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Mortgage debt falls in the first quarter of 2013

Mortgage DebtEnlarge GraphElevated levels of consumer debt has been one of the reasons why the recovery has been so weak

The New York Federal Reserve puts out a quarterly report on household debt and credit, which looks at the total debt as well as the composition of debt. Mortgage debt fell by $1o0 billion in the first quarter to $7.93 trillion, and has been falling steadily since the third quarter of 2008. About 184,000 people had a new foreclosure filing added to their credit report during the quarter, a drop of 12.5% year-over-year and down 68% from the peak of 566,000 in the second quarter of 2009.

Addressing the consumer debt issue has been one of the major driving forces behind quantitative easing and ultra-low interest rates. Since the Great Recession began, the Fed has engineered a drop in interest rates in the hope of lowering the burden on middle class households. In many ways, the Fed has succeeded. On one hand, mortgage rates have dropped precipitously. On the other hand, credit card interest rates have not.

The Fed has been hoping to create modest inflation. Modest inflation (around 2% to 3%) would allow debt to deflate relative to the economy without triggering large increases in interest rates. The Fed is not comfortable with inflation that is too low – when interest rates are up against the zero bound (in other words, they are at zero and cannot go lower), decreasing inflation means real (inflation-adjusted) interest rates are rising. In a weak economy, that is the last thing they want to do. Japan has been struggling with this state of affairs for two decades – deflation in combination with zero percent interest rates means rising real interest rates and very slow growth.

Implications for mortgage REITs

Mortgage debt, or more specifically underwater mortgage debt, has been the subject of numerous government programs to help distressed borrower. The main programs are the Home Affordable Refinance Program (HARP), which allows underwater home owners that qualify to refinance their mortgage at today’s low rates, even if they owe more than the house is worth. The second major program is the Home Affordable Modification Program (HAMP), which makes rate and term modifications to mortgages to lower a borrower’s payments.

The net effect of these programs on REITs, such as American Capital (AGNC), Annaly (NLY), MFA Financial (MFA), or Hatteras (HTS), will be low interest rates and higher prepayments. Low interest rates mean that mortgage REITs will have to use more leverage than usual to generate acceptable returns. As long as there is stability in the financial markets, their borrowing rates will remain low. They will benefit from having steady or rising prices for the assets on their balance sheet. The downside will be prepayments and delinquencies. For agency REITs, prepayment risk is their biggest worry. Prepayment risk occurs when borrowers refinance their mortgage, which removes high yielding assets from the REITs portfolio and replaces them with lower-yielding assets; this lowers net returns.

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