U.S.

Housing And Residential Mortgage Finance: 2014 Outlook

Primary Credit Analyst: Jeremy Schneider, New York (1) 212-438-5230; jeremy.schneider@standardandpoors.com Secondary Contacts: Devi Aurora, New York (1) 212-438-3055; devi.aurora@standardandpoors.com Matthew B Albrecht, CFA, New York (1) 212-438-1867; matthew.albrecht@standardandpoors.com Lawrence R Witte, CFA, San Francisco (1) 415-371-5037; larry.witte@standardandpoors.com Matthew Lynam, CFA, New York (1) 212-438-8002; matthew.lynam@standardandpoors.com Ron Joas, CPA, New York (1) 212-438-3131; ron.joas@standardandpoors.com Blake Mock, New York (1) 212-438-7278; blake.mock@standardandpoors.com Monica Perelmuter, New York (1) 212-438-6309; monica.perelmuter@standardandpoors.com

Table Of Contents
Banks: Right-Sizing For A Less-Robust Mortgage Market Fannie And Freddie: Winding Up Then Down Municipal Housing Industry: Outlook Driven More By Government Than The Market Homebuilders Prepare For A Favorable 2014 After A Short Breather Mortgage Insurers: 2014 May Mark An Opportune Year Mortgage Servicing: Transfers Remain A Key Theme Mortgage Originations: A Shifting Landscape Into The New Year

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U.S. housing made a strong comeback in 2013. Home prices nationally have risen roughly 12%, which is in line with our original forecast early in the year of 11%. Overall, we expect a 6% increase in the S&P Case-Shiller 20-City Home Price Index (December to December % change) in 2014. While historical annual increases are more in the 4%-5% range, a continued rebound in prices from the 35% trough in 2012 is well complemented with an outlook for positive economic momentum in 2014. While the U.S. economy was saddled with unemployment levels above 7% in 2013, our baseline forecast for the unemployment rate in 2014 falls below the 7% mark. Furthermore, we expect a real GDP growth rate of 2.6% in 2014. While the private sector--including the housing market--is showing signs of strength, the federal government could temper momentum in 2014. However, the agreement on a budget for 2014 is a good sign that the governmental episodes we saw in 2013 might not recur in 2014. (For more information regarding our economic forecast, see "U.S. Economic Forecast: Two Economies Diverged In A Wood," Dec. 5, 2013.) Next year will also lay new ground for mortgage finance as the implementation of the qualified mortgage (QM) and ability-to-repay standards are implemented just 10 days into the new year (see "How Will Mortgage Loan Originators, Borrowers, And RMBS Securitization Trusts Fare Under The New Ability-To-Repay Rules?" Nov. 26, 2013). Furthermore, mortgage finance reform legislation proposals (for more information see "U.S. Mortgage Finance Reform Efforts And The Potential Credit Implications," Oct. 11, 2013) are still in discussion, as Fannie and Freddie still hold the dominant position in mortgages. And of course, the recent announcement of the Fed to start tapering bond purchases of the third round of quantitative easing (QE3) starting in January seems to be a step toward conventional monetary policy in lieu of the massive purchases of treasuries and mortgage-backed securities. We also expect a shift in mortgage products as adjustable-rate mortgages gain popularity going into the new year; under our base-case forecast, the 30-year fixed-rate mortgage will increase to 4.6% in 2014 from 4.2% in the fourth quarter of 2013. Overview We expect housing to remain a focal point of economic recovery in 2014. Shifts in the industry--such as non-bank entities more actively participating in origination and servicing--should continue into 2014. This is driven by capital rules and the increase in nonbank lenders. With positive economic expectations in 2014 and our risk of another recession at 15%-20%, we believe the housing market should bode well as negative home equity falls.

While the growth in home prices looks good for 2014, mortgage financing availability and the number of new applications remain key components for demand in the new year. Even as building permits and new starts continue to grow, the availability of financing remains the lynchpin as we hover around a 64% home-ownership rate. The government-sponsored entities (GSEs) and Federal Housing Administration (FHA) continue to be responsible for buying or insuring most new originations. While this model has proven worthy in the housing recovery over the last 18 months, the lower-than-average homeownership rate and swarm of investor purchases might or might not be a

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long-term model for U.S. housing. This model also relies on a form of substantial U.S. government guarantee, which we understand the housing finance reform proposals in 2013 demonstrate to be the less popular option. The impact of housing fundamentals varies across the multiple housing-related sectors and securities that we rate. Although the ongoing recovery has benefits for certain parts of the market, each part of the market will be affected one way or another based on the housing, economic, and political landscape of 2014. As such, we discuss some of the housing related sectors below, going into the new year.

Banks: Right-Sizing For A Less-Robust Mortgage Market

We expect that banks will continue cost-cutting measures as mortgage market activity moderates with increased borrowing rates. In fact, a number of large market players announced sizeable staff reductions in their mortgage banking business when mortgage rates spiked at the end of the second quarter. Mortgage pipelines have suddenly started to shrink, and in a difficult environment for broad revenue growth, cost-cutting appears to be the strategy. In addition, we expect that banks will continue working through legacy mortgage exposures to minimize charge-offs and nonperforming assets, which in turn will lower expenses for bank mortgage servicers. Another cost-cutting measure has been the continued negotiations by banks with the GSEs regarding representation and warranty repurchase obligations. In our opinion, the efforts on this front in 2013 should translate to smaller reserve levels for representation and warranty liability going forward, which should help revenues as well. The origination and sale of mortgage loans by banks to the GSEs has declined. This decline has increased due to increased competition in mortgage origination by others in the market as well as a decreasing appetite of longer-dated fixed-rate assets in the secondary market. In addition, increases in interest rates will continue shrinking the profitability of loan sales for banks. Our outlook for bank mortgage lending isn't completely somber, however. For instance, rising home prices should increase the ability of homeowners to refinance because some homeowners have stayed current on their loans but just haven't had the equity to refinance. Rising home prices have also helped boost market sentiment, which could prompt homeowners to consider moving or upgrading, which should help bank transaction volume, if only slightly. Overall, we expect a shift from refinance to purchase lending activity, with overall market volume declining. We believe that banks remain very interested in putting excess deposit funding to work in their loan portfolios, and they will continue underwriting jumbo mortgages to hold on their balance sheets, particularly those with adjustable rate features. The overall credit quality in mortgage loan portfolios should continue to improve as economic conditions become better and banks work through their nonperforming assets, while at the same time continuing to underwrite new loans to higher standards than they did pre-crisis.

Fannie And Freddie: Winding Up Then Down

The futures of Fannie Mae and Freddie Mac have long been the topic of conversation. One thing that has been consistent over the years is the intent of the Obama Administration and lawmakers to wind the entities down. In the spring and summer of 2013, lawmakers introduced concrete plans to reform housing finance and wind-down the GSEs. Although there is no clear indication of timing for housing finance reform, and there is little consensus about the

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specifics, the leading proposals seek to reduce the reliance of the market on Fannie and Freddie before ultimately winding them down. Notwithstanding the winding down, however, we continue to believe that the debt obligations of these entities will be supported by the government, as they remain part of the housing recovery. The improvement in the housing market has dramatically improved profitability for Fannie and Freddie, and we expect them both to remain profitable in the near future, absent a material downturn in the economy. Although we expect their mortgage volume to decline, we think that higher guarantee fee income and lower credit costs will translate to positive earnings for these firms. We expect they will continue to focus on their mission of providing liquidity to the housing market, while shrinking their investment portfolios and building an infrastructure for a future housing finance market.

Municipal Housing Industry: Outlook Driven More By Government Than The Market
Housing issuers within U.S. public finance are more affected by decisions of the U.S. federal government than by the status of real estate markets. Housing finance reform puts the longstanding role of the federal government in promoting affordability in question, and a trend of funding reductions for housing construction, rental assistance, and public housing has implications for housing availability and--to a lesser extent--credit quality. Although we haven't seen much change in ratings based on declining federal support for housing, we believe that municipal issuers with federal guarantees should fare better than those reliant upon federal appropriations. In affordable single-family housing, financial standing of the housing finance agency sector has been historically strong. Eighty-three percent of HFAs have issuer credit ratings of 'AA-' or better--a higher proportion compared with 75% before the real estate downturn. Equity-to-assets ratios are at historical highs, nonperforming asset ratios are improving, and almost all HFAs have positive net income. Much of the improvement is the result of reactions of management to real estate and financial market disruption and to the very strong support from the federal government in the form of mortgage insurance and guarantees on single-family and multifamily housing. Similarly, we expect multifamily housing to experience better outcomes for sectors with stronger federal support. Debt issues with collateral in the form of mortgage-backed securities from Fannie Mae, Freddie Mac, and Ginnie Mae will retain the rating on the U.S. sovereign, assuming no other elements of the transactions constrain the rating. Housing for the U.S. armed forces will maintain higher credit quality than much of the affordable multifamily market because of a consistent record of government appropriations to cover the collective housing costs of military personnel. The commitment to other sectors is less certain. The U.S. Department of Housing and Urban Development (HUD) is the main source of public funding for affordable housing, and as an entity of the federal government, it is bound to congressional budget decisions; its funding declined by 12% between 2008 and 2012. Sectors with less federal support will see more financial stress. Declining or stable asking rents, which are subject to income restrictions, offset some of the benefits that affordable multifamily properties enjoy, such as declining vacancy rates, relatively stable operating costs, and locations in low-cost markets. Without explicit federal guarantees, the ratings on these properties are much more subject to market forces.

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Housing finance reform poses a different concern to U.S. municipal issuers. The two main proposals increase down payment requirements to 5%--higher than the 3.5% under many current affordable single-family loans that Housing Finance Agencies (HFAs) offer. Because many HFAs provide down payment assistance, the increase in down payment requirements could mean additional costs to the HFAs when making up the difference. The additional costs could decrease their participation in the affordable housing market, thus limiting availability. While the level of commitment wouldn't affect existing issues, we believe the impact of a large reduction in the federal government's footprint in affordable housing could have significant implications.

Homebuilders Prepare For A Favorable 2014 After A Short Breather

The U.S. housing recovery, which was enjoying a healthy recovery in demand through the first half of 2013, has taken a breather over recent months as we see buyers take a step back to absorb and re-adjust to the market dynamics. The combination of rapid home price appreciation, higher mortgage rates, the U.S. government shutdown, and normal seasonal patterns has slowed the previously vigorous pace of new home sales and price appreciation. However, we view this moderation as healthy given the heated pace of growth, particularly in terms of home prices. Despite these recent headwinds, U.S. homebuilders will report strong revenue and earnings growth in 2013. We expect underlying supply and demand fundamentals to remain favorable through 2014, despite the recent pause. Low levels of new construction compared with historical levels continue to constrain supply, while employment growth (albeit tepid) and expanding household formations support steady demand for new homes. While we believe U.S. homebuilders are in the early innings of a recovery, the market reaction to a spike in mortgage rates from whispers of Fed tapering this past summer underscores just how fragile the strength of the recovery is and the potentially uneven trajectory it could take. We expect most builders to selectively utilize promotional incentives through the important upcoming spring selling season to retain the increased average sales prices earned over the past year. An uptick in planned new community openings should drive further revenue and EBITDA growth over the next 12 to 18 months, even if sales absorption rates flat line, according to our forecasts. There has been an improvement in the housing industry. However, Standard & Poor's positive ratings actions on homebuilders have been measured given the heavy debt-financed investments in new land inventory and community construction. We expect credit metrics to continue to strengthen at a much slower pace as builders continue to tap the debt markets to meet growing demand. In addition, we forecast the large cash reserves that supported many ratings through the downturn to be largely consumed as builders begin to rely much more on revolving bank lines of credit for working capital needs and liquidity cushions. As such, our base-case outlook for U.S. homebuilders anticipates credit metrics that are largely supportive of the existing ratings. However, some favorable rating actions are possible, particularly if builders can continue to boost overall profitability, expand market share, and fund growth in a more balanced fashion, leading to credit metrics that exceed our base-case expectations.

Mortgage Insurers: 2014 May Mark An Opportune Year

In our view, 2014 should mark a return to profitability for the mortgage insurance sector, barring any macroeconomic

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setbacks. While the legacy portfolios of mortgage insurers (MIs) continued to contribute losses in 2013, new notices of delinquency (NODs) continue to decline and the severity of claims is improving. In addition, we believe the proportion of new vintages and the accompanying profit contribution will continue increasing, leading to lower loss ratios and improved mortgage insurer performance. Although there could be some adverse developments from diminishing legacy books. There are regulatory changes on the horizon for the sector, but we view them favorably. Many of the MIs are operating under capital waivers from state insurance regulators that allow them to continue writing new business. MIs are working with the GSEs to address capital requirements, which are expected to be announced in 2014. To the extent the MIs are able to accommodate the new requirements, the MIs might no longer need the state waivers that allowed them to conduct business while in breach of capital requirements. MIs have recently finalized negotiations of a Master Policy with the GSEs. These changes are generally consistent with the changes already implemented internally by the MIs and could result in greater focus on maintaining underwriting standards. Over the longer term, changes such as increased federal regulation could be on the horizon for MIs as a result of a recent publication by the Federal Insurance Office. Market competition dynamics are evolving as well. For instance, the increased insurance premiums and more stringent underwriting requirements of the FHA have, in our view, allowed MIs to gain market share. At the same time, however, Fannie and Freddie have raised guarantee fees and effectively increased the price of mortgage insurance. Recently, we observed multiple MIs reduce premiums by 10%, which could help counter the guarantee fee increases. While the net effect of the changes for 2014 is uncertain, there could be some stabilization in these market shifts. We expect the very high credit quality of new insurance being written, combined with improvement in the housing markets and economy, to result in the mortgage insurance business being profitable and capital accretive in the near term. Nevertheless, we believe that significant risks to the economic recovery remain. If a recession were to occur in 2014, the declining trend of new notices of default could reverse, and claim frequency could increase to an extent that could prevent MIs from raising or generating capital to continue writing business through a downturn.

Mortgage Servicing: Transfers Remain A Key Theme

The residential mortgage servicing industry saw continued transition in 2013. Servicers are focused on complying with existing regulations and implementing the Consumer Financial Protection Bureau's (CFPB) final servicing rules, which go into effect on Jan. 10, 2014. While residential servicers have been making changes to their processes for several years, the CFPB's final servicing rules (many of which apply to default management) apply to all servicers and, in our view, provide the industry with clarity going forward. For the first half of 2013, residential servicers benefited from low mortgage rates, which contributed to refinancings of their existing servicing portfolios, helping to lower run-off and retain customers. However, as mortgage rates rose during the second half of the year, refinancing volume fell, and some servicers announced reductions to staff as a result. Transfers of mortgage servicing rights (MSRs) continued in 2013, with many bank servicers transferring MSRs to nonbank servicers. Because MSRs are no longer considered Tier I capital under Basel III, bank servicers would have

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had to hold additional capital against these MSRs if they remained in the bank portfolios. On the positive side, the rise in interest rates tends to raise the value of MSRs because they are associated with lower prepayment speeds. As such, servicers with large MSR portfolios stand to realize higher mark-to-market gains with rising interest rates, though at a diminishing rate. Consolidation in the industry continues as nonbank servicers acquire mortgage servicing operations. We expect most of these trends to continue in 2014. The CFPB will begin monitoring servicer compliance with the final servicing rules, and the national mortgage settlement monitor will expand its testing scope and report additional findings. Transfers of MSRs to nonbanks from banks will likely continue, along with sales of servicing operations and portfolios, especially because the CFPB final servicing rules could serve as a high barrier to entry for new servicers. Aggressive growth strategies might increase operational risks, as servicers must add and train staff, maintain systems and technology, and focus on internal controls and regulatory compliance. As portfolios run off, some servicers could begin to originate loans to replenish their portfolios. We also expect the large bank servicers to continue to exit the servicing business of defaulted assets and focus on servicing new originations. GSE reform may affect servicers of Fannie and Freddie loans if it results in changes to their servicing standards. We believe the CFPB's final servicing rules will result in more consistency and perhaps better experiences for the borrowers, as the rules apply to all servicers.

Mortgage Originations: A Shifting Landscape

Mortgage origination volumes have fallen in the second half of 2013 as a result of increases in mortgage rates, and we expect these lower volumes to continue into 2014. High-quality prime jumbo mortgage loans remained the epicenter of non-agency mortgage origination in 2013. While we haven't observed a material decline in prime jumbo mortgage quality finishing-out 2013, we believe the 2014 characteristics may start to gradually move down the credit spectrum. This is partly based on the diminishing population of high-quality prime jumbo refinance options, which flourished over the last two years. With a larger portion of purchase activity accounting for originations combined with rising home prices, no increase in the conforming loan limits, and more favorable economic conditions, a greater emergence of jumbo mortgage lending should appear. This is further supported by the introduction of QM in January, which establishes rather finite rules regarding eligibility of a qualified mortgage. Final clarification and adoption of the rule has enabled originators to invest in platforms and tool their businesses based on the parameters of QM rules. We expect non-agency securitization volume in 2014 to reach almost $40 billion. This is approximately 30% higher than the 2013 expectation of $29 billion. Of the $40 billion, we expect about two-thirds to be prime jumbo origination and the remainder to encompass the GSE risk-sharing transactions and less-traditional securitizations, such as REO-to-rental. Although mortgage rates have gone up and the wave of refinancing activity in 2013 has fallen, the 2014 lending landscape--including home availability, access to credit, and a focus on maintaining the housing recovery--bodes well.

Into The New Year

We believe 2014 will be a stand-out year in the housing sector, particularly as QM goes into effect. Overall, the

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economic outlook and the continued rebound in housing should bode well for certain sectors in the market. In particular, to the extent mortgage lending becomes more diversified, home-prices keep improving, and the reliance on government related loan purchasers falls, the non-agency mortgage could become a bigger piece of the pie and would-be home buyers might see more options to enter the market. The year should be marked as one of transition that incorporates an improving housing market, the start of the Fed's pullback from QE3, and perhaps movement in GSE reform. All of these developments reflect a continued recovery in the housing market.

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