Why Millions Are Unable to Benefit From Record-Low Mortgage Rates

Over the past few years, mortgage rates have displayed a more or less steady downward trend. Thanks in large part to the Federal Reserve's unprecedented use of its monetary policy tools, rates are now at record lows. Prospective homeowners should be dancing with joy.

But most aren't. Millions are unable to take advantage of these record low rates because of a dramatic tightening of mortgage credit availability.

An era of unprecedented Fed intervention
Since the global financial crisis, the Federal Reserve has assumed an unparalleled role in the markets. It has bought nearly $3 trillion worth of bonds since 2008 in an effort to keep interest rates very low and shore up the ailing economy.

Most recently, the Fed embarked on its latest round of quantitative easing, or QE3, which entails open-ended purchases of mortgage-backed securities in an effort to drive down mortgage rates even further. So far, the plan has been met with some success, as the rate on a 30-year fixed-rate mortgage has fallen by about 0.2% since the Fed's announcement on September 13.

But despite the central bank's efforts, a large chunk of American households is unable to take advantage of drastically reduced borrowing costs. Millions still can't get a loan and are burdened by the persistent overhang of debt. To understand why, it's important to assess the moving parts within the housing finance system.

Why is mortgage credit so tight?
Part of the reason banks are reluctant to make home loans has to do with something called "put-back" risk. Over the past few years, the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac have been requiring banks to repurchase a ton of soured loans that the banks made and then sold to Fannie and Freddie.

While the GSEs argue that put-backs are a crucial part of improving the underwriting process, which went haywire in the three or four years leading up to the housing bust, the banks are not so happy. They argue that the only way for them to protect against the GSE-inflicted "put-back" risk is by tightening credit and documentation standards for new borrowers.

The Federal Reserve, in a recent survey of senior loan officers, reaffirmed this view. The survey's results showed that "put-back" risk was the most important factor constraining lending. A third of survey respondents cited this risk as a "very important" factor, while another quarter called it the most important factor.

Higher credit and documentation requirements
One key area where this tightening is most evident is in higher FICO score requirements for new borrowers. FICO scores, which range from 300 to 850, are a commonly used metric to help lenders assess the credit profile of each borrower. Lower scores indicate a higher probability of the borrower defaulting, and higher scores, a lower probability.

According to Ellie Mae, a software provider serving the mortgage industry, the average FICO score for borrowers who received new loans in August was 750, nine points higher than in the year-earlier period. And for loans approved by Fannie and Freddie, the average score was even higher.

In August, the average borrower approved by Fannie and Freddie reported a FICO score of 769, up six points from a year ago. Given that nearly 80% of all U.S. consumers have a FICO score of less than 750, this means that the vast majority of would-be homeowners are effectively shut out of the market for mortgage finance.

Besides higher FICO requirements, there are other important constraints on lending. For instance, documentation standards and down payment requirements have also tightened over the past few years. In August, the typical borrower who was rejected by Fannie and Freddie had a FICO score of 734 and was willing to put down 19%. At virtually any other time in recent memory, a borrower with this kind of credit profile could have easily obtained a loan.

And lastly, the loan process itself has been slowing down, most likely because of the stringency of all these different requirements. According to Ellie Mae, it took 49 days on average from the time an application was made to when it was closed in August, which represents a nine-day increase from a year earlier.

Who wins and who loses with low rates?
Going forward, the tight lending standards holding back the housing recovery should gradually begin to ease. As home prices stabilize and regulators offer more clarity on the future direction of loan requirements, mortgage lenders should hopefully start making more loans to qualified borrowers.

Moreover, if banks become willing to accept a lower profit margin on the mortgages they make and then sell into the secondary market (no doubt a huge "if"), mortgage rates should fall further, providing an additional incentive to the marginal buyer and those seeking to refinance.

While record-low rates that have prompted a surge in refinancing are great news for homeowners, they're not so kind to mortgage REITs. For several years now, mortgage REITs have earned fat profits thanks to near zero short-term rates. But lately, there has been increasing concern regarding the outlook for these dividend dynamos.

Firstly, interest rate spreads are narrowing, which limits the profits mortgage REITs can earn. Short-term rates are still near zero, but central bank intervention has also driven down long-term rates. Secondly, prepayment risks are on the rise because of the refinancing boom.

What's important to remember here is that not all mortgage REITs are affected by these forces to the same degree. On one end of the mREIT spectrum are companies like Annaly Capital (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) , which invest exclusively in agency-backed securities. These types of securities are less risky because they come affixed with an implicit protection against default through the full faith and credit of the U.S. government.

On the other hand, mortgage REITs like Invesco Capital Mortgage (NYSE: IVR  ) , Chimera Investment (NYSE: CIM  ) , and Two Harbors Investment (NYSE: TWO  ) are buyers of both agency and non-agency securities. While these firms can potentially see higher net interest margins, they also take on greater risk than firms invested solely in agency securities.

To find out more about the risks facing mortgage REITs and whether or not your investment is safe, be sure to check out The Motley Fool's recently released brand-new premium research report on Annaly Capital Management. It outlines three essential points that all current and prospective Annaly investors need to know, as well as a host of other important information put together by our analysts. On top of that, the report comes with a full year of exclusive updates. To unlock your investing edge, just click here.

Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On October 25, 2012, at 10:13 AM, OnTheContrary wrote:

    It figures that most of the 20% of Americans who are still able to obtain a mortgage, are the top 20% by income, whose real incomes have continued upwards over the last dozen years while the real incomes of the other 80% have trended down, for some segments precipitously. Thus, the Fed's QEx programs aimed at lowering mortgage rates are seen to be more welfare and redistribution for the already well-to-do - the top 20%ers - most of whom are included in the ridiculous definition of the "middle class" (family incomes up to $250,000 - median family income is about $50,000) embraced by both presidential candidates. The mortgage deduction falls into that category too: the majority of American families with mortgages don't itemize because they don't own grand enough homes with big enough mortgages to benefit from the deduction. So too is the exemption for income above six figures from Social Security deductions. It has been estimated that if high income earners paid Social Security tax on all of their income as the less well off are forced to do, two-thirds of the Social Security shortfall would be covered.

    Thus do the rich squeeze the financial life out of the real American middle class.

  • Report this Comment On October 25, 2012, at 1:14 PM, dsandman999 wrote:

    You have missed one major reason equal to most of the above - deliberatly low ball appraisals. Now the appraisers work for the bank and the bank wants 30%, not 10 ro 20% equity so the appraisers accomodate. I have been through 3 in the last year and in every case the appraiser made "mistakes" and adjustments in favor of the bank. They used Comps from outside the normal range, date and type. I got comparisons to my 5 bedroom 3.5 bath 3200 sqft home with 1.5 acres of ground - to 1.5 year ago sales 5 miles away (and in a different county) 3 bedroom 1 bathroom 1300 sq ft 0.5 acre lot with adjustments that showed almost $100K less than a 4 bedroom house less than a mile away sold 6 months before (that managed not to be one of the comps). What the appraisers are doing is fraud, and wire fraud at that. (Before all of this started I had a 804 credit score and make low 6 figures and the house was remodled within the last 1.5 years).

  • Report this Comment On October 25, 2012, at 5:18 PM, Darwood11 wrote:

    @OnTheContrary

    You have ignored the positive implications of Fed policy since 2008 for those holding Option and Option-ARM mortgages.

    Those are the ones who got the most favorable terms. No money down, etc.

    With current Fed policy, their loans have not reset. Under almost any other scenario, which would have resulted in interest rate increases, these borrowers would have been hammered by loan resets.

    Of course, there may be no escape but via "strategic default." Some government agencies are making that more difficult. On the other hand, what would the rent be to live in many of these homes?

    No matter what, one has to live somewhere. Rents are generally higher than most of these bargain basement loans. It wasn't free, and surely one could rent a small apartment for less. But that wasn't the intention or aim of these buyers.

  • Report this Comment On October 26, 2012, at 10:12 AM, 4thebird wrote:

    Another rule, if it is not on the front page of your 1040, then it can not be counted as income. So even though we earn money from Limited Partnerships or return of capital, it is not income for a loan. A perfect credit score does not matter. And in our case 50% down did not count either.

    As the underwriter explained to us "I can see the income and the ability to pay but with the new rules no job, no loan."

  • Report this Comment On October 27, 2012, at 11:11 PM, rupus2020 wrote:

    Really?I don't see where a lot has changed since before the recession.I see people everday buying houses with no money down with a 650 score.4% USDA loans with foreclosures in the near past.

    Someone is misinformed.

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