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Housing: Lenders recoil from jumbo mortgages that back pricier homes

Lenders are losing their appetite for originating mortgages on pricier homes.

The spread between rates for jumbo mortgages, which are too big for government backing, and rates on those guaranteed by Fannie Mae and Freddie Mac shrunk as much as 11 basis points in mid-May, an indication that banks no longer see jumbos as an attractive investment. That spread was as wide as 64 basis points in November and now sits at 13 basis points, according to the Mortgage Bankers Association.

The narrowing follows the sudden regional banking crisis this year and "heightened concerns about liquidity," MBA Deputy Chief Economist Joel Kan said. Experts expect these conditions to continue into next year, a hindrance for buyers of higher-priced homes.

“On the securitization side of things, investors are dealing with massive extension risk,” Jeremy Collett, executive director of capital markets for Guaranteed Rate, told Yahoo Finance.

“That basically means loan payoffs are going to be really slow as borrowers who took out mortgages with 2%-3% rates in 2020 and 2021 aren’t likely to pay off anytime soon. So those bonds now have a much longer duration, preventing investors from getting their money back to reinvest at today’s higher rates,” Collett said.

During the pandemic, borrowers of jumbo mortgages were getting a “phenomenal benefit” on rates versus what are known as conforming loans that are purchased by Fannie Mae and Freddie Mac, according to Mike Fratantoni, chief economist at Mortgage Bankers Association.

“Before the pandemic, it was typical for jumbo mortgage rates to be just a small bit lower than conforming rates and last year [those rates] were a half point lower in many cases,” Fratantoni told Yahoo Finance in a phone interview.

Now the average 30-year fixed rate conforming came in at 6.91% for the week ending May 26, according to the latest data from the Mortgage Bankers Association. The average contract interest rate for 30-year fixed-rate mortgages with jumbo loan balances above $726,000 was 6.78%, or just 13 basis points lower.

Weakened demand follows recent distress in the banking sector, which drove First Republic (FRC) out of business as regulators seized the west coast regional lender last month and sold a bulk of its operations to JPMorgan Chase (JPM), marking the largest bank failure since the Great Financial Crisis.

Pedestrians walk past the headquarters of First Republic Bank in San Francisco, Monday, May 1, 2023. Regulators seized the troubled bank early Monday, making it the second-largest bank failure in U.S. history, and promptly sold all of its deposits and most of its assets to JPMorgan Chase Bank in a bid to head off further banking turmoil in the U.S. (AP Photo/Godofredo A. Vásquez)
Pedestrians walk past the headquarters of First Republic Bank in San Francisco, Monday, May 1, 2023. (AP Photo/Godofredo A. Vásquez) (ASSOCIATED PRESS)

One of the causes of First Republic’s troubles was a strategy to entice wealthy clients with bigger mortgages by offering sweet terms, Bloomberg reported.

Executives at the regional lender offered interest-only mortgages to wealthy homebuyers and investors, where the borrowers didn’t have to pay back any principal for the first decade of the loan.

“In other words, they took a loss on the mortgage and made it up elsewhere,” Collett said. “Banks can hold loans as investments on their balance sheets and not have to take mark-to-market losses.”

That strategy worked for a while until First Republic Bank was confronted with having to “sell billions of underwater mortgages because their deposits had dropped substantially. Banks must maintain a responsible ratio of deposits and assets,” Collett said.

Data from Inside Mortgage Finance shows that First Republic had the fourth-highest market share of jumbo loan originations totaling $31.59 billion last year.

These high-dollar loans have now become a sour spot for banks, which typically hold these mortgages on their balance sheets.

“The current turbulence in banking has the potential to hit jumbo loans harder, as banks' willingness to hold jumbo loans declines,” Odeta Kushi, deputy chief economist at First American, told Yahoo Finance in a statement.

Tom Merton via Getty Images

That’s become a problem for buyers in the market for home prices above the conforming loan limits because there are fewer options available due to the smaller pool of lenders.

What options remain come with elevated rates as lenders hedge against risk.

“[Borrowers] who are willing to play ball are having to bite off on a higher cost of funds despite having 30% down or more looking to take out a $3 million or a $4 million mortgage loan,” Scott Sheldon, branch manager of New American Funding, told Yahoo Finance in a phone interview.

The only solace for these borrowers is that they have some leverage since so many buyers have left the market.

“They are able to negotiate a little bit more because the competition is not as fierce,” Sheldon said.

“Not as many people want to play ball at 6.5% mortgages or higher, depending on their amount financed when just nine months ago they were paying a hundred basis points less.”

The loan officers anticipate problems to continue into next year, including tighter restrictions for jumbo loans.

"Liquidity for jumbo loans is most likely to remain incredibly challenged for the foreseeable future," Collett said. "Not only are depositories struggling with underwater portfolios of loans with low yields and considerable duration risk, but the outlook for deposit growth is also not encouraging."

"We expect to see balances continue to evaporate and for more financially savvy depositors to pull cash to invest in treasuries at these historically attractive yields. What the jumbo market needs more than anything is some good news on the inflation front and for the Fed to signal they are finished hiking rates," Collett said.

Dani Romero is a reporter for Yahoo Finance. Follow her on Twitter @daniromerotv

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