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2013 mid-year mortgage market update

Back in December 2012 we looked forward, as we do every year, to what we think will be the most important factors influencing the mortgage and real estate markets in the coming year. The last few years have been turbulent and unpredictable to say the least, and 2013 (so far) has been no different. In no particular order of importance, here is our mid-year update to 10 issues affecting the markets in 2013.

No: 1: Refinances will dwindle

Original outlook: Already solid refinancing activity was goosed by perhaps 20 percent in 2012 by the expansion of HARP. According to the Federal Housing Finance Agency, more than 709,000 borrowers refinanced through HARP during the first nine months of 2012. HARP 2.0 essentially created a class of borrowers eligible for a nearly no-doc mortgage on properties which were not appraised, and to borrowers who didn't need to prove the amount of their income. Couple these looser underwriting standards with mortgage rates falling to new record lows and we’ve enjoyed a refinance "boomlet" in 2012 as a result.

Those fortuitous market conditions seem unlikely to repeat in 2013; as a result, the available pool of borrowers who can successfully refinance at present interest rates (and in light of today's tight lending standards) will diminish. Refinances will shrink unless mortgage rates continuously decline (unlikely), a massive new government-backed refinance program is announced (unlikely), underwriting standards are significantly eased (highly unlikely), or the economy improves so quickly as to see battered credit scores or equity stakes restored to prerecession levels (also highly unlikely).

The result: Slower origination activity at times may increase competition for business among lenders and help lower rates.

Mid-year update: A balancing act for mortgage rates in the first half of the year--a plummet to near record lows on the week ending May 3, followed by a run-up to 2011-highs during the week ending June 28--has largely seen refinance activity grind to a halt. In late June, applications for mortgage refinancing slipped to the lowest point since 2011, a likely harbinger of things to come. On balance, activity is cooling and will probably continue to do so. Although no new non-GSE refinancing plan has come (and likely won't), quickly rising home prices have allowed some non-HARP eligible borrowers to refinance.

No: 2: Recovery in home sales continues

Original outlook: Despite a strong market for rentals and still-wary consumers, we think 2013 will be a relatively good year for home sales. Rising rents are one component of the equation. At some point, the cost of renting a place to live becomes close enough to the cost of actually owning a home giving the renter a reason to consider a purchase instead. Kiplinger forecasts that average rents will rise perhaps 4.5 percent in 2013, and with the worst of the real estate downturn arguably falling behind us, more renters or live-at-homes will likely take the plunge and buy a home.

The Federal Reserve remains committed to getting people back into the market, and even with some signs of firming, home prices should remain attractive. It's hard to reckon a final figure for the year, but we should be close to five million sales in 2012. For 2013, probably five percent more or so should be expected.

The result: Fewer homes at rock-bottom prices, with a “seller’s market” forming in some areas of the country.

Mid-year update: Since the start of the year, sales of existing home have nudged closer to the five million (annualized) mark. Sales of new homes continue on an upward trajectory, too, rising from an annualized 396,000 when we wrote this in December 2012 to a 454,000 rate (though April 2013), a 14.7 percent rise over that time. Thin inventory levels may be holding back some sales, but as home prices rise, more existing properties may hit the market, and backlogs of foreclosures are starting to clear as well.

No. 3: Mortgages: Shorter terms and building equity

Original outlook: Obtaining shorter-term mortgages was a trend which formed in 2012 and should carry into 2013. While primarily a refinance-fostered phenomenon in 2012, the low-interest-rate environment might just see somewhat more homebuyers looking at 25- and even 20-year terms. This change is more likely to come from homebuyers in the trade-up market, where activity should start to improve as the economy slowly firms.

For other borrowers, rebuilding lost equity will continue to be a desire (if not a focus) and we think we'll continue to see both refinancing to shorter than 30-year terms as well as a move toward retiring mortgage balances more quickly though prepayment.

The result: Improving equity positions for many homeowners.

Mid-year update: The process of trimming back interest costs by permanently eliminating mortgage payments continues. Freddie Mac reported that 28 percent of refinancers took a loan with a shorter term in the first quarter of 2013, and there has been considerable interest in loans with 10-year terms, especially among homeowners approaching retirement age. Short-term mortgages are often portfolio loans, not sold to Fannie Mae or Freddie Mac, so rates for these may remain low even as longer-term loan costs rise.

No. 4: Mortgage rates: More flat than not, overall

Original outlook: If we're right about several items noted here, mortgage (and other) interest rates should remain low and fairly stable through most of 2013.

The slow economy should produce some downward pull, especially in the post-cliff first-half of the year, and Federal Reserve policy should tend to keep them both low and generally stable throughout. A few considerations might push mortgage rates higher at times, including concerns about inflation as a result of the Fed's programs, some unease with regard to an impending change at the helm of the Federal Reserve, or an economy which shakes off the shackles of slow growth and begins to put in above-par performances for several quarters.

The result: The best borrowing opportunity in perhaps 60 years persists.

Mid-year update: The lowest mortgage rates of 2013 (late winter, early spring) were quickly replaced with the highest rates of 2013 (late spring, early summer). Mortgage rates do remain favorable, but considerably less so for homeowners looking to refinance. Home purchases are less affected by the bump in rates. The difference in monthly payment for a $200,000 loan from the lowest rate of 2013 to the highest rate to date is just $68.26, so even with the rate increase it would be hard to claim that mortgages have become pricey or unaffordable.

No. 5: Underwriting standards: Cracks appear

Original outlook: We believe that in 2013 we will see the first cracks in tough mortgage underwriting standards which have been in place for years. While the FHA program continues to suffer from poor-quality loans of 2007-2009, the GSE's book of business has been improving on balance for several years, and firmer market conditions suggest that will continue.

As such, we think that the first market-based add-on to mortgage prices--the Adverse Market Delivery Charge (ADMC)--will also be the first to go. The quarter-point ADMC fee first made its appearance in 2008 as a response to declining home values. With housing markets continuing to improve, and with home prices again firming in many locations, there are considerably fewer "adverse markets," and the fee will probably disappear (or be otherwise named) by the time 2013 comes to a close.

The result: A minor improvement in costs for mortgage borrowers.

Mid-year update: No meaningful change yet, but there has been an improvement in the availability of lower-down-payment mortgages. LendingTree reported that the average down payment fell from 17.6 percent in May 2011 to 16.1 percent in May 2013. While not "easing" per se, smaller down payments do make purchases more accessible to potential homebuyers. The decline in down payment requirements is largely attributable to increased availability of private mortgage insurance, as declining foreclosures and fewer losses have helped the books of these key players to solidify. Other indicators of easing haven't yet revealed themselves, but we have heard that 80-10-10 "piggyback" loans are creeping back into the market.

No: 6: How much will QRM derail the market?

Original outlook: The Dodd-Frank Wall Street Reform and Consumer Protect Act was passed into law over two years ago, but a key component has yet to be defined, let alone enacted. Under the law, a Qualified Residential Mortgage (QRM) needs to be defined by the Consumer Finance Protection Bureau and put in place early in 2013. Loans failing to meet this definition will require that the party who securitizes the loan hold back a certain amount of cash should the loan default, while loans adhering to the rule will not require this, and can be sold freely to the secondary market.

Since it will eventually be required by law, the absence of the definition to date means private mortgage markets have been crippled. With a definition, they might also be crippled, since lenders may opt to use only the new standards by which to make loans, cutting less-qualified borrowers from the market completely (or only offering non-QRM loans at rates and fees as to make them unaffordable).

The result: Unknown. Investors may welcome the enactment of rules so that they can begin to "move on" and form new private markets, or they may simply decide to no longer offer mortgages that don't meet the new requirements.

Mid-year update: Still too soon to tell. However, private securities markets have revived considerably of late, especially for jumbos, but new rules don't kick in until January 2014, so any disruption would start to be seen perhaps 60 to 90 days before the implementation comes.

No. 7: Economy: Dinged by cliff or agreement

Original outlook: Whether we fall off a steep fiscal cliff or merely slide down a ramp remains to be seen as this is being written. One thing seems certain, any combination of tax increases and government-spending cuts will have at least some economic impact. A "cliff" would likely toss the economy back into recession, while a compromise or agreement would probably see us skirt the two quarters of negative growth which defines an economic recession.

That said, the impact of these changes (and others slated to hit the economy in 2013) will serve to diminish growth to some degree. The strongest blast of government spending in three years pushed GDP to 2.7 percent in the third quarter of 2012, but the underlying pattern for growth is still quite weak. It won’t take much additional headwind to slow the economy to a rate virtually indistinguishable from recession for at least a portion of the year.

The result: The drag on growth may produce 2013's lowest mortgage rates.

Mid-year update: We did get a fiscal cliff agreement, which largely consisted of the expiration of payroll tax reductions and some tax increases on upper-income Americans. Worries about a spring-to-summer swoon did foster low mortgage rates for a time, but surprising economic resilience so far has turned them the other way. The federal spending sequestration continues to add a drag, as do recessions in Europe and slower growth in China. So far, we look to be holding perhaps a 2 percent GDP rate for the second quarter, a deceleration from a 2.4 percent rate in the first, but there doesn't seem to be much momentum.

No. 8: Fed changes at the top?

Original outlook: While Federal Reserve Chairman Ben Bernanke's term does not expire until 2014, it is thought that his present leaning is not to seek reappointment when his term expires. This should give markets room to speculate as to his possible replacement in 2013, and those markets may be swayed by how much any replacement believes (or does not believe) in the Fed’s unconventional monetary policies which have been the hallmark of Mr. Bernanke's tenure.

Given statements (if not firm commitments) to low-rate policies which will be in place well after 2014, any potential successor could disturb financial markets just by having his or her hat thrown in the ring. How much ease or unease the market will display will depend upon the candidate's previous commitment to (and comments about) unconventional Fed policies, open communication and forward guidance about interest rates.

The result: Unless Bernanke announces plans to stay on, there could be some market unease during times of speculation regarding his replacement.

Mid-year update: No word yet, but this should grow in importance as we get past September.

No. 9: Fed policy: Operation Twist ends, something new starts

Original outlook: We think the Fed's present program of selling its short-term Treasury holdings in favor of buying long-term ones, called "Operation Twist," will come to an end as scheduled at the end of 2012, as the Fed has nearly exhausted its short-term holdings at this point.

However, we believe that the central bank will take a page from its own playbook, replacing Operation Twist with a commitment to buy new Treasury debt for an open-ended period and in an amount "up to" something approximating the size of Operation Twist, worth about $40 billion per month in 2012. In this way, the Fed can help keep long-term interest rates low, which in turn helps keep mortgage rates low and stimulates the housing market, if not the economy in total.

A half-trillion commitment though 2013 would certainly expand the Fed's balance sheet, but if the economy weathers the expected slow patch and begins to strengthen, the Fed could trim back the plan (hence the "up to").

The result: The Fed's in a bit of a box, but lower interest rates matter greatly to the recovery, and the Fed wants them to remain.

Mid-year update: The Fed did end "Operation Twist," replacing it with the so-called Quantitative Easing III (QE3) program, where they are directly purchasing some $45B per month in Treasuries in addition to the $40B in MBS they had already been accumulating. This program has provided important support to the economy in general and housing specifically, but there are signals that the beginning of the end of at least part of the program will come before the year is out.

No. 10: GSE reform: Not in 2013...or maybe ever

Original outlook: The hot political fires to reform Fannie Mae and Freddie Mac have been waning, and will wane even further as we move beyond the housing crisis. Even now, losses have slowed; Freddie Mac has begun to regularly turn a profit again, and even Fannie Mae started to run in the black again in the second fiscal quarter of 2012.

Since the Treasury has exchanged its preferred stock in the institutions for all of their profits, the cash hole dug by the crisis will begin to fill more quickly, lessening the desire to reform the firms, and they will be contributing considerable sums back to the government before too long.

The importance of Fannie and Freddie in the maintenance and recovery of the housing market is indisputable, and we expect that they will be part of any conversations about systemically important firms which may occur in the coming year. Some kind of reform will eventually come as Fannie and Freddie's "private" investment portfolios (which caused the majority of losses) need to be reduced by 15 percent per year, but even that will take years to complete, and still leave them with $250 billion in holdings.

If they are making money, repaying their debts and maybe even kicking money into the Federal coffers, there's less reason to press reforms quickly.

The result: For good or bad, the mortgage market will continue to be dominated by the GSEs.

Mid-year update: Since the above was written, six months have passed. While there has been some discussion and even a new reform bill introduced by Senators Bob Corker and Mark Warner, the most significant reform has arguably come from within. Earlier this year, the FHFA prompted Fannie Mae and Freddie Mac to start to move to a single unified securitization platform, which might set the stage for a new market entity to emerge at some point. More to come, but with both GSEs again turning regular profits, changing them becomes politically more difficult.

After a number of truly difficult years, the housing market began to turn in 2012, and 2013 has been a continuation of that trend. Home sales and home prices should continue their modest upward trends, while refinancing may begin to slow as there become fewer borrowers who want or need to refinance. Mortgage rates should remain low and favorable, perhaps setting new records at times, and the reform of mortgage markets should finally get underway (the GSEs excluded). With an active Federal Reserve to watch, and perhaps the first signs of underwriting standard moving more toward “normal,” it should be an exciting, interesting year.

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