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Monday, August 25, 2008

NYT: The GSEs Invent the Risk Premium

by Tanta on 8/25/2008 09:59:00 AM

Either I've finally lost what passes for my mind, or business press's increased fixation on blaming every problem in the mortgage market on Fannie Mae and Freddie Mac has just about jumped the shark. I don't know how else to explain this, from the NYT:

MORTGAGE rates are typically driven by the financial market’s outlook for long-term interest rates, but not always. Policy changes at Fannie Mae and Freddie Mac, the two government-sponsored companies that buy most mortgages issued by United States lenders, recently helped drive that point home.

This month, Fannie and Freddie increased the fees they charge lenders for many loans, effectively bumping up interest rates for many borrowers who have marginal credit. The companies also tightened their policies on refinance loans that enable an owner to take cash out of a home.
Um, what kind of profound mental confusion could make someone write those first two sentences? Mortgage rates have always been driven by the market "outlook for long-term interest rates," they still are, and they always will be. So have Treasury rates and the yield the local bank offers you on your certificate of deposit. That yield curve thingy. You've heard of it, maybe.

But mortgage rates have never been "purely" about the bond market's outlook for benchmark yields, since the benchmarks, like U.S. Treasuries, are credit risk-free investments. Treasuries are backed by the full faith and credit of the U.S. Government, which has financial resources that Joe Blow the homebuyer doesn't have. Mortgage loans, like corporate bonds, have credit risk: the borrower might default and you might not get all your money back.

This is why interest rates on home mortgages are always higher than the rate on risk-free bonds of equivalent duration, like Treasury notes. If they weren't, nobody would invest in mortgages, they'd just buy the risk-free bonds. Are you still with me, everyone?

So there are always two main ingredients of mortgage rates, comparable-duration bond yields and the credit risk premium. And the credit risk premium, theoretically as well as practically, can fluctuate pretty widely, depending on, well, one's "outlook" for credit risk.

Fannie and Freddie have always guaranteed the credit risk of the mortgage-backed securities they issue. That is what they do and why they're here. In the "required yields" they establish for the loans they securitize, there has always been this little extra bit that they do not pass through to investors; it's the part they keep for themselves to cover credit losses, because they do not pass credit losses on to investors. You can call it a guarantee fee or a loan-level pricing adjustment or a post-settlement fee, if you want to be technical, or you can just call it a "credit risk premium."

One possibility here is that the GSEs are increasing their credit risk premium--which, in the absence of marked changes in required net yield to the end investor, will appear to make mortgage rates rise "independently" of other long-term interest rates--because, well, current conditions in the housing and mortgage market suggest that mortgages are pretty risky right now, credit-wise. One thing that indicates the extent of this risk, of course, is that by and large nobody but the GSEs are buying mortgage loans right now. Perhaps this is what is confusing the Times reporter: if Fannie and Freddie had any competition right now--if there were anyone else out there buying loans--it might be more obvious that everyone increases risk premiums when perceived credit risk rises. But really, you know. When nobody else but the government-chartered investors are in the market, that can be understood to mean that risk is so high that nobody else is even feeling strong enough to be willing put a price on it. The absence of competitors in a market often suggests that risk has risen in that market. If you've ever tried to get flood insurance, you may have noticed this phenomenon.

Of course, there's another way to look at this, which is that in the last five to seven years it did not "appear" that there was much of a risk premium in mortgage rates because, well, there wasn't much of one. Since we cannot actually open a newspaper or get on the internet without another story of horrible losses taken by investors in mortgages whose "cushion" for defaults--their credit risk premium--was ludicrously low given the riskiness of the mortgages they were investing in, we might have concluded by now that things like the increased risk premiums that the GSEs are now charging are something along the lines of a return to "normal" interest rates. Normal rates being ones that have a realistic risk premium in them.

These two issues do, actually, converge: if the GSEs are the only ones buying loans right now, then they are likely to be buying more of the kinds of loans that private investors used to buy before they quit buying anything. Unless they want to go the same way their private competitors have gone, they have to either tighten standards or raise risk premiums or a combination of both, since it's pretty obvious that the private investor loans of the last few years--mostly subprime, Alt-A, and jumbo--were pretty seriously underpriced. Mortgage markets really aren't that weirder than any other market: you can't make up a negative margin on volume.

This Times piece strikes me as just a somewhat subtler version of the "GSEs Refuse to Save the Day" rhetoric we've seen expressed somewhat more stridently before. What else can we make of this:
Those buying homes will have little choice but to absorb the cost. But the new policies will be felt more by those thinking of refinancing mortgages.
Ohhh-kaaay. If you have to buy--apparently people do "have to" buy--you just have to pay a higher interest rate than buyers did until recently. But if you already have a mortgage and refinancing doesn't look promising right now because the rate you have is lower than the rate on a new loan--you're really suffering? Well, OK, what we seem to mean is that if you "have to" refinance--to get cash or to get out of some crazy high-risk ARM--then you will feel some pain. Because apparently Fannie and Freddie aren't willing to take borrowers who "have to" supplement their income with cash-outs or bail out of loans that let them buy too much house without charging extra for it.

Strangely enough, the Times piece makes pretty clear that this "charging extra" doesn't really amount to all that much, relatively speaking. Another eighth of a percent on the annual interest rate isn't exactly going to hit the usury ceiling any time soon. It also provides a nifty little chart showing that one-year ARM rates are still out there with a pretty decent discount. If you don't like paying 6.93% (in New York) for a 30-year fixed, you can always get an ARM for 6.01%. What? You don't want an ARM because you're afraid rates will rise in the future? And we thought rates no longer had anything to do with such expectations . . .