Conforming Loan Limit Decrease = Higher Rates?

Like many of you I initially cheered when I heard about the economic stimulus bill and the increase of the conforming loan limit. If you’ve been under a rock, this means that the $417K limit on conforming loans will increase 125% based on your MSA (Metropolitan Statistical Area). It could mean that the loan limit would rise to as much a $729K in some areas.

The big deal here is the difference between the conforming loan rate and the jumbo rate.

Mortgage Rate Snapshot

Right now the spread is about 1%, which is a lot of money if you’re taking on a mortgage of this size. So why am I not cheering now? First off, the change puts a lot of strain on the already financially precarious Fannie Mae and Freddie Mac. (I know, it doesn’t seem like it would affect you, but stay with me.)

The thing about mortgages is that they are part of a larger financial market, where investors are going to determine the risk of such investments against the potential returns. Here’s what one poster (Cal) had to say in response to an L.A. Times blog post about Junior Jumbos.

I also forgot to mention the other obvious reaction (unintended consequence) of this action … higher mortgage rates.

The market for these securities isn’t unlimited for them to attract more capital (since they are rescuing the market, they are writing more loans, right?) they must increase yields. There is a cost for everything, it doesn’t come free.

If they mix the “conforming jumbo” in with conforming, the people buying the bonds will price all of them as if they were a jumbo risk. If they break them out into jumbo and conforming then the higher risk jumbos will get higher rates. Either way the savings wont be nearly as pronounced as some might think. It will probably reduce the current spread about half (from 1 % to .5%)

Okay, so maybe this guy is a crank, right? Maybe you and I shouldn’t take stock in what they have to say. Problem is some leading lenders have already signaled this will be the case. Sources tell me that a major top 10 lender has warned brokers that a stair step rate may be used on these ‘junior jumbo’ loans. Something akin to an extra .25% between $417K – $500K, .50% between $500K and $625K and so on and so forth.

In this case, the market is reacting (rationally) to this government intervention. They are suspect of the financial health of Fannie Mae and Freddie Mac and just got burned (and bad) by the subprime mess. The result is an unwillingness to blindly place the same risk on these junior jumbo loans just because they’re backed by the government. Fool me once, shame on you, fool me twice, shame on me.

Thankfully this would ensure that the true conforming loan rate would remain low, otherwise the rates would go up as they mixed risk across the total conforming loan portfolio. It also means that those looking at loans over $417K will still be paying a premium, just not quite as much as before. The gold rush we all thought might happen is looking more like tin.

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