The new "jumbo lights": magic cure or big bust?
The new "jumbo light" loans, officially called "high balance" or "conforming jumbo" loans, are touted as the cure to one symptom of the current credit crunch: the increased "spread" between conforming and non-conforming loans.
Don't worry, this article comes with sub-titles. And the subject, while dry, should be of interest to Bay Area entry-level homebuyers. Because affordable low-down-payment home loans may be making a comeback.
First, a little background.
The mortgage market is divided into "conforming" and "non-conforming" loans. A conforming loan is so called because it conforms to underwriting guidelines established by two government-supervised entities ("GSEs"), Fannie Mae and Freddie Mac. Conformance makes a loan eligible for purchase by either GSE, which buys it, packages it with other conforming loans and sells the package to investors as a mortgage-backed security (MBS). This process, born of the credit crunch of the Great Depression, is intended to assure homebuyers a ready supply of credit by ensuring that lenders always have capital to lend.
A non-conforming loan, on the other hand, cannot be purchased by Fannie or Freddie and thus is either held by the lender in portfolio or sold to a Wall Street investment banking firm which packages it with other non-conforming loans into a mortgage-backed security bought by institutional investors. You'll have noticed that both conforming and (many) non-conforming loans are packaged and sold so that capital can flow back to lenders. But there's one big difference. Because the GSEs don't purchase non-conforming loans, often called "jumbo" loans, to package, lenders with jumbos have a smaller market of packagers to sell to. The investment bankers who do buy jumbo loans to turn into mortgage-backed securities are a smaller market than the GSEs who buy conforming loans to turn into MBSs. And because there's less demand for jumbos to package, the homebuyer who takes out a jumbo loan pays a higher rate of interest than he or she would pay for a conforming loan. The difference in interest rate between the two types of loans is called the "spread".
Typically the interest-rate spread between conforming and non-conforming/jumbo loans has been modest, about one-quarter of one percentage point. So if a particular conforming loan product carried an interest rate of 6 percent, the non-conforming or jumbo version of that loan product was priced at perhaps 6 1/4 percent. But as the subprime mortgage crisis shakes investor faith in all mortgage-backed securities, the secondary market's demand for jumbos has plummeted and the current spread between conforming and non-conforming loans is now a full point or more. Which, of course, makes non-conforming loans more expensive than they were.
If non-conforming loans have always been more expensive, why would anyone take one out? Because until March of this year the upper limit on conforming loans was $417,000, which in the Bay Area and other high-cost areas might get you a de-commissioned boxcar to sleep in. But the credit crunch prompted Congress to allow Fannie Mae and Freddie Mac to raise the conforming limit to as much as $729,750 in high-cost areas, including most of the Bay Area. These "conforming jumbo" loans have been nicknamed "jumbo lights".
Which brings us to the title of this article, and to the item of interest to Bay Area entry-level homebuyers I promised.
There's been another recent development designed to mitigate the credit crunch: when Congress raised the conforming loan limit for GSEs, it also raised the limit for loans insured by the Federal Housing Administration (FHA) to $729,750. And it's these FHA-insured loans that seem to offer the most promise to Bay Area entry-level buyers, who in many sub-markets have been sitting on the fence, waiting for the smoke to clear and the flashing neon "Buy Now" sign to appear.
What's so special about these loans? In many ways FHA-insured loans offer a return to the good old days of easy credit, but are coupled with responsible underwriting to ensure a level of mortgage market sanity not seen since at least 2004.
For example, at a time when 100 percent financing is virtually impossible to find, and even 90 financing is on the way out the door, FHA offers a 97.15 percent loan-to-value ratio. That's right, credit-starved America, you can conceivably buy a home with less than 3 percent down.
And FHA's pricing, currently 6.25 percent, is extremely attractive at a time when conventional jumbos are priced about a full point higher.
And since FHA isn't fixated on FICO scores, as are conventional lenders these days, a low FICO score isn't a roadblock to getting financing. The borrower's credit history is checked, of course, but FHA's standards are more lenient—a bankruptcy is okay, for example—and alternate sources of credit are acceptable.
The debt ratios (the percentage of borrower income that goes to housing costs) for FHA loans are generous, and can be raised for a good borrower. The income of "non-occupant co-borrowers", also known as "Mom and Dad helping out the kids", can be "blended" into the borrower's debt ratios, which means that parents' income is counted along with the borrower's.
In fact, the FHA's guidelines offer unusual flexibility at a time when conventional lenders are rapidly reverting to their former hidebound selves. A large down payment—20 percent or more—can offset whatever negative baggage a borrower might have. So can a borrower's potential for increased earning and advancement, a demonstrated ability to save, attending a Home Buyer Education course and exceptionally high FICO scores. If a borrower has a long-term roommate who will be following her to her new home, FHA will even count income from the roommate's rent against the borrower's loan payment. And unlike conventional lenders, the FHA doesn't require that a borrower have at least two months cash in reserve to handle the payment of loan principal, interest, property taxes and homeowner's insurance.
Isn't this a return to the bad old days when anyone with a pulse could get a loan? I've heard FHA loans described as "similar to subprime but with full documentation". Apparently it's the infamous "liar loans", also known as "stated-income" loans, that today cause most of the trouble in the subprime market. FHA loans, on the other hand, require full documentation.
These advantages plus others too numerous to mention here have suddenly made the FHA potentially a major player in the Bay Area's entry-level market. But note that word: "potentially".
There's a rub. The higher limits for conforming and FHA-insured loans are great news, but an unanticipated problem may negate their impact.
When higher loan limits were proposed a few months ago, it was assumed that Freddie Mac, Fannie Mae and the FHA would treat the new jumbo lights just as they treat conforming loans under the old $417,000 limit. But that looks increasingly unlikely. Freddie Mac and Fannie Mae will continue to purchase, and the FHA will continue to insure, loans up to the old $417,000 limit; the jumbo lights won't affect this end of their operations. But it's becoming apparent that conforming loans falling between $417,000 and the new upper limit of $729,750 will be penalized with an interest rate spread, just as conventional non-conforming loans are now. Why? Because the risk factor—the default rate—of these jumbo lights is unknown, both to Freddie, Fannie and the FHA and to the investors this new breed of mortgage-backed securities will be offered to. And as you may have noticed, lately markets of any kind don't like uncertainty.
Novelty and potentially greater risk demand a risk premium, and no one knows how great the spread between the old conforming and new jumbo light loans will have to be to assuage the organizations packaging or insuring jumbo lights, on the one hand, and the investors buying securities containing jumbo lights on the other. If the spread is well under the current point or more, then jumbo lights—particularly FHA's easy-qualifier loans—will almost certainly be a major shot in the arm for the Bay Area's entry-level market, a market badly in need of a pick-me-up. If not, then it's all much ado about nothing, at least until the new MBSs and the loans which underlie them establish a track record, and this "seasoning" could take at least two years. And the higher conforming loan limits will expire at the end of 2008 unless extended.
I've heard it said that whether the investors who purchase mortgage-backed securities (or, increasingly, don't purchase them, except at steep discounts) will accept jumbo lights depends not so much on the performance of jumbo lights themselves but on whether investors regain their faith in mortgage-backed securities of any sort.
That might take a while. And that's sobering news.