Why Conforming Loan Limits Should Be Part of Housing-Finance Reform — But Aren’t

The U.S. housing finance system is national, but housing markets are local. Local markets often face different housing challenges: today, California’s coastal communities face an affordability crisis, while Florida is dealing with foreclosures and Detroit and other Midwestern cities are wrestling with neighborhoods of vacant homes. The housing finance system – as well as other national housing policies – needs to serve a country where local home prices in some markets are 10 times as high as in others, and where local and state laws affect how much new construction is allowed, how long foreclosures take, and more.

One way the national housing finance system explicitly accounts for local market differences is through the conforming loan limit – the maximum dollar amount of a home loan that Fannie Mae and Freddie Mac can guarantee (they purchase mortgages from originators, package them into securities that investors buy, and guarantee the payments in the event that a borrower defaults). Loans above this limit are “jumbos.” Until 2008, the conforming loan limit was the same throughout the country (Alaska and Hawaii are treated separately), but the 2008 Housing and Economic Recovery Act (HERA) granted “high-cost areas” higher conforming loan limits to reflect local price differences. Now, in 2014, the limit in high-cost areas is up to $625,500, which is 50% above the $417,000 limit that applies in most of the country.

For a borrower, one advantage of conforming mortgages is that they typically (though not currently) have a lower mortgage rate than jumbo loans; also, jumbo loans often require higher down payments, a higher credit score, or a lower debt-to-income ratio. Part of the rationale for having conforming loan limits – rather than allowing loans of any amount to be guaranteed – has been to target the benefits of conforming loans to borrowers buying more modestly priced homes and not to borrowers buying luxury homes.

This week, the Senate will markup the leading housing-reform proposal – the Johnson-Crapo bill – which would overhaul the housing finance system by replacing Fannie Mae and Freddie Mac, introducing an explicit but limited government backstop, and creating a new fund for affordable housing. Despite these major changes, the bill keeps current conforming loan limits intact. Is this implied vote of confidence in the current system of conforming loan limits warranted? Let’s assess how well these limits reflect local price differences.

Conforming Loan Limits Don’t Reflect Differences in Local Housing Prices

To see whether the conforming loan limits bind equally tightly across local housing markets, we calculated the share of for-sale homes on Trulia in each of the 100 largest U.S. metro areas that is above the local conforming loan limit, assuming an 80% loan-to-value (LTV) mortgage (that is, a 20% down payment — see endnote for details). If loan limits fully reflected local housing market differences, then a similar share of homes in every metro would be above the local loan limit. But the results show that a much higher share of homes is above the local loan limit in some metros than in others.

In the San Francisco metro area, 61% of homes for sale are priced above the conforming loan limit (the local limit, $625,500, equal the loan amount for an 80% LTV loan on a $781,875 home); the typical San Francisco home priced near the loan limit is a modest 1500 square feet. In several other California metros, as well as in New York and Boston and their respective neighbors of Fairfield County, CT, and Middlesex County, MA, 30% or more of the homes for sale are above the local conforming loan limits. These 10 metros with the highest share of for-sale homes above their respective local loan limit all are “high-cost” areas with limits above the national baseline of $417,000, but even with their higher loan limits, they have the highest share of homes for sale that would require jumbo loans.

The metros with the smallest shares of for-sale homes above the local limit include El Paso, Little Rock, and Memphis in the South and Southwest; Dayton, Toledo, Akron, and Detroit in the Midwest; and the upstate New York metros of Rochester, Syracuse, and Buffalo. Relative to the low home prices in these metros, the $417,000 loan limit is very generous. In some of these markets, 4000 square-foot homes typically fall within the conforming loan limit. More broadly, in 48 of the 100 largest metros, fewer than 10% of homes for sale would be above the local conforming limit.

In short: despite higher loan limits in high-cost areas, conforming loan limits do not reflect the huge cost differences in housing markets across America. For loan limits to reflect the differences across local markets, the spread between loan limits in inexpensive markets and loan limits in expensive markets would have to be much larger than it is today. The gap between the national baseline of $417,000 and the maximum high-cost-area limit of $625,500 is much smaller than the difference in home prices; furthermore, markets with the national baseline loan limit of $417,000 include a wide range of local markets, from mid-to-high priced metros like Denver, Portland, and Miami to much cheaper metros like El Paso and Dayton.

But – you might ask — aren’t the people buying homes in expensive markets rich? Not necessarily: in expensive markets, households spend more of their income on housing. In fact, Census data show that median household incomes for homeowners whose homes are near the conforming loan limit were significantly lower in metros where more of the market is priced above the local loan limit. For instance, among households that own homes near the local loan limit, the median income of those households in San Francisco (where 61% of homes are above the local loan limit) is less than $120,000, while the median income of those households in Houston (where just 13% of homes are above the local loan limit) is $172,000. In other words, a San Francisco household is less likely to own a home that falls within the local conforming loan limit than a Houston household with the same income. More broadly, the correlation across metros between (1) the share of homes over the local loan limit and (2) median household incomes among homeowners whose homes are near the limit is negative (-0.37) and statistically significant. Therefore, the current system of conforming loan limits isn’t sufficiently aligned with local home price differences to give households at the same income level similar access to conforming loans.

The Complicated Politics of Loan Limits and Housing Policy

If conforming loan limits don’t reflect actual differences in local home prices, why not change the loan limits as part of overhauling the entire national housing finance system? Because changing loan limits would mean hurting or helping some local areas more than others, and that’s tricky politics. Lowering the limit in low-cost areas or raising it further in high-cost areas are both politically unrealistic:

• Lowering loan limits in specific local markets would meet resistance from those areas’ elected officials. A lower loan limit would push more borrowers into the jumbo category, which, as explained above, means mortgages that are (at least historically) more expensive and more difficult to get.

• Raising the loan limit further in high-cost areas would benefit borrowers in those areas but would increase the share of mortgages guaranteed or insured by the government – which runs counter to a central goal of national housing-finance reform, which is to reduce the mortgage market’s dependence on government.

Furthermore, aligning loan limits with home prices probably wouldn’t get bipartisan support. The current system of conforming loan limits favors “red” America, where home prices tend to be lower than in “blue” America. In the reddest housing markets – the 32 of the 100 largest metros where presidential candidate Mitt Romney got more votes than President Barack Obama in the 2012 Presidential election — only 10% of homes for sale are above the local conforming loan limit. But in the bluest housing markets– the 28 of the 100 largest metros where Obama beat Romney by at least 20 points – nearly twice as many homes for sale (18%) are above the conforming loan limit. Six of the 10 metros with the highest share of homes over the local limit (from the first table, above) are deep blue, including San Francisco, San Jose, Middlesex County, MA, New York, Oakland, and Boston.

Looking across the 100 largest metros, the correlation between (1) Obama’s margin over Romney in 2012 and (2) the share of homes for sale above the local loan limit is 0.39 (and statistically significant). Because the current system favors red housing markets, a change that would get loan limits more in line with home price differences would disproportionately help blue areas – and might not get much Republican support. (Side note: not all national housing policies favor red America. For instance, the average household in an Obama-voting state claims 66% more for the mortgage interest deduction than the average household in a Romney-voting state. The mortgage interest deduction benefits people where home prices are higher and where incomes are higher, which tend to be blue states.)

What will happen if the conforming loan limits don’t change, even as the housing finance system gets overhauled? Ironically, by removing the implicit subsidy and therefore reducing the cost advantage to borrowers of conforming loans, the Johnson-Crapo bill and other housing reform proposals might end up making conforming loan limits largely a moot point.  But the passage of these reforms is far from a done deal, and their implementation would be years into the future.

Until then, the failure of conforming loan limits to reflect local housing differences is likely to get worse, not better. In the housing recovery, home prices have been rising faster in the less affordable markets, so the gap in home prices between lower-priced markets and higher-priced markets has been widening. Our current system of conforming loan limits will fail to account for the large and growing differences in local housing markets.

Note: The conforming loan limits for 2014 are available here. Loan limits are determined separately for each county, but counties within a metropolitan area are all assigned a uniform loan limit. We calculated the share of for-sale homes, excluding foreclosures, for which an 80% LTV loan would exceed the local conforming loan limit. We also calculated the median square footage among homes for which an 80% loan would be within 10% of the local conforming loan limit. Both of those calculations were based on for-sale listings on Trulia as of March 22, 2014. We used the 2012 American Community Survey Public Use Microdata Sample to calculate median household income among owners of homes for which an 80% loan would be within 10% of the local conforming loan limit. Sample sizes limited the analysis of income to a few dozen metros. “Statistically significant” means at the 5% level.