Stable Loan Limits Mean Stable Housing Markets

The Office of Federal Housing Enterprise Oversight (OFHEO) recently issued final guidance on how fluxing house prices would affect Conforming Loan Limits (CLLs) in the future. In a nutshell, the loan ceiling is no longer subject to reduction regardless of declines in price metrics - ever. The ceiling can go up but it will not come down. (Group hug?)

To appreciate the magnitude of this decision, background is in order. OFHEO, the safety and soundness regulator of Fannie Mae and Freddie Mac, govern loan limits to temper the GSEs exposure to the market. Since combined the enterprises fund about 70% of US mortgages, unsafe and unsound practices or policies can threaten the housing market and broader economy. Because of the massive buying power of the companies, their implied government guarantees, and "perceived" quality of their securities, lower rates are afforded to lower/middle class Americans as part of their core mission.

This said - every October the Federal Housing Finance Board (FHFB) issues its Monthly Interest Rate Survey (MIRS) which OFHEO relies on to set limits for the following year. When the MIRS report reveals house price increases, limits go up accordingly. When it reports declines however, OFHEO defers the reduction for 1-year following the results for the subsequent year. Somewhat of a wait and see thing. If indeed there is a persistent fall in prices, theoretically reductions would be in order the year after. This is why a reduction in loan limit was not seen in 2008 despite declines in 2006 and 2007.

As prices skyrocketed this decade, loan limits increased from $252,700 in 2000 to its present ceiling of $417,000 in 2006. That's nearly 40% growth in only 6 years. (See historic limits here). Inversely, imagine if years of decline occurred and this policy was not in place, indeed loan ceilings would have to recede sharply.

There have only been three instances when a reduction in CLL's occurred since established back in the seventies'. They were faint to say the least and rather disorderly (you should read the guidance for details). Given the enormity of the modern mortgage market and severity of declines in recent quarters - any open-ended question about limit drops next year was of high concern (at least to those who thought about this).

Here's an example of what it would mean to NOT have this policy.

Let's assume you bought a house this year and financed $400,000. Then next year the limit dropped to $370,000. Without clear grandfathering provisions, you'd be in a precarious situation if you wanted to refinance since your loan no longer qualified for favorable agency guides' and rates. Now imagine if you had to sell this house. The reduction in loan ceiling for access to GSE-insured financing would require your prospect buyers to; (a) put more money down, or (b) accept less-than-favorable non-conforming/jumbo financing. Either of these two options would materially affect its market value.

But OFHEO finally laid those uncertainties to rest.  

In the guidance, it explains that it will defer percentage drops in the MIRS report until such time increases offset the net decreases. In other words, it will only raise the loan ceiling by the net percentage of growth based on the average of positive net-change in the MIRS report over many years. Once again, it will only raise the loan ceiling by the net percentage of growth based on the average of positive net-change in the MIRS report over many years.

For example: If the October MIRS report for 2007, 2008, and 2009 net a total of a 5% decline in prices (yeah right, probably more), and the subsequent 3 years yield an increase of 7% (yeah right, probably less); We could expect a net 2% raise in loan limits the year after the net increase was calculated. (Not too shabby, huh? At the very least it adds to long-term stability).

If you agree that Fannie/Freddie are the underlying force bolstering property values as we know them, then you appreciate significance of this policy. It is one thing for mortgage rates to change with the market's ebbs and flows, but it's entirely another to have volatility in the access threshold to prime financing.

Should we be breathing easier? I think so.

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Conforming Loan Limits No Longer Subject to Decrease - OFHEO Examination Guidance EG-08-001

Fannie, Freddie and the Future of Property Values (Original Post 11/20/07)