Fed Watcher: Recession Remains Preferable to Inflation

No matter who the Federal Reserve Board chairman may be, its message is that if there is a choice between inflation and recession, it will let the country slide into recession.

That is what Mortgage Bankers Association chief economist Doug Duncan told both a separate press briefing and a general session at the group's annual convention here.

The Fed will raise rates 25 basis points at each of its next two meetings, Mr. Duncan said. He made the point that under Ben Bernanke, the policy will not change.

Another point that Mr. Duncan made during his presentation is that spreads between the 10-year Treasury and 30-year fixed-rate mortgage have returned to approximately 150 basis points.

After the "flight to quality" in 1998, the spreads had widened to approximately 200 bps.

For 2005, the mortgage banking industry should have its third-best year ever, with volume of $2.78 trillion.

Volume for the next two years will decline to $2.26 trillion and then $2.15 trillion, he predicted. Rates on the 30-year fixed will rise from 6.2% at the end of this year, to 6.8% by the end of 2007.

Refinancings, expected to be 46% of volume this year, will fall to 35% of volume in 2006 and 32% the next year.

When asked during the press briefing if it could be expected there will be refinancing of exotic loan products in a rising interest rate environment over the next few months, Mr. Duncan said that 2007 is really the year to watch. In that year, $1 trillion of 3/1 interest-only adjustable-rate mortgages will hit their reset point.

MBA vice president of research and economics Jay Brinkmann said that anecdotally he has heard of some loan officers going back and soliciting the customers, but the consumer is more likely to wait until that trigger date before taking any action.

Mr. Duncan added that consumers have become very good at optimizing their benefits in the timing of switching loan products.

He made another point about the worry over payment shock and ARM loans by noting that while the current share of ARM loans is high, 35% of the homes in this country have no debt encumbrance at all, so they are not interest rate sensitive.

Another 50% is secured by fixed-rate debt, meaning that only 15% might be rate sensitive.

Of that group, 4% is in jumbo loans, whose borrowers are assumed to be more sophisticated and knowledgeable. Another 2% or 3% is in conforming loans, leaving between 7% and 8% where the performance is unknown.

Mr. Duncan also said there is no evidence that interest rate rises are causing declines in housing prices. When rates rise, typically it impacts both supply and demand. The only time where there is no cut in supply but a decrease in demand is when there are job losses.

In response to a question from the audience during the general session regarding the economics of the industry, where profits are low and a large number of companies are reportedly for sale, Mr. Duncan noted the obvious. If there is capacity for production of over $3.9 trillion of mortgages out there, but actual volume falls to $2.8 trillion, "something has got to give," he said.

As long as there is excess capacity, margins will remain low. The fact that a lot of companies are for sale is a sign of that excess capacity and it will take another year or so to work through that.

In the area of delinquencies, Mr. Brinkmann warned if energy prices continue to rise into the heating season, there are some consumers who would have to decide to heat their home or pay their mortgage.

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