Future of Mortgages, part 2: Is 30-Year Fixed Dead?

Currently 95% of home loans are controlled by the government using Fannie Mae, Freddie Mac, and FHA, but U.S. Congress is reviewing 3 options to overhaul home financing in this country. Below we examine how this will materially change loans and rates available to you in the future. This is part 2 in a series, here’s part 1.

3 Loan Reform Options
Fannie and Freddie buy most U.S. loans up to $729,750 after banks close them, giving banks liquidity to make new loans more quickly. It also means banks can keep rates lower because Fannie and Freddie package the loans into bonds so risk is shared by securities markets. FHA goes one step further: in exchange for lender and borrower paid mortgage insurance fees, they actually reimburse lenders if the loan goes bad, which enables lenders to offer even lower rates to consumers. The 3 reform proposals for these 3 government entities are: (1) reduce government’s home loan role to only support lower income families and rely on private markets to fill the Fannie and Freddie role, (2) involve government only in crisis, or (3) expand the FHA insurance concept to include the whole market. The market and political reality is that home finance in the U.S. will be some combination of these three options.

Near-Term Loan/Rate Changes
Due to political risk for all parties, we won’t see huge changes in home finance before the 2012 presidential election, but we will see Fannie and Freddie buying less from banks. Congress will likely reduce the loan caps Fannie/Freddie are eligible to buy from $729,750 to $625,500 by October. This will send the right signal to private investment firms that Fannie/Freddie market share is decreasing and give them confidence to start buying these loans from banks. After a 3.5 year drought, private investors are already beginning to buy loans again, but for now it’s Jumbo loans above $729,750. Setting up these Jumbo loan buying relationships with banks now will pave the way for expanding the relationship to lower loan amounts when Congress begins reducing loan caps later this year. For the next couple years, it means steady rates and more availability for large loans, and also slowly replaces Fannie/Freddie.

The End of 30-Year Fixed?
One fear of eliminating Fannie & Freddie is that private investors won’t have a tolerance for 30-year fixed loans, so they’ll only offer consumers loans fixed for 5, 7, or 10 years. This would mean a buyer who wants to own their home long-term must get a new loan at (potentially higher) market rates in 5, 7, or 10 years. The fear is rooted in how banks manage risk. Since rates swing so much, they prefer not lock their entire portfolio into low rates for the long term. In doing shorter-term loans, they can keep borrowers’ rates closer to market rates over time. However the Jumbo deals investors and banks are making right now are mostly for 30 year fixed loans. This suggests some faith in the ability of securitization to mitigate risk, and bodes well for availability of competitive 30-year mortgages even in a post Fannie/Freddie era.