Jumbo woes in the mortgage market

The meltdown of the subprime mortgage industry, often associated with the lower end of the U.S. housing market, continues to spread upward, bringing uncertainty into the jumbo mortgage loan market (loans above $417,000). Luxury home communities are impacted, but so are less fancy neighborhoods in cities such as Los Angeles, where mortgages on small homes occupied by middle income families fall into the jumbo category. At this point the severity and duration of the impact on the high-end market are still unknown. The surprise is how far the subprime contagion has already spread, say experts at the W. P. Carey School of Business.

The meltdown of the subprime mortgage industry, often associated with the lower end of the U.S. housing market, continues to spread upward, bringing uncertainty into the jumbo mortgage loan market (loans above $417,000) and into luxury home communities.

At this point the severity and duration of the impact on the high-end mortgage and housing market are still unknown, but as with the other credit markets, the surprise is how deep and how far the subprime contagion has already spread.

"Although it may take years before the subprime market readjusts, if the credit market can stabilize, difficulties should only be transitory for the high-end segment," notes Herbert Kaufman, professor of finance at the W. P. Carey School of Business.

Reading the signs

Depending on how one reads the portents, the high end of the mortgage and real estate market is uncertain at best, or in a spiraling slowdown at worst. Witness the spread between the 30-year, fixed-rate jumbo mortgage and the 30-year, fixed-rate conforming loan (sold to Fannie Mae and Freddie Mac).

Normally, these two sets of mortgages track very closely, within 25 to 50 basis points. HSH Associates, which collects information on consumer loans, reports that beginning in 2001 (after the tech bubble burst) and continuing until this year, the two tracked within 20-30 basis points except for one or two short spurts.

This year, the spread has climbed to 90 basis points. "The magnitude of the spread demonstrates the fear in the financial markets," says Anthony B. Sanders, professor of finance and real estate at the W. P. Carey School of Business.

"While the magnitude of the subprime meltdown is relatively small (less than 30 percent of all mortgages originated in the United States, and only 15 percent will likely be in difficulty), the shockwave it has sent through the mortgage market has been large." The problem is that when spreads widen, the cost of the jumbo mortgage goes up, at a time when many high-end real estate markets appear to be weakening.

"The big issue that is causing the jumbo market to have problems is the fact that housing prices are still declining," says Sanders. "Markets were expected to pick up in April, but here we are in August and we are still seeing softness, and that is also affecting the higher-end homes."

On top of that, it appears some high-end markets have been overbuilt. A lot of home buying occurred simply because interest rates were low and homes were appreciating. Except in select markets though, homes have stopped appreciating and interest rates are not so low anymore.

The interest rate on jumbo mortgage loans continues to be erratic. In early August, the average interest rate on a 30-year, fixed-rate jumbo rose to 7.34 percent, reported HSH Associates, but this week dropped back down to 7.06 percent. However, that was still 87 basis points over a conforming 30-year fixed-rate, which climbed to 6.19 percent.

The flight to safety

"This is all about a flight to safety," says Kaufman. "Subprime and even Alt-A loans don't have much to do with the jumbo markets, but anything not associated with Fannie Mae and Freddie Mac, which encompass conforming loans, has become suspect. The spreads between jumbos and conforming loans just popped this year and that means that many creditworthy borrowers are getting priced out of the market."

Sales at the high-end of the housing market "will be impacted if this goes on for any length of time," Kaufman adds. During any credit crisis, lenders and investors tend to step back from the market until more information becomes available.

The Mortgage Bankers Association reported that lenders have behaved defensively, raising rates on prime jumbo loans because they are unsure what rattled investors may be willing to pay for them. Lenders are justified in being defensive. Earlier this week, the Office of Thrift Supervision reported troubled assets (loans 90 days past due or in default) rose 49 percent in the second quarter compared to the same period a year earlier.

That's a significant data point, considering savings and loans have a hand in one of nearly every four mortgages, and specialize in prime and jumbo loans. Lenders and investors in mortgages are also looking at the direction of the housing markets. Here's the deeper problem.

The ability of people in the lower-tier mortgage range to sell their homes and move up to a more expensive residence and a bigger mortgage drives the jumbo market. For the jumbo market to be fluid, some of the homeowners carrying Fannie Mae and Freddie Mac conforming loans need to be able to sell their present home and buy a bigger house.

Think of it this way: A single man residing in a $560,000 home wants to buy a $750,000 home. He tries to sell to a person moving up from a home priced under $400,000. The woman who owns the $750,000 home is trying to sell so she could buy a $1 million property. If the buyer at the bottom of the chain can't find a mortgage then the two move-ups at the high end of the market don't happen either.

This scenario is already playing out. Toll Brothers Inc., the nation's largest builder of luxury homes, last week reported that net income for the first nine months of fiscal year 2007 plunged to $117.5 million, or $0.72 per share, from $513.4 million, or $3.10 per share.

"We continue to wrestle with the interrelated challenges of softer demand and excess housing supply in most markets," reported Robert Toll, chairman and CEO of Toll Brothers. The state of the high-end real estate and jumbo mortgage markets may get worse before it gets better.

Two bulges of adjustable rate mortgages, or ARMs, will be resetting by early next year. Many households are going to experience higher mortgage payments and this may trigger even more delinquencies and defaults.

"Even if it is just the low end of the housing market that falls apart because of affordability issues, the problems don't stop there," reiterates Sanders. "If less expensive housing drops, that puts pressure on the next housing group above to decline as well. Systemic risk occurs in the housing market when just one segment — it doesn't matter which — goes bad."

Bottom Line:

• Problems in the subprime mortgage industry, often associated with the lower end of the U.S. housing market, are spreading upward into the jumbo mortgage loan market (loans above $417,000).
• The ability of people in the lower-tier mortgage range to sell their homes and move up to a more expensive residence and a bigger mortgage drives the jumbo market.
• Systemic risk occurs in the housing market when any segment — it doesn't matter which — goes bad.
• Although it may take years before the subprime market readjusts, if the credit market can stabilize, difficulties should only be transitory for the high-end segment.