Stimulus bill could have consequences

Stimulus bill could have consequences
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First Published: Wed, Jan 30 2008. 11 53 PM IST
Updated: Wed, Jan 30 2008. 11 53 PM IST
Wall Street has mostly cheered the $146 billion (Rs5.75 trillion) stimulus package just passed by the US House of Representatives. But financiers should think twice. It could cause a lot of headaches for the banks and investors that hold mortgages.
Specifically, the proposal to increase the size limit on so-called conforming mortgages—high-quality loans usually purchased by Fannie Mae and Freddie Mac—could backfire. Currently, Fannie and Freddie can buy mortgages up to $417,000 in size. Lenders usually charge 50-75 basis points more in interest on “jumbo” mortgages over that amount, since they’re harder to sell. The stimulus package would increase the jumbo mortgage cut-off to more than $700,000. This a component of the package that still needs Senate approval. That’s meant to prop up property prices at the higher end of the market.
But it could actually hurt mortgage lenders. One of their big problems is prepayment risk. As interest rates fall, borrowers often choose to refinance their mortgages, returning cash to lenders just when other attractive high-yielding investments are scarce.
Mortgage-backed bonds also fall in value when prepayments increase. So,if banks start offering mortgages up to the new jumbo threshold with interest rates 0.75 percentage points lower, a raft of existing mortgage borrowers who paid jumbo rates for loans that now fall under the new ceiling might scramble to refinance. They are already being tempted by falling interest rates.
Investors who hold their original mortgages, or the bonds backed by them, would suffer. In addition, when Fannie and Freddie securitize the new, larger mortgages, the resulting bonds will have greater prepayment risk than bonds packaged under the old rules. That’s because homeowners, who have borrowed larger sums, see a bigger benefit, in dollar terms, from refinancing when rates fall. Investors may demand higher yields on those bonds to compensate for the additional prepayment risk.
If so, the additional cost will probably be borne by home buyers, eliminating most of the benefit of having a conforming mortgage, rather than a jumbo loan, in the first place. It’s a reminder how indirect, unintended effects can undermine superficially alluring policies to stoke the economy.
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First Published: Wed, Jan 30 2008. 11 53 PM IST