One of the primary reasons the Federal Reserve's monthly purchase of $40 billion worth of agency mortgage-backed securities, known as QE3, isn't working to successfully drive housing and the economy as intended is because of the large number of mortgagors who cannot take advantage of the low rates offered by the Fed program. This isn't the Fed's fault, but the Fed will have to address this issue as it relates to future monetary policy.
The mortgage market is roughly broken down into three segments: first-time buyers, move-up buyers and high-end buyers.
Since the financial crisis of 2008, first-time buyers are served almost exclusively by the government-guaranteed loan programs offered through the Federal Housing Administration (FHA) and the Veterans Administration (VA). Move-up buyers are served almost exclusively by loans offered through government-sponsored enterprises Fannie Mae and Freddie Mac. The high-end buyers are mortgagors with jumbo loans in excess of the limits placed on the FHA, VA, and Fannie and Freddie.
There are about $10 trillion worth of first trust residential mortgages in the U.S. today. Since the 2008 crisis, the government-guaranteed and sponsored loans have made up almost all of the new loans originated. But only about 60% of all existing loans fall within those categories. The remaining 40% of mortgages that originated without a government guarantee or sponsorship are almost all residual loans originated prior to the 2008 crisis. These loans are ineligible for the mortgage modification and refinance programs offered by the government. The majority were originated as adjustable-rate loans tied to short-term interest rates, with most originating between 2000 and 2006.
The Fed's traditional monetary policy of holding down short-term rates keeps the loan rates on these mortgages from increasing, but most of these borrowers do not have the ability to refinance into the low, long-term fixed rates being afforded by QE3 because of a lack of home equity caused by a decline in values.
This is also why the value of adjustable-rate mortgages being carried by the banks remains very high, as I discussed last December in the column "Adjustable-Rate Mortgages Are Still a Problem." The majority of these loans were consolidated into the big four money centers -- JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), and Wells Fargo (WFC) -- as they absorbed the financial companies that were carrying them. This led to the percentage of adjustable-rate mortgages being carried by the banks to peak at 38% in the fourth quarter of 2009. Even as the Fed drove long-term rates down dramatically, the percentage of adjustable-rate loans has only decreased to about 36%. These borrowers are stranded in adjustable-rate loans they can't get out of and any increase in short-term rates will have a negative impact on their ability to pay. These borrowers are acutely aware of the situation.
Further, and this is important, the majority of these borrowers were between 40 and 50 years old -- at their peak earning and consumption -- when these loans were originated. This demographic largely represents the top 10% of income earners, and their consumption accounts for about half of all consumer spending. Consumption by this group is the primary component to all consumption and the key to the virtuous cycle.
But this group has to divert income from consumption to debt service, as well as savings, to recapture lost equity. This group's failure to consume is the primary reason the economy continues to stagnate and the Fed can do nothing to reverse it. The bottom 90% of consumers cannot make up the difference because their incomes are largely tied to the consumption of the top 10%.
Unless the federal government creates a program allowing this group to access the low fixed rates engineered by the Fed, this situation is likely to continue to be a drag on economic activity.