Dilemma for the Fed as property recovery falters

Dilemma for the Fed as property recovery falters

By Krishna Guha and Sarah O’Connor in Washington

Published: May 28 2009 19:02 Last updated: May 29 2009 00:32

A record 9.1 per cent of all US mortgages were delinquent at the end of the first quarter, the Mortgage Bankers’ Association reported on Thursday, highlighting the pressure on policymakers as they attempt to engineer a still elusive bottom in the US property market.

Housing starts and sales appear to be stabilising, and homes no longer look expensive. But house prices are still falling rapidly – down 2.2 per cent in March alone, according to the Case-Shiller index.

Delinquencies and foreclosures are rising and spreading to so-called prime mortgages.

Now a partial rebound in mortgage rates – in conjunction with the growth of negative equity – threatens to maintain downward pressure on prices, while also limiting the capacity of indebted households to refinance at ultra-low rates.

“The housing recovery hasn’t even started, and it is already at risk,” said Ed Yardeni, president of Yardeni Associates.

Bank examiners say house prices and unemployment are critical for determining bank credit losses.

While the Federal Reserve and US Treasury have never set out to target house prices, they have attempted to mitigate the risk that house prices undershoot their fundamental value.

The Fed has sought to compress risk spreads on mortgages by buying up to $1,450bn (€1,040bn, £906bn) in securities issued by Fannie Mae and Freddie Mac, the home loan giants. Its strategy pushed mortgage rates down to levels not seen for decades.

But yields on Fannie and Freddie paper have moved higher in recent days as yields on government securities jumped. Mortgage rates – already back above 5 per cent – may climb higher.

Fed officials do not appear alarmed by the rise in mortgage rates thus far, which still leaves them low by historic standards, with ample room for borrowers to refinance. However, some analysts worry the financial market is moving too fast for the housing market. While cheap mortgages prompted a wave of refinancing applications, the downsizing of the mortgage industry since 2006 means the system cannot process large numbers of borrowers quickly. The danger is that mortgage rates rise before a large chunk of total household debt can be refinanced at very low rates.

Some economists say the Treasury should reconsider directly providing low-cost loans for new borrowers – an idea debated by George W. Bush’s administration.

Negative equity threatens to compound house price declines. Celia Chen, director of housing at Moody’s Economy.com, says one in five US homeowners has negative equity, and about one in 10 has a loan to value ratio of 130 per cent or higher.

US officials are considering whether Fannie and Freddie should be allowed to refinance mortgages worth more than 105 per cent of the underlying house.

Some administration officials are wondering whether they also need a policy that directly tackles the risk that households deeply “underwater” on their loans will start to walk away, fuelling further price declines.

Barack Obama’s administration has focused on making monthly payments affordable – and avoided subsidising politically controversial debt forgiveness.

A push towards debt renegotiation by giving bankruptcy judges the power to force writedowns failed in the Senate.

Some officials think they may have to revisit the negative equity problem and look at ways to revamp initiatives such as Hope for Homeowners, which set out to support loan writedowns but never gained scale, in part because of a lack of subsidies.

However, some analysts are sceptical. “You have so many properties so far underwater that foreclosure or at least a short sale ... is probably the only way out of the problem,” said Adam York, economist at Wachovia. “You’ve got to clean out the negative equity.”

Copyright The Financial Times Limited 2009