Jumbo Mortgages and Mortgage Market Conditions
Mortgage markets can have a big effect on the economy more generally, as recent turmoil in financial markets—which began with turbulence in the mortgage industry—affirms. Conditions in mortgage markets are therefore followed closely. One interesting indicator of mortgage market conditions is the interest rate spread on jumbo mortgages.
Jumbo mortgages are loans too big to be purchased by Fannie Mae and Freddie Mac, the two largest secondary market lenders (together, they own or securitize more than 70 percent of the residential mortgage loans in the United States). Fannie and Freddie are permitted to buy only those loans that conform to a limit set by the Office of Housing Enterprise Oversight—$417,000 for the continental United States since 2006 (higher for remaining states and territories). Loans above the conforming limits are usually purchased by financial institutions ranging from commercial banks to hedge funds, as well as Wall Street conduits that provide warehouse financing for mortgage lenders.
Jumbo mortgage loans pose a higher risk for lenders, and this risk is consistently reflected in the spread between the interest rates on jumbo mortgages and conventional mortgages, where the historical average is about 30 basis points. The risk reflected in this long-term average arises because it is harder to sell a luxury residence quickly for full price in the event of default. More generally, luxury homes are harder to price, and their prices are more vulnerable to market highs and lows; as a result, prices are more difficult to forecast. An increase in the volatility of housing prices could also increase the perceived risk associated with jumbo loans and hence, the spread.
However, the spread between jumbo and conventional mortgage rates is affected by more than just the different sort of homes that belong to the jumbo pool. Interest rates on jumbo mortgages also reflect changes in the liquidity of the secondary market and the willingness of investors to buy its securities. Because Fannie Mae and Freddie Mac don’t buy nonconforming loans, the secondary market for jumbo mortgages is generally less liquid than for conventional mortgages. In addition, the liquidity of the conventional secondary mortgage market is boosted by the implicit government guarantee investors believe the bonds issued by Fannie and Freddie enjoy. These bonds are perceived as having risk equivalent to government bonds (close to zero), because Fannie and Freddie are government-sponsored enterprises (GSEs), even though GSE securities are not, in fact, backed by the U.S. government. Consequently, the spread between interest rates on jumbo and conventional loans also measures the premium which must be paid to compensate investors for the lower liquidity of the secondary market’s securities and should measure investors’ appetites for jumbo mortgage-backed securities.
The trends in average interest rates for both jumbo and conventional mortgages are clearly determined by the broad macroeconomic factors that affect the overall economy. By plotting the difference (spread) between the two rates, we isolate information about the premium paid for jumbo-based securities relative to conventional ones (note that our dataset includes loans called super jumbos, those that exceed $650,000). This premium was pretty stable until the summer of 2007. In fact, the only notable spike before then was in the winter of 2001, just before a recession and in the aftermath of 9/11.
However, the biggest jump ever in the spread series happened only recently, in the summer of 2007. This jump is clearly associated with liquidity conditions in the secondary mortgage market: outside of Fannie Mae and Freddie Mac, buyers in the secondary market were finding it extremely difficult to resell mortgage-backed securities.
The premium on jumbo loans started to rise abruptly at the end of July, and by the end of August, it broke the 100 basis point threshold. The sharpest increase in the spread anticipated many August events, such as BNP Paribas freezing its three funds and the Cheyne downgrade.
The high volatility of the spread persisted until mid-September, when it began to slowly subside. At the moment, we still seem far from “normal” times, with a spread that is still about double the average seen over the last eight years.