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The U.S. housing market continues to play a significant role in the overall economic outlook. In a recent interview, Scott Simon, managing director and head of mortgage- and asset-backed securities at PIMCO, offered his view on the severity of the housing crisis, what it will take to reinvigorate the housing and mortgage markets and how government policy responses have fared in working toward that goal. (The following is an excerpt from that interview).

Q: The U.S. government has established a number of programs to shore up the mortgage market and support housing, Are they working?

Simon: These programs are all helpful, especially in aggregate. Mortgage rates are about 1.5 percentage points lower than they were in November; it’s hard not to view that as some degree of success. That drop in mortgage rates increases the affordability of housing by about 15%. There are two ways you can look at that: for the same monthly payment you can buy a 15% bigger house, or you can buy the same house you wanted for 15% less. Ultimately that’s the most important issue, because the purchase rate is more important than the refinancing rate. For instance, if $2 trillion of loans are refinanced at rates 100 basis points lower, that’s only about $20 billion in aggregate savings for consumers. Obviously it’s important to each individual, but in the scope of the entire economy it’s not a tremendous savings compared to gasoline, for example, which given the drop in prices from its peak is saving consumers about $400 billion a year in aggregate. The housing market and the economy really need rates to drop to a level where individuals believe houses are cheap enough, or payments low enough, that they have to own one. That’s how to get housing prices to stop going down – by mopping up inventory. Foreclosures also need to be addressed, and truly preventable foreclosures avoided. In the end, though, we need to see housing prices stop going down, and the easiest way to accomplish that is to give people more buying power to purchase houses.

Q: What else can be done?

Simon: There are two things I see that would be very important: 1) addressing the negative equity problem that homeowners have, and 2) targeting lower purchase mortgage rates. The negative equity issue is huge. Almost 30% of mortgage holders are upside down on their homes – the mortgage is larger than the value of the home. This means that “willingness to pay” is becoming a bigger factor than “ability to pay” in many housing markets. Rational people will start walking away from their homes just to jettison the negative equity position. The original Frank-Dodd proposal to Congress was on the right track: combine loan principal reductions with an immediate refinancing into a government-sponsored loan through Ginnie Mae (GNMA), Fannie Mae (FNMA) or Freddie Mac (FHLMC). This has a host of real benefits, including 1) it helps homeowners stay in their homes by reducing their underwater position, and 2) it helps the banks and investors, as it removes “toxic assets” from their balance sheets due to refinancing. It also solves the valuation issue on securities as it focuses only on the value of the home and mortgage, not the value of some arcane security. This will help the overall markets (both housing and mortgage markets), reduce foreclosures (and help real estate values), reduce uncertainty about securities valuations, reduce uncertainty about the value of bank assets and help remove toxic assets from bank balance sheets in a less controversial way. The other simple program would be for the government to subsidize purchase-only mortgages for homeowners. Inventory diminishes through purchases, not refinancing, so purchase loan subsidies have a much bigger bang than refi subsidies. I don’t know the rate that makes everyone "need" to buy a home, but I believe 4% to 4.5% will attract a lot of new buyers.

Q: Are banks more willing to lend or are investors more willing to buy mortgage-backed securities (MBS)?

Simon: There is almost no appetite to buy MBS except those that are issued by government-sponsored enterprises (GSEs). The only real MBS demand is for Ginnie Mae, which is explicitly guaranteed by the government, or Fannie Mae and Freddie Mac, which are now explicitly supported by the government. This means that homebuyers seeking jumbo loans – even prime borrowers with big down payments – are still getting rates that are a percentage point or two higher than conforming mortgages, which meet the Agency requirements. That spread between jumbo and conforming mortgages is exceptionally wide, in part because the market is afraid that programs to modify loans in the non-Agency market could lead to violations of contract law and property rights. The main reason lenders are willing to lend money to homebuyers at all is that the loan is collateralized by the house. The buyer puts some money down as well, and if there is a problem the lender gets the house. But at the point where the market questions whether that is truly the case, or whether modification programs may interfere with contract law and property rights, the lender is going to require a premium for taking on that added risk. From the investor standpoint, extending a home loan where there is a risk of not getting the collateral back is basically the same as investing in unsecured debt, such as credit card debt. There are not a lot of investors willing to lend $500,000 at 5¼% on a credit card. So to the degree that the non-Agency mortgage market is perceived to be debased, and heading from a collateralized market to an uncollateralized market (cf. the credit card market), the availability of loans of that size goes down and the cost of that credit goes up.

Q: Do you expect mortgage rates to keep falling?

Simon: There are two elements that we have to consider: one is the really soft economy and another is the lack of inflation in the current environment. While the Federal Reserve can try to stimulate housing, it can’t repeal the business cycle. It can’t change how savings rates are rising because people were overextended. It can ameliorate the economic weakness somewhat by keeping policy rates low for some time. With low policy rates and no imminent inflation threat, we don’t expect mortgage rates to go meaningfully higher from here. They could periodically drift higher, but we don’t expect them to go back to where they were before all of these programs were implemented. That said, rates probably won’t go significantly lower unless economic fundamentals get considerably worse and the Fed and the Treasury try more aggressively to lower mortgage rates.

Q: Is a 4% target rate for mortgages realistic?

Simon: A rate that low would be helpful in terms of increasing affordability. But if policymakers do that, they should target buyers instead of refinancers, especially at this time of year when home sales are seasonally pretty slow to begin with. Currently about 90% of the mortgage volume is in refinancing and only 10% is for home purchases. Going back to my earlier point, given the limited amount of money available for these programs, loans that are used to purchase a house are a much more efficient way to support the housing market. Unlike refinancing, purchases reduce inventories and support prices, which in turn stem the decline in value of the collateral for all outstanding mortgages. Q: Will home prices continue falling? Simon: Our view really has not changed very much since 2005, when we forecast that 2007 would not be a good year, 2008 and 2009 would be very bad, and that prices would eventually bottom late in 2010. We are about two-thirds of the way from peak to trough. With the actions the government is taking, we are seeing probably the first glimmer of increased hope. Whether it is by making credit cheaper or more available or working on loan modifications, these programs will mean the bottom in housing prices is likely to be higher in price, and likely to happen sooner than it otherwise would have. So, depending on what comes out of Washington in the next few months, it’s possible that housing could bottom out at the end of 2009. If they adopt the 4½% target we discussed, or if they implement responsible loan modification programs, I think that this could happen. But housing is still going down, and even if it hits bottom by the end of 2009, it’s not going to recover anytime soon. Prices will stay flat for a while after they bottom out, but the key is to make housing prices stop dropping.

Q: How are the trends in the housing and mortgage markets driving your investment outlook? What are your views on MBS – are they still attractively priced?

Simon: PIMCO’s MBS purchases are plateauing at a very high level. We still like mortgages very much. We think that government-guaranteed or explicitly supported Agency MBS is still very inexpensive, particularly compared to Treasuries, which actually have a similar risk profile. We think Agency MBS represent excellent value relative to both Treasuries and swaps, and that they offer investors some of the highest risk-adjusted returns. Our investment in Agency MBS is not dependent on any of the outcomes in the economy or in the housing market. It is not a credit play. That is, we’re not betting that housing will either turn around or collapse. As is the case with many of our current investment strategies, we are, essentially, investing alongside the government.

Q: What are the risks to the outlook at this point, whether it’s a recovery that’s sooner than expected or a recovery that takes longer than expected? How are the risks distributed?

Simon: There is more of a risk that a recovery will take longer than expected. It could be that the government pumps all of the stimulus into the economy, and we still end up in a situation like Japan in the 90s, where the economy just continues to flounder for a very long time. Ultimately, people need to come out of their shells and buy houses, and buy products; that’s what’s going to create jobs. Many people have been emotionally scarred by all this. People believed they were wealthy, but their wealth was in their houses, and it went away. And unlike the NASDAQ bubble, which affected a relatively small number of people, there are 70 million households in the U.S., so this is being felt throughout the economy.