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8 keys to 2011's mortgage market

8 keys to 2011's mortgage market

House prices -- but also interest rates -- declined in 2010, and the housing market continues to struggle. A mortgage expert looks at what's likely to happen next.

In 2010, the housing market was hit hard as the U.S. struggled to emerge from the worst economic downturn since the Great Depression. House prices declined, there was an abundance of homes for sale, and mortgage rates dipped to lows that hadn't been seen in decades.

Now, though, the market is still struggling, and mortgage rates on are on the rise. What can you expect in 2011?

Here are eight key factors to watch:

1. The new Consumer Financial Protection Bureau will start operating. By July 21, the structure to promote what may be a sweeping overhaul of mortgage products, processes and disclosures will be put in place. Elizabeth Warren, charged with creating the structure of the new bureau, is expected to have much of the framework in place for the new regulatory body by the official July start date. By that time, a director will have been named and regulators and regulations drawn from other bodies will be assembled.

It seems likely that mortgage disclosure reform will be first on the list for the bureau to tackle. Confusing, unclear and seemingly conflicting documentation has been implicated in the mortgage-market mess, and a push for more explicit yet simpler forms for consumers to review and sign are thought to be a top priority for the new body. That said, a simplification of the document stream has long been a dream of any number of regulators, with an exhaustive study completed just a few years ago with limited results. The change in 2010 to the Good Faith Estimate to make fees charged to borrowers more explicit was helpful to a degree, and trying to revise required Real Estate Settlement and Procedures Act and Truth in Lending Act documents will surely be an even greater challenge.

2. Fannie Mae and Freddie Mac will change . . . maybe. Reforming the government-sponsored enterprises (GSEs) has been an on-again, off-again, on-again crusade for the last couple of administrations. To be sure, it's a love-hate relationship; the GSEs have totally distorted the mortgage market, but without them, there would be no mortgage market to distort. They have eaten tens of billions of taxpayer funds but remain perhaps the key support for millions of homebuyers and homeowners. In such a fragile market, making immediate, substantial changes could have many unwelcome consequences. Reforming these entities is a thorny issue, to be sure.

After having been kicked down the road three times by the Obama administration, recommendations for change are expected to come from the Treasury Department in January. But will reform follow quickly? Probably not. There has been some talk of perhaps a five-year wind-down plan for the GSEs, some discussions of separating their "public" function of securitizing mortgages from their "private" investment portfolios, and both have proved useful to politicians at various times.

No matter what the proposals say, we expect long and contentious debate between Democrats and Republicans over the role of government in housing finance markets. If the housing market can begin a small but steady recovery, the companies' losses will start to ease and possibly reverse, and so any delays in making changes argue in favor of the status quo. We think that if there is no real progress toward reform made by perhaps October, it is very likely that GSE overhaul won't happen until after the next presidential election. We're betting on little if any real change in 2011.

3. The economy improves. If you want to know what will happen to mortgage rates in 2011, watch what happens to the economy. As we write this, the economy has put in about six quarters on the positive side of the economic ledger, and Federal Reserve stimulus and the recent tax agreement seem likely to ensure that growth continues on an upward track in 2011. The labor market recovery should continue to gain momentum as the year progresses, but unemployment will remain stubbornly high for perhaps years to come.

That said, continual but gradual improvement seems likely. As the economy finds firmer footing, so will mortgage rates. After being pressed to 56-plus-year lows in 2010 by various crises, deflation concerns and government manipulation, we may see a bit of the other side of the coin in 2011. Although the Fed will keep short-term interest rates low, it is unlikely to leave them at emergency levels forever; as the economy recovers, the market will probably demand that the Fed begin to raise short-term interest rates and back off on policy "accommodation" in order to avoid an inflation problem.

Because it would tend to temper any outsized growth potential, which in turn would trim inflation concerns, any rise in short-term rates (whether directly or through the process of managing currency reserves) should keep long-term mortgage and other interest rates from rising too far. As we begin 2011, mortgage rates have moved off recent bottoms and have probably overshot where they should actually be, given current economic conditions.

4. Homebuyers return in greater numbers. We'll stop short of calling 2011 "the year of the homebuyer," but the gentle improvement in the labor market, still-low interest rates and what should be gradually easier lending conditions seem likely to foster a stronger housing market.

Whether we see easier lending conditions depends upon Fannie and Freddie reform, a resurrection of private secondary markets and whether consumers find an appetite for mortgage products that banks prefer to put in their own portfolios and can exercise full underwriting control over, such as adjustable-rate mortgages. Few banks want to hold sizable portfolios of low-yielding, long-term fixed-rate mortgages, and so the vast majority of those are sold to Fannie and Freddie and are thus beholden to their standards. Without a competitive private market, the restrictive standards put in place by the GSEs over the last couple of years will continue to be the only game in town and will continue to limit access to the cheapest mortgage credit.

With only one private offering of a new mortgage-backed security in 2010 -- a "best of the best" package of loans early in the year -- and financial market reforms still being digested, it seems unlikely that we'll see a huge swing away from tight underwriting standards, but we could see some nibbling around the edges. This may come in the form of some flexibility in borrower employment history, for example.

5. The "distressed" real estate market improves. Recently, there was a slight improvement in the number of "underwater" homes that occurred not because of any gains in home prices, but rather because a rise in foreclosures produced a final "cure" that loan modifications did not. It makes a curious headline, indeed: "Underwater crisis solved by foreclosure crisis," but this does seem to be a resolution for at least some underwater loans in 2011. The combination of an increase in the use of principal forgiveness in modifications and FHA "short refinances" in 2011, coupled with a resumption in the stream of foreclosures, should ultimately render fewer loans delinquent and fewer homes underwater, and the headline figures should begin to improve.

Loans written in 2008 to 2010 and the new ones to come in 2011 are certainly subject to economic tides, but they are underwritten far better than those from 2004 to 2007, which are still being wrung out of the system. Loan failures from fundamentally flawed, "bad" or "risky" loans are fading behind us; many weren't curable no matter the offer of assistance or modification. More recent delinquencies and failures have been economically driven and probably are more curable as hiring resumes and household finances improve. To be sure, the improvements will be gradual.

6. A "soft demise" for the Home Affordable Modification Program. By now, it should be fairly clear that the Obama administration's goal of saving 3 million to 4 million homeowners from foreclosure by 2012 was wildly optimistic. By the program's end, we may not even make half that number, but the administration is claiming some success in shaping and focusing the loan servicing industry to deal with borrowers in crisis, fostering more private and lasting modifications. With the big push to get people into various Making Home Affordable programs now over, and the economy gaining strength, it stands to reason that the number of new entrants into mortgage-assistance programs would begin to dwindle.

7. Mortgage rates remain favorable. Of course, we mean this from a historical perspective. Barring a new, widespread economic crisis, it's increasingly unlikely that we will challenge the lows for mortgage rates seen in 2010. Borrowers will again have to become accustomed to rates in the low- and mid-5% range for 30-year fixed loans. Still, much of the year should continue to feature rates that rank among the best seen in a generation or more, even if they don't test record lows. The low mortgage rates of 2010 came as a result of multiple financial panics and investor fears of more losses, and to wish for their return is to hope for renewed economic catastrophe. For our part, we'll take low- and mid-5% rates in a growing economy over 4% rates in a collapse any day.

8. The Federal Reserve's Quantitative Easing 2 (QE2) program ends. Initiated in November 2010, the Fed's program of purchasing Treasury securities in hopes of fostering lower interest rates has had the exact opposite effect, and interest rates have risen off their panic-level bottoms. This is partly due to an improving economy and partly due to the expectation that the Fed's moves will further spur economic growth in 2011. We've come to believe that the Fed is using the program to buffer the market, keeping market interest rates from rising more quickly than it would like.


As the economy improves, interest rates will rise, but a sustained, unanchored spike could push the economy back into recession. The Fed's program is perhaps a means to keep this from occurring, and there have even been discussions that the program could be extended when it expires about midyear. We think that this is unlikely unless there is at the time a general buyers' strike for U.S. government debt. The program will go, and the economy will continue to grow . . . and the Fed will probably consider draining excess reserves and raising short-term interest rates before the summer comes to a close.