Stimulus plan may lead to higher mortgage rates

NEW YORK (Reuters) - A key element of the stimulus package aimed at jump-starting the ailing U.S. housing market may have the unintended consequence of raising mortgage rates, said analysts studying the plan.

A real estate sign, which indicates the 'new price', stands outside a three-bedroom and one-bath home in Burbank, California October 9, 2007. REUTERS/Fred Prouser

A federal proposal to increase the size limit on loans eligible for purchase by mortgage finance giants Fannie Mae and Freddie Mac has unsettled traders in the $4.5 trillion market for bonds backed by the “conforming” mortgages.

Increasing the eligible loans to $729,750 from $417,000 would change the characteristics of mortgage-backed securities, leading traders to exact a premium for increased interest-rate risk.

Borrowers with large, jumbo loans are more likely to refinance since their savings are greater for each incremental drop in rates than for a smaller loan. The loans will taint the bonds since traders don’t initially know the make-up of the securities known as “agency” MBS.

Higher mortgage rates would make it even harder to unload already high housing inventories and existing homes on the market, delaying any housing recovery and potentially extending the U.S. economic slowdown.

Potential damage to the “to-be-delivered” (TBA) market -- the most actively traded agency mortgage market where investors can buy bonds before they are actually created -- prompted Wall Street dealers to call a special meeting with the Securities Industry and Financial Markets Association at 3:30 p.m. Friday, market sources said. A SIFMA spokeswoman would only say the group is in ongoing discussions with its members.

“The amount of money that investors are willing to pay for agency mortgages (bonds) could be lower if these loans are TBA deliverable and so mortgage spreads could widen,” said Ajay Rajadhyaksha, co-head of U.S. fixed income strategy at Barclays Capital in New York, who will listen to the SIFMA meeting by phone.

Mortgage rates would rise for the “vast majority” of agency-eligible borrowers, he said.

When falling rates prompt refinancing of loans in mortgage bonds, investors can be hurt since principal may be returned to them at a price below market value. The investor is also faced with reinvesting principal in bonds paying lower rates.

MBS paying low interest rates have been hurt in recent days amid expectations the addition of many jumbo loans will boost supply in those coupons, analysts said. As much as $500 billion in jumbo loans could qualify, according to Barclays research.

Wall Street MBS traders last beat down SIFMA’s door in October when the advent of the Federal Housing Administration’s FHA Secure program threatened to taint TBA pools of Ginnie Mae securities. The dealers got their way -- Ginnie Mae created new “specified” pools outside of their TBA issues for FHA Secure.

“The street is on high alert,” one mortgage trader at a New York-based primary dealer said in an e-mail.

Rajadhyaksha and other analysts, including RBS Greenwich Capital’s Noah Estrin, expect the TBA market will be protected if Congress and President George W. Bush approve the stimulus plan as written.

“When you start throwing a lot of jumbos into a pool you spoil the fungibility of the collateral,” said Linda Lowell, a mortgage market veteran and principal of Offstreet Research LLC. “That has made the market as liquid as it is. Home owners have benefited from lower mortgage rates.”

The stimulus bill is expected to move ahead despite the U.S. Treasury’s opposition to raising loan limits without legislation tightening controls of the government-sponsored enterprises. It also “flies in the face” of the GSE’s chartered purpose of creating affordable housing for Americans, Treasury Secretary Henry Paulson said on Thursday.

Brian Faith, a Fannie Mae spokesman, declined to comment about the plan’s impact on its mortgage bond program. A Freddie Mac spokesman had no immediate comment.

Macroeconomic reasons for increasing the size of loans eligible for purchase by the GSEs are many. Home owners in high-cost areas where home prices exceed the current $417,000 cap have been unable to capitalize on the drop in rates on conforming mortgages because investors have been less willing to buy bonds without Fannie Mae and Freddie Mac guarantees.

As the credit crunch deepened in mid-2007, a jumbo borrower had to pay about 1 percentage point more in rate than one with a smaller loan, compared with a 0.15 percentage point premium during the housing boom. Today, jumbo borrowers pay about 0.75 percentage point more.

“To the extent that it is (available) in areas that are stressed, I think that it will help at the margin,” said Lewis Alexander, managing director and chief economist at Citigroup Global Markets at a conference on Thursday.

Editing by Leslie Adler