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Lower conforming loan limits to shift the jumbo space

Some jumbo borrowers may find themselves sidelined, priced out of the market

The Federal Housing Finance Agency may reduce its conforming loan limits for Fannie Mae and Freddie Mac-purchased loans, creating a new opportunity for the private jumbo market to soar again.

While lower government-sponsored enterprise loan limits and higher guarantee fees reflect continued efforts to reduce the government's footprint in the mortgage market, a private-label takeover may be more expensive and burdensome to the market, analysts with Royal Bank of Scotland (RBS) said. In other words, it's not an easy transition.

"The lower loan sizes will continue to help boost the jumbo mortgage market as loans above the limit would have to be funded by private investors," explained RBS mortgage-backed securities analysts Sarah Hu and Ashley Gam.

They added, "However, without government backing, those borrowers who once qualified for conforming high balance loans will find themselves facing jumbo rates. In addition, they will have to meet jumbo/non-conforming guidelines that require larger downpayments and higher credit scores."

The jumbo market has continued to grow while the conforming market has continued to shrink on falling refinance demand.

For instance, jumbo loan originations reached $59 billion during the second quarter of 2013 — representing the highest volume since 2007, and a 9.3% increase from the first quarter of 2013, RBS pointed out.

Some market participants expect jumbo rates to go up by as much as 50 basis points, likely reversing the recent trend in which rates were in line with or sometimes even cheaper than conforming rates.

While the FHFA has not specified what the new loans limits would be, some mortgage experts believe limits will be reduced to $400,000 and $600,000, respectively.

Although a relatively small number of borrowers are in the impacted range on average, the change in loan limits will have a larger impact in certain high cost markets.

"While the change will be small, it will be assumed that borrowers in the middle class won't have an option for a home loan unless FHA takes over the loans that are no longer eligible," argued Mortgage Bankers Association CEO and president David Stevens.

For example, California has a higher concentration of large-balance loans compared to the rest of the nation — 15% of loans originated in the state had a loan amount between $400,000 and $417,000 from 2010 to 2013, RBS analysts noted.

The looming policy change points out two critical obstacles housing officials continue to face, including the availability of credit for potential buyers and guarantee fees.

With the ultimate goal of bringing private capital back to the market, the enterprises have gradually increased g-fees. RBS believes g-fees will go up to 70 basis points by the end of the year.

However, since there has not been a commensurate g-fee hike for jumbo loans, the spread recently declined.

With respect to trading, the impact of lower loan limits could slightly improve the convexity of the To-Be-Announced market — given that there might be less prepayment from the smaller-sized loans.

Over the past few months, average jumbo rates have been close to or even lower than conforming mortgage rates, with the difference between the jumbo spread down 25 basis points.

This recent trend is opposite of the usual positive jumbo spread, as jumbo rates are typically higher than conforming rates.

The reversal of the jumbo spread can be attributed to conforming jumbo mortgages holding lower loan-to-value ratios and higher FICO scores on average. Additionally, despite better credit quality, jumbo loans typically have higher-risk premiums.

"One of the possible reasons for this is that the GSEs have long subsidized conforming mortgages causing their guarantee fees to be underpriced and conforming rates to be artificially lower than jumbo rates," Hu and Gam stated.

Jumbo rates are also lower because of bank demand.

As refinance volumes taper, banks are aggressively making portfolio loans to make up for the reduced volumes elsewhere — jumbo loans with pristine credit are naturally the ideal target.

Overall, a lower conforming loan limit will help boost the jumbo mortgage market as loans above the new limit would have to be funded by private investors.

However, without government backing, those once eligible borrowers for conforming high balance loans will find themselves facing rates that could be priced at higher default risks and more expensive overall.

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