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 (NLY +0.40%) and American Capital Agency (AGNC +0.73%), 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 (IVR +0.61%), Chimera Investment (CIM +0.88%), and Two Harbors Investment (TWO +0.18%) 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.
