer than 50 percent are making loans in the companies’ lowest credit tier, the Fed’s Duke said last week.
Although Fannie Mae and Freddie Mac’s ability “to put back loans to lenders helps protect the taxpayers from losses, an open question is whether the costs of the associated contraction in credit availability outweigh the benefits” of lower losses, she said.
Borrowers Locked Out
Most troubling is that creditworthy borrowers are being locked out for minor blemishes or documentation challenges as lenders look to protect themselves, said Willie Newman, head of residential mortgage originations at Cole Taylor Bank (TAYC) in Chicago.
“There are people where everything about them looks good except this one little thing,” he said. “But you do precisely what they tell you to do, you don’t deviate, because the price of getting it wrong is too large.”
Refinancing has also slowed because lower prices have left about a quarter of homeowners with mortgages owing more than their properties’ values. Almost half of the more than $3.7 trillion of 30-year fixed-rate home loans in government-backed bonds have rates of about 5.5 percent or more, according to data compiled by Bloomberg.
In December, prepayments on Fannie Mae’s 5.5 percent securities, containing loans with 6 percent rates, averaged a pace that would erase 27 percent of the debt in a year. That compares with a peak of 45 percent in 2003, when loan rates reached as low as 5.21 percent, and fewer mortgages were being retired by foreclosures.
Eliminating Loan Fees
Obama’s three-year-old Home Affordable Refinance Program for Fannie Mae and Freddie Mac loans with little or no home equity is being expanded to help homeowners by cutting lender risks, lowering fees and allowing borrowers to refinance no matter how much their home’s value has dropped. The changes, which started in December, followed the program reaching less than a quarter of its 4 million to 5 million target.
Bernanke’s Fed study said “more might be done,” including eliminating entirely the reduced fees for risky loans, “more comprehensively” cutting lenders’ put-back risks; and further streamlining refinancing for other Fannie Mae and Freddie Mac borrowers. The U.S. also should consider having Fannie Mae and Freddie Mac refinance loans not already backed by the government, which would add credit risk for the companies, according to the report.
Corinne Russell, a spokeswoman at the Federal Housing Finance Agency, which oversees the mortgage firms, declined to comment on the paper.
Government Limitations
The limitations of the government’s Home Affordable Refinance Program meant that Karthik Narayanan, who bought a house in Gilbert, Arizona in 2007 for $300,000 that he estimates has lost $100,000 in value, gained only minimal benefits.
The software engineer refinanced under HARP in October 2009 into a 5.3 percent rate, using cash to pay off a $30,000 home equity loan that he had used to fund half of his down payment, because he was told he couldn’t otherwise qualify for the program. Then he heard that HARP was being expanded and looked to cut his costs further, only to discover that loans made after May 2009 still don’t qualify.
“Help the people who are responsible, who are trying to stay in their home, that’s what I would say to” Bernanke and policy makers reading the Fed chief’s report, Narayanan said in a telephone interview. He might pay down his mortgage faster or buy a second home to rent out with the savings, he added.
Bernanke Repercussions
Though the bigger ideas in Bernanke’s report may sound good, “repercussions” would include further entangling banks and the government in housing, said Jim Vogel, a debt analyst at FTN Financial in Memphis, Tennessee. That could limit financial companies’ access to capital and make it impossible for the U.S. to unwind its involvement in mortgages for decades, he said. The study said it avoided discussions of “longer-term restructuring of the housing finance market.”
“They say they’re not going to think about the future of the system, but that leaves such a large, empty spot in the white paper,” Vogel said.
Some actions taken thus far by Congress and Obama’s administration have recently added to challenges for housing.
To pay for a payroll-tax cut extension last month, Congress directed Fannie Mae and Freddie Mac to boost their annual fees for guaranteeing mortgages bonds by at least 0.10 percentage point. The FHFA said it must further raise the charges, which lenders tack on to borrowers’ rates, to better reflect the companies’ risks.
‘Very Low Pay-Off’
The Fed is getting “a very low pay-off for the amount of risk they’re generating,” said Sanders of George Mason.
The central bank is funding its portfolio mainly with cash borrowed from banks at 0.25 percent, a financing cost that will rise when it raises its benchmark for short-term rates. The central bank may lose money on the investments if it sells the securities after increases in long-term rates, or pays more on its borrowings than the yields on its holdings. The central bank would take those steps to stem inflation.
Yields (MTGEFNCL) on Fannie Mae 30-year mortgage bonds trading closest to face value -- the focus of the Fed’s buying because they most affect loan rates -- have averaged 3.1 percent since the central bank started reinvesting in October, data compiled by Bloomberg show. That compares with 4.3 percent during its initial buying.
They’ll probably “make out like bandits” for several years as interest rates that guide the Fed’s funding costs remain close to zero, Sanders said.
Prints Money
While the Fed has pledged to hold short-term rates near zero through mid-2013, George Goncalves, head of interest-rate strategy at Nomura Holdings Inc. in New York, says he can envision its target rate reaching 3 percent by 2017.
“The good news” is that the Fed pays zero percent on about 40 percent of its liabilities because it can print money, said Doug Dachille, chief executive officer of First Principles Capital Management LLC in New York, which oversees $8 billion.
The projected average lives of Fannie Mae-guaranteed securities with 3.5 percent coupons, which accounted for the largest portion of the Fed’s purchases last week, would extend from 5.2 years to 10.8 years if rates rose 3 percentage points, according to data compiled by Bloomberg. That means the central bank could be stuck with them for longer and their value would drop more with further increases in interest rates.
‘No Confusion’
“Rates go up, and you’re going to see a pretty significant level of extension in terms of the duration and meaningful book losses residing on the Fed’s balance sheet,” said Jason Callan, head of structured products at Columbia Management Investment Advisers LLC, a Minneapolis-based firm overseeing $170 billion in fixed-income. “That’s kind of the name of the game in mortgages.”
A report by the New York Fed in March discussed how the central bank’s net income can remain “sizable” even if it sells some bonds at losses, while Sack said in July that the central bank’s bond portfolio will earn about $500 billion from 2009 to 2018.
“There should be no confusion, no mistake, that we’ve put duration risk onto the Fed’s balance sheet,” Sack said in 2010. “These decisions are being made to produce economic outcomes” rather than “to produce a certain return on the portfolio.”
To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net
To contact the editor responsible for this story: Rob Urban at robprag@bloomberg.net
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