Wells Fargo & Co (WFC), JPMorgan Chase & Co (JPM), EverBank Financial Corp (EVER): Want a Cheaper Mortgage? Buy a Bigger House

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For the first time in history, the interest rate on jumbo mortgages is lower than that on conforming mortgages.

Wells Fargo & Co (NYSE:WFC)

Data released yesterday by the Mortgage Bankers Association showed that the average interest rate for a 30-year fixed-rate mortgage with a conforming loan balance ($417,000 or less) came in at 4.73% last week. Meanwhile, the rate for a mortgage with a nonconforming loan balance (greater than $417,000) was 4.71%.

According to an industry executive quoted by The Wall Street Journal, “In my 30-year career, I’ve never seen nonconforming loans priced below conforming loans.”

At first glance, it’s hard to understand how this could happen. It’s axiomatic that the interest rate on a loan is principally a function of credit risk. The higher the risk of default, the higher the interest rate. The lower the risk, the lower the interest rate.

This is why conforming mortgages are one of the cheapest loans that an individual can get, as both the principal and the interest payments are guaranteed by Fannie Mae or Freddie Mac (and, by implication, the U.S. government). In other words, there is no credit risk.

Jumbo loans, on the other hand, aren’t similarly risk free. Because jumbo balances exceed the level that Fannie or Freddie will insure, they carry the ever present threat of default. If the mortgagee goes broke, there’s no one to backstop the payments.

As the recovery in the housing market has progressed, however, the spread between these two rates has compressed. And this trend has been particularly pronounced over the past three months — that is, following the Federal Reserve’s announcement that it may soon begin to tailor its monthly open market purchases of mortgage-backed securities.

At the beginning of May, the cost of a conforming mortgage was 20 basis points less than that of a jumbo mortgage. By the beginning of June, the spread had been cut in half.

The explanations for this are twofold. On a policy level, both the Fed and the Federal Housing Finance Agency (the governmental body that oversees Fannie and Freddie) have created an environment in which it’s less lucrative to originate smaller mortgages that are then sold to the government-sponsored enterprises.

The Fed has done so by driving down the price of mortgage-backed securities that are collateralized by conforming mortgages. And the FHFA has done so by increasing the cost of their guarantee.

Meanwhile, the banks have responded in kind.

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