The Impact of Fannie and Freddie’s Loan Limits

How might increasing the conforming loan limit impact the housing market?

Last month, the Senate passed a bill that aims to re-increase the conforming loan limit (CLL), the maximum sized loan that Fannie Mae, Freddie Mac, and FHA can purchase, securitize, or guarantee. The legislation is currently under consideration in the House. The CLL dropped from $729,750 to $625,500 at the end of September when Congress made no move to stop its scheduled reduction. Before the Congress completely signs off on re-raising the CLL, they should consider how that might impact the housing market.

The argument in favor of raising the loan limits back to where they have been since 2008 primarily rests on the notion that now is not a good time to reduce the role of government in the housing market. Groups like the National Association of Realtors argue that lower conforming loan limits mean higher interest rates for those buying a home that costs more than $625,500, which in turn means less people buying houses at that price and beyond.

However, the interest rate on a jumbo mortgage (those that are above the CLL cap) is only about 0.75 percent more than a conforming loan. Historically the difference has been even lower.

Furthermore, many homebuyers looking at homes costing $625,500 or more typically are able to afford slightly higher housing costs. The American Securitization Forum noted last week that reducing CLL levels means an increased cost of about $40 a month for a $700,000 home.

Beyond the estimates, early signs since the CLLs were lowered are that the housing market has not suffered any severe contraction. Even with most lenders adopting the new CLLs back in July, home sales actually increased in September.

With the benefits of increased conforming loan limits minimal at best, the question becomes would an increase in the CLL hurt the housing market?

One way to consider that question is to frame it in positive terms about what needs to happen for the housing market in general to recover. There are at least four things that need to happen before the housing market can fully recover: first, the housing price bubble needs to finish deflating; second, the shadow inventory has to decline and foreclosure pipelines get cleared out; third, investors need to have confidence and room to operate in the market; and fourth, there needs to be realistic expectations for what recovery looks like.

There are other factors needed for recovery as well, including substantial deleveraging of household debt. But at the very least these four problems need to be resolved before there is a recovery in the housing market. How conforming loan limits impact these pillars of recovery is critical for determining if increasing CLLs would be harmful or helpful.

First, the housing bubble needs to finish deflating. The housing bubble was an unstable environment for the home market. However, policymakers have been using the GSEs and Federal Reserve’s quantitative easing programs to push mortgage rates down and prevent housing prices from falling as fast as they otherwise would have. Home values are still roughly 10 percent above where historical trends suggest they should be.

High conforming loan limits are a critical aspect of the GSE’s attempts to support prices because they help define the scope of loans that can be purchased. A lower conforming loan limit would reduce the GSE and FHA capacity to support mortgages and may see mortgage rates rise 50 or so basis points, leading to a decline in home values. But further price declines are necessary if there is going to be sustainable recovery-we cannot build recovery on inflated home prices.

Some may think that it is a good thing to prop up housing prices, but with narrow price differences between conforming and jumbo loans, either the CLLs have not helped much-in which case it does not hurt to lower them-or they are supporting prices and thus preventing the housing bubble from fully deflating. In the later case additional price supports would be harmful to the economy.

Second, the shadow inventory of homes needs to be reduced. This means the foreclosure pipeline has to be unclogged. It is not pretty to see mounting foreclosures, but there are half a million mortgages that have not been paid in over two years, and there are 1.6 million mortgages 90+ days delinquent though not in foreclosure. It is not a matter of if, but when these homes will be repossessed and put up for sale. And it would be much better for the foreclosure to be cleared out of the system now, rather than wait dozens of months, adding to the shadow inventory and dragging out the housing recovery timeline.

It is well documented that negative equity is a significant contributor to the likelihood of foreclosure. By keeping prices from falling further and faster, the GSEs have made the rate of foreclosures slower, and since the conforming loan limits have helped price support efforts, they too have contributed to the foreclosure pipeline jam and subsequent expansion of the shadow inventory. Although no one wants to see families go underwater on a house or be displaced by foreclosure, there are many which simply are going to happen and the CLLs enabling the GSEs to slow down the process ultimately causes more harm than good.

Third, investor confidence in the legal process has to come back. The state attorneys general cannot continue to drag the mortgage servicing debate through the mud. Either agree on a settlement or begin to tackle known abuses directly. The continued talk about principle reductions and massive refinancing does not create an environment that encourages capital to flow towards housing finance. Another way that investors are being pushed away is by taxpayer subsidized competition.

Last week, FHFA Acting Director Ed Demarco affirmed that under the current paradigm, the private sector is unable to compete with the GSEs that he supervises. However, lowering the conforming loan limit would reduce the rate at which the GSEs are crowding private investors out of the market. In fact, with originators adopting the lower conforming loan limits back around July, non-GSE/FHA/VA mortgage originations tripled in September 2011 when those changed standards began to kick in.

Still, private mortgage-backed securities deals have been nibbling around the edges wherever possible, but groups like Redwood Trust have been begging the government to lower CLLs so that it has more room to put private financing deals together that don’t require a government guarantee. Pushing private capital away from the housing finance market with high CLLs is not the path to recovery, and it suggests that the government’s attempt to help the housing market recover is actually doing the opposite of its intent.

Finally, it is important that the expectations for what recovery looks like be grounded in reality. Home values are not going to return to highs seen in 2005 and 2006, nor should they. Historically, home values grow about 3 percent over a home’s lifespan, when prices are adjusted for inflation. The trend broke starting in 1994 when home prices began to double in real terms, but they are slowly falling back to the historical housing price trend line. Trying to stabilize prices through principle reduction or GSE support as enabled by high conforming loan limits means subsidized prices-and there is nothing stable about a market depending on subsidies.

The nature of high conforming loan limits, therefore, is to assume that the government needs to support the old definition of what a housing recovery would look like: rapidly rising housing prices with taxpayer guarantees ensuring private investment. But if the expectation for the future housing market is more realistic, the argument for the need of high CLLs becomes less compelling.

Almost everyone agrees that the role of government in the housing market needs to be reduced, at least by some measure. Even the White House suggested this in their housing finance white paper in February 2011, and the House Republicans included reducing Fannie and Freddie in their pledge to America back in 2010. But there will never be a time better than now to act on these beliefs. There will always be voices clamoring that it is not the right time to remove government support-either the market will be too fragile for change or policymakers will not want to derail a growing market. But if price supports are holding back a stable, sustainable recovery, then the time for reform is now.

The lower the CLL standards, the faster the housing market will move towards real recovery. Therefore, Congress should not move on re-increasing the conforming loan limits. It would have a negative impact on the housing market-further delaying the bubble deflation, dragging out the foreclosure crisis, and crowding out private investment-and subsequently, the economy as a whole.