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The return of the purchase market.

Purchase originations this year should hit record levels as total home sales hit their highest level since 1979. So says Fannie Mae's chief economist, who sees another "banner year" in the mortgage market ahead.

Last year was an extraordinary time for the mortgage market. Single-family originations soared to levels far beyond those of any previous year. Even the heady years of 1986 to 1987 paled in comparison with last year's level of activity.

The housing market picked up some strength in 1992, giving the mortgage market a good start with increases in purchase originations. Home sales increased by more than 10 percent, with existing home sales climbing by nearly 9 percent and new home sales jumping by almost 20 percent. As a result, purchase originations increased by 16 percent to a record $447 billion--despite the widespread notion that the housing sales market remained weak.

The year of the refi

Even with the gains last year in purchase originations, 1992 will go down in history as the year of the "refi." There have been other noteworthy refinance booms in recent years--1986 and 1987, for example--but none compares with the surge in refinancings experienced last year.

Fannie Mae estimates that refinance originations rose by 136 percent in 1992 to $355 billion--a figure larger than all originations in any year before 1985. This combination of stronger purchase originations and soaring refinancings brought total originations in 1992 up to $800 billion, far beyond 1991's previous record volume of $535 billion. Figure 1 shows mortgage originations during the last several years, differentiated by purchase and refinance activity. (Note that Figure 1 and the Fannie Mae economic forecast that yields the projections for 1993 and 1994 were made before President Clinton's economic address on February 17, 1993. The sharply positive response of the bond market to Clinton's proposals has caused us to raise our forecast of originations for 1993 to slightly more than last year's record level.) It clearly shows how robust the mortgage origination market was last year, with strength coming from both purchases and refinancings. In addition to record levels of total purchase and refinance originations, our estimate of the refinance share of total originations,--nearly 45 percent--is also an all-time high.

The National Bureau of Economic Research (the official arbiter of the arrival and departure of recessions and recoveries) dated the end of the recession as March 1991. And while most economists agree that the most recent recession ended in 1991, it is clear that this economic recovery has been the weakest on record. The modest economic recovery held down job and income growth, keeping consumer confidence at recessionary levels, but it also had the beneficial effect of pushing down inflation.

The combined effect of weak economic growth and declining inflation prompted a drop in interest rates, especially at the short end, as the Federal Reserve eased monetary policy in an attempt to boost the pace of the recovery. Rates on 1-year Treasury notes fell by 55 basis points during the course of the year--and dropped to 29-year lows in the fall, before rising slightly at the end of the year. The impact of Fed easing is evidenced clearly by the 135 basis point decline in the federal funds rate that occurred during the year. This decline in short-term rates pushed the start rate on 1-year Treasury-indexed, adjustable-rate mortgages (ARMs) down to just less than 5 percent in October--the lowest such rate since ARMs gained widespread acceptance in the early 1980s.

Deficits kept long rates higher

Long-term rates also fell last year as a result of lower inflation and a weak economic expansion. The drop was much less than that for short-term rates, however, as ever-increasing estimates of future federal budget deficits kept inflation expectations from falling much. Rates on 10-year Treasury notes fell by only about 20 basis points during the course of the year. However, from peak (March) to trough (September) during the year, they declined by roughly 120 basis points.

These movements in longer-term Treasury rates were reflected in fixed-rate mortgages. Rates on 30-year, fixed-rate mortgages (FRMs) also declined by approximately 20 basis points during the whole year and by about 120 basis points from peak to trough during the year.

ARM volume modest

The relatively sharper drop in short-term interest rates left the yield curve steeply sloped in 1992. The 350 basis point difference between yields on 10-year Treasury notes and 3-month Treasury bills was a record, as was the 312 basis point spread between 10-year and 1-year Treasury notes. This sharply upward-sloping yield curve was reflected in the start-rate differential for ARMs and FRMs: ARM start rates averaged a record 277 basis points below 30-year FRM rates, with the difference rising to more than 300 basis points last fall.

The borrower's choice of loan type depends on many things, but one of the important determinants is the spread between ARM and FRM rates. The wider the spread, the greater the share of loans expected to be ARMs. This did not occur last year, however, as the ARM share of loans fell to record-low levels, despite a record-high spread. Figure 2 shows the ARM share of originations from the period when ARMs first became an important mortgage instrument in 1983.

What 1992's ARM share tells us

The drop in the ARM share last year shows that borrowers respond to more than just the spread between ARM and FRM rates--in particular, they respond to the level of rates. With FRM rates falling to nearly 20-year lows in 1992, borrowers showed a decided preference for the certainty of a fixed-mortgage payment by shiedng into FRMs.

Another consequence of the weak economic recovery--as well as the recession that preceded it--was a rising share of loans that were either delinquent or in foreclosure. Data from the Mortgage Bankers Association of America's (MBA) National Delinquency Survey through the third quarter of 1992 show that serious delinquencies--loans 90 or more days past due--rose to their highest level since the end of 1988, when the impact of the mid-decade collapse in oil prices on home prices in the "Oil Patch" states was winding down.

Delinquency rates typically lag an economic recovery because households whose loans become delinquent are usually those in which one or more workers become unemployed. Unemployment rates are themselves lagging indicators of an economic turnaround. This is so because firms typically try to increase production without adding workers until it becomes clear that the rise in demand is long-lasting and that the least expensive way for the firm to meet the higher demand is with new workers.

Slowest job-market recovery in 40 years

This phenomenon of a lagging employment market has been even more noticeable in the current modest economic recovery. While employment has increased during the past year (by 1.6 million jobs using the Bureau of Labor Statistic's Household Employment Survey and by 600,000 using the Establishment Survey), the employment recovery has been even weaker than the overall economic recovery. Figure 3 compares the growth in nonfarm payroll employment during the seven quarters of the current economic expansion with the average of the previous eight postwar expansions. The current employment recovery is by far the slowest in the past 40 years. As a result, default and delinquency rates continued to rise well after the recession ended in the first quarter of 1991.

The outlook for 1993

We expect another strong year in the mortgage market in 1993, although at this point, it is doubtful that last year's boom will be repeated. Purchase originations are expected to grow strongly again this year, with home sales up by about 9 percent, average home prices increasing by nearly 6 percent and average loan-to-value ratios edging upward. All of these factors should combine to push purchase originations up to a record $520 billion.

This forecast of purchase activity is based on our projection of faster economic growth this year, with real gross domestic product (GDP) growth increasing by 3.3 percent--the fastest pace of growth since 1988, although still modest by historical standards. The factors that have held back the economy during the past several years--especially high debt levels for both households and businesses, as well as the lack of expansionary fiscal policy--appear to be slowly fading. In addition, the Clinton administration has proposed modest expansionary fiscal policy of about $30 billion. Still, the structural problems in the economy remain--exacerbated by likely defense cutbacks and the previous over-building of commercial and multifamily structures that will prevent these important sectors from helping to boost the economy.

Deficit is wild card

Refinance activity will depend crucially on the course of interest rates during the year. We expect longer-term interest rates to be relatively stable this year, as increased borrowing demands are roughly offset by flat inflation and increased capital inflows from abroad. The wild card with interest rates will be what Congress does with the Clinton administration's deficit reduction proposal. So far, financial markets have liked what Clinton has proposed with long-term rates falling to 20-year lows. If the Clinton plan is passed substantially unaltered, then a new record for mortgage originations is likely. Stronger growth this year, as well as lower interest rates, would lead to a new record for purchase originations and another full-blown refinance boom.

The drop in long-term rates since early November, but especially in the last month, has left mortgage rates at 20-year lows. As a result, a third refi wave is occurring that gives every indication of being as large as the second refi wave of last July through October. If rates remain relatively stable for the rest of the year, with mortgage rates moving in a narrow range between about 7.50 percent and 8.00 percent, then refi activity should begin to tail off in the second half of the year. Unless rates fall significantly more, or first rise and then drop sharply, then refinance originations should slide a bit from last year's record pace to about $275 billion, with the refi share dropping to about 33 percent.

Yield curve staying steep

The yield curve should remain very steep this year, although we expect some flattening as stronger borrowing demand pushes short-term rates up slightly. As long as inflation stays subdued, and economic growth is below 3 percent to 3.5 percent on a sustained basis, the Federal Reserve should keep monetary policy unchanged. With the yield curve remaining historically steep, and with FRM rates staying relatively low, the ARM share of mortgage loans will not have much of a chance to increase significantly. Furthermore, if long-term rates decline further this year, then the ARM share could drop again to record lows with a flatter yield curve. Even so, we expect a small increase in the ARM share as the California economy--and housing market--begins to turn around. Even the expected modest pickup in the California housing market should mean that the national ARM share will rise, given California's large share of the national housing market.

The delinquency outlook

The key to mortgage delinquencies in 1993 will be the strength of the labor market. If overall economic growth increases to the 3 percent to 3.5 percent range this year, then the labor market should finally start to show more sustained improvement. Monthly increases in nonfarm payroll employment averaged only about 50,000 workers last year, with a modest improvement to nearly 75,000 workers during the last quarter. This should increase to between 100,000 to 150,000 workers per month this year with a stronger economy. As a result, the unemployment rate should drop more quickly this year than last.

The weak job market in 1992 caused the unemployment rate to rise during much of the year, before it finally began to decline toward year-end--finishing the year at 7.3 percent. We expect the unemployment rate to decline slowly but consistently during 1993, ending the year at 6.6 percent--the lowest rate since early 1991.

This strengthening of the job market should be reflected in an improvement in serious delinquencies. Figure 4 shows Fannie Mae's forecast of serious delinquencies (defined as the sum of all loans 90-or-more days past due and loans in foreclosure measured by the MBA National Delinquency Survey). The lagging effects of the weak job market in 1992 should push serious delinquencies up to a peak in the first quarter of 1993, before they begin to fall on a sustained basis during the remainder of the year. We expect that serious delinquencies will fall by about 5 basis points from the peak in 1993 to the end of the year (and we expect an even larger decline in 1994, when they should drop to 1991 levels).

Another good year

Taken as a whole, the housing market should improve still more in 1993, with the strongest level of activity since 1988. The mortgage market, too, is expected to have another banner year, although the level of mortgage originations will depend upon what happens to President Clinton's deficit reduction plan. If passed, then another new record for the mortgage market is in sight, otherwise, we should see a good year, but one that is probably a little less strong than 1992. In any case, the improvement in the housing market--with the highest level of total home sales since 1979--will push purchase originations up to record levels. Even so, the level of refinance originations will remain very strong in historical terms. Despite the steep slope of the yield curve--which we expect to continue throughout 1993 notwithstanding some flattening in the second half of the year--the ARM share of mortgage loans is likely to remain very low as a result of continued low FRM rates. Finally, the pickup in the economy that we expect for this year should lead to a stronger labor market and to a decline in mortgage delinquencies as the year progresses. Thus, 1993 appears to shape up as yet another very good year for the mortgage market--and for those whose fortunes ride on it.

David W. Berson is vice president and chief economist at Fannie Mae, Washington, D.C.
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Title Annotation:good prospects for mortgage market
Author:Berson, David W.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Mar 1, 1993
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