Jumbo Credit Spread Back to Pre-Lehman Levels

As we explained in a previous post, the jumbo vs. conforming credit spread is the difference between the rates of a jumbo mortgage and a conforming mortgage. A conforming loan is a mortgage loan that conforms to the government-sponsored enterprises’ guidelines – think Fannie Mae and Freddie Mac.

These guidelines set a limit on the amount of the loan that varies by region in the United States. In many regions this limit is $417,000 for a single-family home, however in higher-priced regions this limit is higher due to higher living costs. The loans that fall between $417,000 and this higher limit for the pricey regions of the U.S. are called expanded conforming loans. If a potential home buyer is interested in purchasing and financing a home that is more expensive than $417,000 (or the expanded limit in the pricey regions of the U.S.) he or she has to choose a so-called jumbo mortgage. So a buyer who wants to buy and finance a $1.2M ranch in Kentucky, where the limit is $417,000, would have to apply for a jumbo mortgage.

This type of mortgage is considered riskier by lenders because the secondary market for jumbo mortgages is relatively illiquid. Fannie Mae and Freddie Mac only buy loans that follow their guidelines and therefore fall under the category of conforming loans. They will repackage these loans for the secondary market in form of mortgage-backed securities (MBS).  An MBS allows investors to purchase a share of the return from the pool of mortgages inside the security, thus lowering the risk to any single investor of default by an individual loan within the overall pool of mortgages. Because this type of securitization is less prevalent for non-conforming loans (because Fannie and Freddie aren’t buying them), it is harder for lenders to sell these types of loans making them, in turn, riskier to hold. Due to this illiquidity, jumbo loans will have a higher interest rate than conforming loans.

In the months leading up to Lehman Brothers declaring bankruptcy (September 2008) the jumbo vs. conforming credit spread was right around 50 basis points. After that it spiked to over 120 basis points and had been hovering around 90 basis points until the beginning of 2011. That is when we started to enter a period of relatively steady decline in this spread. As of June 2011, we are almost back to pre-Lehman levels of 50 basis points.

The spread we calculated is plotted below in Figure 1 and has been smoothed by a lagging three week average.