How the Housing Recovery Will Become Sustainable

We need lower government guaranteed loan limits.

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House with a 'For Sale' sign in the yard.

After the country (and the world) witnessed the debacle of the government shutdown, most Americans are now convinced there isn't a thing policymakers in Washington truly agree on. Only the threat of a global economic calamity in the form of a debt ceiling breach forced Congress to agree on reopening the federal government.

But while most issues facing the country have become decidedly red or blue, when it comes to getting private investors back into the mortgage market, and decreasing the reliance on government by resolving the fate of Fannie Mae and Freddie Mac (known as Government Sponsored Enterprises or GSEs), Washington, D.C. is downright purple.

Since the mortgage meltdown in 2008, however, private capital has been a very small part of the mortgage making process. The government currently backs more than 90 percent of all mortgages made. The slow trickle of private investors who have been coming back into the market is increasing, but they have so far only shown interest in the safest, most pristine borrowers.

[See a collection of political cartoons on the economy.]

But as investors increasingly develop an appetite for private mortgages, which is a good thing, the size of the pools of private loans (known as securitizations) seems to be shrinking.

Just this month, Shellpoint Partners, a recent entrant into the private mortgage market, cut its second sale of bonds tied to mortgages by $60 million after a month delay. This on the heels of JP Morgan Chase cutting its issuance forecast from $20 billion to $15 billion for 2013. In the peak years of 2005-2006, private issuance reached $1.2 trillion annually.

So if interest by private investors is increasing, why are private mortgage securitizations decreasing? The problem facing investors is that they are running out of loans to make.

Private lenders have generally been operating in what is known as the jumbo, or non-conforming market. These are loans that are larger than the limits allowed by the GSEs and the FHA, normally around $417,000 in most places, but as high as $729,750 in certain high-cost areas like San Francisco and Washington, D.C.

[Read the U.S. News Debate: Should Big Banks Be Broken Up?]

Companies like Shellpoint and Redwood Trust would like to make more loans below these limits, which would be a good thing, but say they can't compete with the low rates and down payments afforded government backed loans. This has lead to new risks in private mortgage securities that didn't exist prior to the 2008 meltdown due to such robust private investor participation.

For instance, geographic concentration is emerging as a new threat that credit rating agencies, companies like Fitch and Standard & Poor's, have to asses and account for when issuing ratings on these pools of mortgages. A recent $440.1 million securitization had three states account for an astounding 94.4 percent of the loans; California comprised 74 percent by itself.

With large down payments, perfect credit and well-documented income, loans defaulting might not seem like a big issue at first blush. But if geographic concentration seems far-fetched, consider the recent case of Detroit, Mich., where the auto industry went overseas and left a city half the size. One state over is the Akron/Cleveland, Ohio area, where the rubber and manufacturing industry moved elsewhere and decimated the local economy over time.

[Read the U.S. News Debate: Should the Federal Government Provide Support to the Mortgage Market?]

And if you think economic is the only type of risk posed to a particular geography, think again. Natural events such as Hurricane Katrina can alter the history of a city's physical and economic landscape for 100 years.

One solution is to lower loan amounts guaranteed by the government nationwide, so these pools of securitizations can be geographically diversified. A decision to decrease loan limits is facing Congress and regulators of the GSEs, and lowering these loan limits would help open up the pool of borrowers that investors want to target, and in turn bring more private capital participation off the sidelines. Barclays Plc estimates that private mortgages could balloon past $50 billion in 2014 if the government reduced its loan limits, far exceeding this year's estimate of $15 billion.

This widespread lowering of loan limits is essential and cannot be limited to just the high cost areas – which would only reinforce more pockets of concentration, not achieve true geographic diversification.

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The real estate industry and some lawmakers are pushing back on regulators lowering the limits. They claim private investors filling the space vacated by the new, lower limits will only lend on the most pristine loans worthy of a AAA rating. They have a point. Anything other than perfection probably won't get funded, so many worthy borrowers will be pushed out of the market. In other words, loan liquidity will decrease.

A decrease of too many loans would be an unwelcome headwind in the still evolving housing recovery. But it would be a small bump in the road compared to what the $11 trillion mortgage market would face if Congress enacted current GSE reform proposals, while wildly misjudging investor appetite. With a loan limit decrease, if investor appetite is not there, and liquidity becomes an issue, Congress can always re-raise the loan amounts.

So achieving geographic diversification is crucial to the establishment of a reliable private market, which is an essential pre-condition to truly resolving the fate of Fannie and Freddie. And only then will the evolving housing recovery become sustainable.

Jason R. Gold is director of the Progressive Policy Institute's "Rebuilding Middle Class Wealth Project" and senior fellow for financial services policy. Keep up with his work at PPI here and follow him on Twitter at @PPI_JGold.

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