Pro and cons of raising the conforming loan limits

With a 35% market share in California during 2007, jumbo loans were the fuel of choice for loans over $417,000, the conforming loan limit that enabled Fannie Mae and Freddie Mac to buy loans for their portfolios. With the new economic stimulus plan including higher conforming loan limits through the end of the year (permanent for FHA-backed loans, which still needs to be approved by both houses of Congress), it could provide a much-needed boost to a market mostly in paralysis. While it's not clear what the new limits will be -- ranging from $625,000 to $729,750 depending on who you ask -- it could definitely spike the housing market in California and higher high-priced housing markets. And yet such a move wouldn't be without its risks. From today's Wall Street Journal:

Raising the loan limits should allow a larger pool of borrowers to qualify for lower-cost mortgages or to refinance existing mortgages, something that has been difficult to do since mortgage lenders pulled back from nonconforming loans. "This, along with the fact that interest rates have dropped, will give a big kick to the demand side of the housing market," said Nariman Behravesh, chief economist at Global Insight, an economic consulting firm in Lexington, Mass... But the plan means a major expansion of Fannie's and Freddie's already large role in providing funds and setting standards for American home loans. With the compromise, moreover, the administration is continuing a retreat from its efforts in the first half of this decade to scale down Fannie and Freddie and let free-market forces have more sway in the mortgage market.

Major accounting scandals severely tarnished both companies earlier this decade. But they continue to exert political power, largely because builders and Realtors see them as a vital prop for the housing market and fiercely resist efforts to constrain them.

Though the rise in the conforming-loan limit is supposed to be temporary, Congress may find it tough to reverse it in the face of warnings by builders and Realtors that such a move would cause another drop in home prices.

Yesterday, Treasury Secretary Henry Paulson said he had wanted to increase the conforming-loan limit only if Congress would pass long-stalled legislation designed to tighten regulation of Fannie and Freddie. But, he said, "I got run down by a bipartisan steamroller...Republicans and Democrats were united on this."...

Still, in the short run it's definitely a good thing for the building industry, which often relies on contingent buyers who need to sell an existing home to move forward:

Home builders cheered the likelihood that the stimulus package would raise the conforming-loan limit, saying it could make it easier for buyers to purchase higher-priced homes and may reduce the glut of homes in several costly markets. "It's a shot in the arm to the market," says Dom Cecere, chief financial officer at Los Angeles-based KB Home, one of the nation's largest home builders. "It's going to spur people to move up to a more expensive house, and that's going to get the new and used markets moving again."

And that's a good thing -- but only if these new loans are made to people who are willing to verify income, don't lie on their applications and are made to sworn that they fully understand the mortgages for which they're signing.

Another benefit of the plan could be an immediate lowering of interest rates on jumbo loans, which currently exact a toll of more than one percentage point. From another story on CNNMoney.com:

Homeowners with jumbo mortgages also pay higher interest rates because, with no guaranteed secondary market for the loans, lenders take on more risk, and charge borrowers more for doing so.

For instance, the interest rate difference between loans that fall within the cap limit and jumbo loans was more than 1 percent on Thursday -- 6.39 percent compared with 5.30 percent, according to Bankrate.com. On a $500,000 mortgage, the difference is about $350 a month.

"The 1 percent drop is a huge factor," said Yun. "In California, it could create a mini-boom."

Before the stimulus package was announced, analysts including Merrill Lynch had come out with dire forecasts for housing markets over the next couple of years.

But, said Mike Larson, a real estate analyst with Weiss Research. "[the raise in loan limits] could remove some of the inventory overhang and alter the buyer psychology a bit. Right now they're still waiting for prices to fall."

Yun added, "There's a lot of pent-up demand in the market. This will boost confidence among these potential buyers, and some of the people on the fence will start buying."

Of course there's the obvious question remaining: does this only postpone the eventual day of reckoning for home prices which have become unaffordable for those without equity to trade up? Is this an election-year ploy to shift the misery until 2009 or will this really help soften the downturn?