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Something stinks in jumbo mortgage town.
For most of my adult life, jumbo loan interest rates have been at least 0.25 percentage points (or more) higher than conforming loan interest rates, but this relationship has recently reversed.
Remember, the main goal of the giant “government sponsored enterprises” (GSEs) Fannie Mae, Freddie Mac and Ginnie Mae is to provide more affordable housing financing to the American people.
GSE mortgage-backed securities (MBS) come with an implicit guarantee of the “full faith and credit” of the U.S. government (which was actually shown to be “explicit” when Fannie and Freddie were placed into receivership at the height of the Great Recession), allowing the mortgage-backed securities market to be preferentially priced for nearly risk-free investment grade securities to benefit borrowers seeking lower interest rates.
In contrast, the private “non-conforming” loan market (i.e., loans that do not comply with the GSE limits/standards; the so-called “jumbo” loan market) would logically demand higher interest rates, given that the private lenders funding this market bear the entire credit risk and do not benefit from any implicit or explicit government guarantee.
This generally meant that private lenders would conduct more rigorous due diligence when making loans, require larger down payments (i.e., taking on more risk), be more critical of home appraisals, and offer higher interest rates compared to GSE loans.
However, since the beginning of 2022, this relationship appears to have reversed, with jumbo loan rates now 25 bps to 100 bps below conforming rates. In my market, local bank lenders are advertising jumbo loans 1 percentage point lower than conforming loan rates.
Below is a Federal Reserve FRED visualization (click for a larger version) showing the relationship between interest rates on a 30-year fixed rate conforming loan and a jumbo loan since 2017.
Clearly, a different risk-return calculation exists in the current private lending market, which appears to be having a significant impact on the pricing of the potential risks arising from the performance of these loans.
One explanation could be that underwriting is so tight that private lenders are able to offer very favorable rates, but I have my doubts given some of the trends I have observed in my local market (Boston…a true indicator of the housing market) during this cycle.
First, while you can't really compare now to 2006 (the height of the housing bubble madness) in terms of “creative lending,” there seem to be different demons afoot.
In 2006, there were a number of creative loan products available to help borrowers reach ever-increasing home prices (i.e. home affordability loans). Negative/reverse amortization loans, interest-only options, low or no documentation (liar loans) were all complicit in driving home prices to record highs in order to sustain borrower/buyer profits and originator/lender loan amounts.
You don't see these types of loan products being widely advertised today, but I could give you a few examples: However, I have seen sales completed like this one (for convenience I've calculated the sale price above the list and withheld the exact address):
It's important to note that, generally speaking, these are three and four bedroom homes (one is even a five bedroom) that are pretty common in the suburban Boston housing market. From my perspective, these aren't anything special. These are the types of homes that most middle to upper middle class families would be expected to be able to afford at some point in their economic lives.
But look at the price and, more importantly, the bidding war that exceeded expectations.
This is pure insanity, and there is no way that lenders could have properly performed careful due diligence during the evaluation and underwriting process of these transactions.
I believe this anecdote reveals one of the most significant weaknesses in the recent real estate boom cycle: private lenders once again fell into the same trap they did during the Great Recession housing boom by over-lending, believing that residential real estate would be immune to market downturns.
Meanwhile, buyers were clearly acting like mad, throwing pointless amounts of money at bidding wars in an attempt to get their hands on properties at all costs. This was to be expected with very low inventory and very favorable mortgage rates over the past two years, but the gatekeeper to the sound financing of these transactions is the banking system, which should have prevented this madness, but once again appears to have failed in its systemically important function.
As interest rates continue to rise, real estate markets across the country are experiencing rapid price declines, and we will undoubtedly be witnessing a severe housing market downturn.
Of course, it will take some time given how slowly deals close in the housing market, but the lesson we can learn from this new Housing Bubble 2.0 is no different than what we learned from the last one: what goes up must come down.