As of this writing, we continue to slowly emerge from the deepest recession in years. Most economic indicators point to a slightly better picture than they did last summer. Although the sun is not yet shining, economically speaking, there are patches of lighter gray amidst the overcast sky. And the sun may begin peeking out in late 2011 and early 2012. Gross domestic product (GDP) growth has been revised up for the third quarter and most forecasts, including ours (the Mortgage Bankers Association's research division), will likely reflect stronger growth into next year. The stronger growth has been partially driven by increased consumer spending--as overall conditions and expectations improve, people are gaining confidence and spending again. * Job growth appears to be picking up, with the October and November employment situation reports showing significant payroll increases in the private sector and weekly jobless claims at their lowest levels in more than two years. Moreover, businesses continue to spend on capital goods and information technology (IT), albeit at a slower rate than in recent months. * Despite this job growth, unemployment and labor underutilization remain high. We expect that given the current path of economic growth, the unemployment rate will remain above 9 percent in 2011, and over 8 percent well through 2012. There are still large numbers of workers who are discouraged, marginally attached to the work force, or who have been forced to take a temporary job. As of November, about 42 percent of the unemployed have been looking for a job for more than six months. * The job market is instrumental in the recovery of the housing sector because homeownership and mortgage performance hinge directly on households' incomes. A loss of employment or income is one of the "trigger" events for mortgage delinquency, and in a declining home-price environment homeowners cannot easily sell their homes if they are no longer able to afford their mortgage payments. And those who can afford their mortgage payments may be faced with a loan balance that is still greater than the value of their home.
The housing sector is still crawling along the bottom, as home prices continue to fall by most measures. A large inventory overhang of unsold homes remains, as well as a significant "shadow inventory"--homes that are either in foreclosure or with mortgages that are delinquent and that could potentially come onto the market as a result of their nonperforming mortgage status.
Purchase application data are just beginning to reattain levels last seen in early May, immediately following the expiration of the homebuyer tax credit. Until we see a sustainable and significant rate of job and income growth, as well as a better consumer outlook for the future, home-price growth will continue to either decline or grow slowly, with variations by market increasing as the recovery develops.
Finally, there are risks also from abroad--specifically the possibility of a currency war as other countries move to devalue their currencies relative to the U.S. dollar and more sovereign debt crises in other European countries, as seen most recently in the case of Ireland.
Given this economic backdrop, prices and wages are unlikely to increase, and inflation will remain contained for now. However, we think that the recovery is for real, and coupled with the end of the Fed's most aggressive actions to jump-start the economy, rates are likely on a slow uphill climb from here.
We anticipate that the 10-year Treasury is likely to be at 3.5 percent by the end of 2011 and 4 percent by the end of 2012. We expect the 30-year mortgage rate will move above 5 percent by the end of 201 r and push closer to 6 percent by the end of 2012 (see Figure 1).
[FIGURE 1 OMITTED]
In the remainder of this article, we review the Fed's recent actions, discuss the outlook for the federal budget and examine the implications of both in the context of our economic forecast. We also examine the outlook for mortgage originations in the year ahead.
Monetary policy considerations
Monetary policy has typically been shrouded in mystery. How can the Federal Reserve "manage" the economy through the setting of a single short-term interest rate? As in other settings, no two economists will give you exactly the same answer on this.
The Federal Reserve is a rather unusual institution--an independent agency within the executive branch, with significant ability to impact the economy, but substantially insulated from political pressure by design and historical tradition.
Even with this background, the Fed's actions over the past few years have been extraordinary and perhaps more perplexing to the "uninitiated" outside of the central bank. Consider the following:
* The Federal Reserve's balance sheet swelled from roughly $700 billion in early 2008 to more than $2 trillion by the end of that year (see Figure 2).
[FIGURE 2 OMITTED]
* The Fed's holdings expanded from being primarily short-term Treasury securities and discount-window loans to banks, to include commercial paper and other money market instruments, loans to broker-dealers, swaps with other central banks, longer-term Treasuries, and significant holdings of mortgages and agency debt.
* During a relatively short period at the end of 2008 and into 2009, the Federal Reserve loaned in excess of $3 trillion to virtually every sector of the U.S. economy, and to many foreign entities as well. Without this lending, it appears, some of the biggest names in finance and industry would not have been able to survive.
Arguably, of greatest interest to the mortgage industry, were the Fed's purchases of mortgage assets--$1.25 trillion of agency mortgage-backed securities (MBS) purchased through 2009 and into the first quarter of 2010, which led to record low mortgage rates. (The Fed also purchased $170 billion of agency debt securities, which provided further indirect support to the mortgage market.) The rate on 30-year fixed loans remained within a narrow band of 4.8 percent to 5.1 percent for much of that 15-month period.
This venture into "quantitative easing," targeting a quantity of asset purchases rather than a rate, was an untested monetary policy tool. However, as the short-term rate target was already as low as it could go (the Federal Funds rate had been at essentially o percent since the beginning of 2009) and the economy was in free fall and losing hundreds of thousands of jobs per month, the Fed must have determined such a move was absolutely necessary.
Adjustments to the program were made along the way, notably extending the program through the first quarter of 2010 and allowing for a gradual tapering off of purchases to allow the private sector time to get back in. As a result, when the Fed left the mortgage market at the end of March, there was little reaction evidenced in either the level or the volatility of mortgage rates.
The European sovereign debt crisis, with Greece at the forefront in early 2010, led to a global flight to quality. That brought U.S. Treasury rates significantly lower, and mortgage rates followed them down. Despite these unprecedented low rates, the job market in the United States continued to sag, with the unemployment rate remaining near 10 percent.
Meanwhile, inflation continued to decline, leading many economists to fear that the United States might actually experience deflation, with prices--rather than just inflation--falling. (The United States during the Great Depression, and Japan over the past two decades, were caught in a debt-deflation spiral as prices and incomes dropped, and borrower defaults increased, which led to further drops in asset prices and further reductions in other prices and incomes.)
Moreover, growing concern regarding outsized budget deficits and accumulating public debt, (something policymakers encountered during midterm elections), meant that it was infeasible to suggest another fiscal stimulus either through additional spending or tax cuts.
We discuss the budget outlook in the next section, but suffice it to say, monetary policymakers at the Fed did not believe that fiscal policy measures were available to help the economy, and believed they needed to step into the breach to try to increase aggregate demand.
Beginning as early as the middle of the summer of 2010, Federal Reserve officials began to hint that another round of asset purchases by the central bank could be used to try to bring interest rates down further. This was seen as a way to potentially stimulate households and businesses to increase their spending either through new financing or through refinancing at lower rates. By early fall, the Fed had signaled it was certainly going to start a new round of purchases, and it would likely he limited to the purchase of longer-term Treasury securities, but it did not clearly indicate the size of QE2--the second round of quantitative easing.
Just this announcement that the Fed would be acting to buy Treasuries brought longer-term rates down, and mortgage rates reached new record lows. However, uncertainty remained regarding the specifics of the QE2 program. Some Fed officials indicated that the program could be incremental, with perhaps $100 billion of purchases announced at their November meeting, with clear indications that additional purchases would be dependent upon economic developments. Others indicated the Fed's purchases could be substantially larger, perhaps exceeding $1 trillion and taking place over more than a year.
The November meeting announcement, indicating that $600 billion would be purchased over eight months, was quite close to market expectations, and interest rates actually increased slightly that day.
Subsequently, the level of uncertainty regarding the future of QE2 has only increased.
Kevin Warsh, a governor of the Federal Reserve, indicated in a Wall Street Journal op-ed that the program would be subject to ongoing review. With the G-20 international meetings as a backstop, finance ministers around the world criticized the Fed's actions, fearing that it would weaken the dollar and increase U.S. exports at the expense of their countries.
And in mid-November, many conservative U.S. economists signed a letter indicating that the policy was misguided and inherently inflationary. The net result of all this noise is investors have come to doubt the resolve of the Fed, and longer-term rates have risen as a result--as of Thanksgiving week, 30-year fixed mortgage rates were at their highest level since June 2010.
Our outlook is that the unemployment rate will remain high over the medium term, likely above 8 percent at the end of 2012. With that level of unemployment, inflation is likely to remain low, and thus the Fed will be unlikely to raise short-term rates over this time period. However, at some point, it will need to unwind the growth in its portfolio and reduce the level of excess bank reserves currently in the system.
Fed officials insist that they have the means to do this. The Fed is already allowing its mortgage assets to run off as loans amortize or prepay, replacing the MBS with longer-term Treasuries. At some point, it will more actively reduce these holdings through large-scale repurchase agreements or outright sales. The Fed also has developed a term deposit program as another means of tying up bank reserves to forestall a jump in lending that could spark inflation.
The Federal Reserve System is filled with remarkably talented and dedicated individuals. But no central bank has ever attempted such a maneuver on this scale. And the costs of getting it wrong are huge--essentially a return to levels of inflation that we have spent the past 30 years painfully wringing out of our economy. Investors are not sending a signal of no confidence, but they are appropriately wary.
The federal budget outlook and longer-term rates
Perhaps the most worrisome aspect to some regarding QE2 is that the popular shorthand for the program, "the Fed is printing money to buy government debt," conjures fears that the United States may end up repeating some of the worst episodes in economic history. In the past, countries that could not sell their debt to any investor forced their central bank to buy it, which led to hyperinflation a la Weimar Germany.
No one is seriously suggesting that hyperinflation is a risk here. However, any serious analyst who looks at the U.S. budget situation is right to be worried.
The United States is currently running budget deficits in the range of 9 percent to 10 percent of national income (see Figure 3). The publicly held debt has increased from about 45 percent of national income to more than 60 percent, and is headed toward 70 percent by 2020 even if significant spending cuts and/or tax increases are made. It could go much higher--80 percent to 100 percent--if such heroic spending and tax changes are not made.
Figure 3 Projected Budget Deficits and Surpluses in CBO's Baseline ($ Billions) Actual 2009 2010 2011 2012 2013 2014 2015 On-Budget -$1,550 -$1,419 -$1,154 -$766 -$639 -$569 -$650 Deficit Off-Budget $137 $77 $88 $101 $114 $131 $143 Surplus * Total -$1,413 -$1,342 -$1,066 -$665 -$525 -$438 -$507 Deficit Memorandum: -9.9% -9.1% -7.0% -4.2% -3.1% -2.5% -2.7% Total Deficit As a Percentage of GDP Debt Held by 53.0% 61.6% 66.1% 68.5% 68.4% 67.3% 67.3% the Public As a Percentage of GDP ** 2016 2017 2018 2019 2020 Total Total 2011-2015 2011-2020 On-Budget -$732 -$727 -$711 -$777 -$817 -$3,778 -$7,542 Deficit Off-Budget $148 $148 $149 $143 $132 $576 $1,296 Surplus * Total -$585 -$579 -$562 -$634 -$685 -$3,202 -$6,246 Deficit Memorandum: -3.0% -2.8% -2.6% -2.9% -3.0% -3.8% -3.3% Total Deficit As a Percentage of GDP Debt Held by 67.7% 68.1% 68.3% 68.8% 69.4% N/A N/A the Public As a Percentage of GDP ** Note: GDP = gross domestic product; N/A = not applicable * Off-budget surpluses comprise surpluses in the Social Security trust funds and the net cash flow of the Postal Service ** Debt held at the end of the year SOURCE: CONGRESSIONAL BUDGET OFFICE (CBO)
As indicated by Congressional Budget Office (CBO) Director Douglas Elmendorf, "Those are numbers that are not very common among developed countries. We are pushing our way toward debt levels that we don't have experience with in this country, [and that raises the risk that] people will be concerned enough not to want to buy so much U.S. debt at current interest rates."
President Obama's National Commission on Fiscal Responsibility and Reform suggested a range of deep spending cuts, large tax increases and major reductions in existing entitlement programs. Other parties have suggested complementary plans. Even were these draconian plans to be enacted, there would still be upward pressure on longer-term rates over the medium term. These pressures are reflected in our outlook for rates--namely that longer-term rates have turned a corner and are going to be headed higher.
Without a serious change in the deficit and debt outlook, there is a risk that longer-term rates could head much higher than we envision currently.
The sovereign debt crises experienced to date by Greece, Ireland, Portugal and Spain, and the dramatic cuts in government spending adopted by the United Kingdom and others are wake-up calls to the United States. Market confidence can turn on a dime, sending rates spiking higher or shutting off credit to countries.
We do not think this will happen to the United States, but policymakers need to act to bring deficits down and curtail the growth in debt before we reach a crisis point.
The outlook for mortgage originations
Rising mortgage rates will slow refinance volumes, while a gradually improving housing market should lead to only a modest increase in purchase activity. Complicating this picture is the fact that underwriting standards remain quite tight, and regulatory activity around the definition of a qualified residential mortgage (QRM) and other new rules stemming from the Dodd-Frank Wall Street Reform and Consumer Protection Act are likely to only further tighten standards.
We expect total mortgage originations of roughly $r trillion in 2011--a significant drop from $1.5 trillion in 2010 and $2 trillion in 2009.
There were repeated refinance wavelets as rates fell during the past two years, and most borrowers who had an incentive and were able to refinance (i.e., to lower their monthly payments, lock in a fixed rate or refinance into a mortgage product more suited to their financial goals) have already done so. The contract rate for a 30-year fixed-rate mortgage (FRM) averaged a little over 5 percent in 2009 and is around 4.7 percent to date in 2010. The rate has been below 5 percent for the past seven months.
For borrowers ineligible to refinance based on their credit profile, lack of equity in their home or employment situation, rates will likely remain relatively low for the next year, so opportunities should continue to exist if their situations change.
As shown in Figure 4, there are a considerable number of agency mortgages outstanding with a significant refinance incentive. Those with coupons higher than 5 percent, roughly $2 trillion, represent a portion of those unable to refinance. Most in the non-agency universe, another $500 billion in loans, have also been largely locked out.
[FIGURE 4 OMITTED]
Refinance originations will decline sharply in 2011 as the pool of eligible borrowers and borrowers who stand to benefit from a refinance shrinks. The refinance wave persisted longer into 2010 than we had first anticipated, as lenders had to extend refinance timelines to process the high volume of purchase transactions earlier in the year--many of which had to be done in advance of the tax credit deadline.
Additionally, with much of their resources devoted to other industry efforts (modifications, reporting and compliance), lenders faced some staffing constraints that also hampered processing of originations in general.
As rates continue to rise, refinance activity will fall through 2012.
Purchase originations are closely tied to the health of the housing sector--both the volume of sales and the path of home prices. A large excess supply of homes remains on the market. The stock of existing homes for sale remains high, coupled with the threat of additional inventory from homes tied to loans that are seriously delinquent. This keeps downward pressure on home prices, even though housing starts have remained at extraordinarily low levels.
For households with a secure income, however, the lower prices combined with historically low mortgage rates may prove to be a good incentive for them to purchase a home. We have seen some life of late in mortgage applications for home-purchase transactions, existing-home sales and pending-home sales (see Figure 5).
[FIGURE 5 OMITTED]
We expect that purchase originations will fall in 2010 relative to 2009, given that the second phase of the homebuyer tax-credit program expired in the spring of 2010, after which home sales fell 25 percent between the second and third quarters. Sales have not really picked up significantly since.
Purchase originations should increase in 2011 and 2012 as home sales and housing starts begin to strengthen again.
An improving economy, rising rates and a tougher year
In summary, the net effect of these factors--frustratingly slow improvements in the economy and housing markets, an overextended federal government and a Fed that has run out of options--means that mortgage rates are likely to rise. This will cause refinance volumes to plummet, but purchase volumes are unlikely to increase much due to the lingering weakness in the job market.
Those patches of light gray in the still-dark sky are promising, but more so for 2012 and beyond than for 2011.
There are, of course, both upside and downside risks to the current outlook. At press time, one immediate threat to growth is the fact that the issue of extension of the Bush-era tax cuts had not yet been fully resolved. It appears possible that a deal negotiated between the White House and congressional Republicans could get enacted, but if the tax cuts are not extended, consumers will undoubtedly receive a hit to their paychecks in January--and they would cut back their spending in the near future as a consequence.
If this were to lead to renewed fears of deflation or even a double-dip, rates could drop again and refinance volumes could end up higher than what we're currently forecasting.
On the other hand, both business and consumer spending are lagging due to lack of confidence in the future. Expectations about future demand can turn quickly, and can create virtuous cycles that could accelerate the rate of growth in both the housing market and the broader economy. Of course, this would mean higher mortgage rates and lower refinance volumes, only partially offset by an increase in purchase activity.
Happy New Year!
Mike Fratantoni is vice president, research and economics, and Joel Kan is director of research and business development for the Mortgage Bankers Association (MBA) in Washington, D.C. They can be reached at firstname.lastname@example.org and email@example.com.…