Fannie Mae has projected that the recent bank failures may act as the catalyst that tips an already precarious economy into a recession — primarily due to the combination of tighter lending standards by small- and mid-sized regional banks.

The ongoing banking instability may affect the availability of jumbo mortgages and residential construction loans due to the high concentration of those originations stemming from small and mid-sized banks, Fannie Mae’s Economic and Strategic Research (ESR) Group said.

“Inflation has now been joined by financial stability concerns as threats to sustained growth,” Doug Duncan, senior vice president and chief economist at Fannie Mae, said. “These particular pre-recessionary conditions are not unusual, as bank failures often follow monetary tightening – but this may well be the catalyst for the modest recession we’ve been expecting since April 2022.”

Fannie Mae raised its first quarter GDP forecast to grow 0.9% on an annualized basis — up from its prior expectation of a 0.4 contraction. The ESR group also pushed the timing of an anticipated recession from the second quarter into the latter half of this year.

“While we do not know how long-lasting the current banking concerns will be, banks have borrowed a record amount from the Fed’s discount window over this past week, while Federal Home Loan Bank advances have also surged,” according to the ESR group. 

This is a clear sign of liquidity stress among many regional banks that may be facing deposit run pressure, Fannie Mae noted.

“We anticipate this will stabilize, but it is likely to result in greater reluctance to lend as banks seek to preserve liquidity,” it said.

The group expects the recent banking turbulence to impact single-family mortgage lending in the jumbo market, leading to fewer sales in related regions and market segments. 

Unlike conforming loans, which are largely financed through mortgage-backed securities (MBS) via capital markets, the jumbo mortgage space is almost entirely funded via the banking sector, and some regional banks are more concentrated in jumbo mortgage lending than others.

Ongoing liquidity stress could limit home financing, and therefore sales in the related market segments and geographies with high jumbo concentration, the group noted. Jumbo loans account for approximately 12% of all loans originated as of February 2022.

Construction activity may also be hampered, as construction and development loans for single-family home construction are heavily financed by regional and community banks, Fannie Mae noted. 

If some banks are selling their MBS holdings to manage liquidity, or if investors simply anticipate such behavior, this will likely add to upward pressure on the Treasury/MBS and MBS/30-year fixed-rate mortgage spreads.

But to the extent that mortgage rates do pull back, Fannie Mae said this may add some short-term support to the spring home buying season in the conforming mortgage space, as buyers currently on the sidelines may look to take advantage, as others did at the start of the year when rates fell from their peak over 7%. 

Regardless of how the banking turbulence plays out, Fannie Mae continues to expect home sales activity to remain subdued for the remainder of 2023. 

While single-family housing starts rose 1.1% in February from the revised January figure, the government-sponsored enterprise anticipates further near-term declines, even aside from any recent repercussions to construction and development loan credit tightening.

Even if mortgage rates were to pull back to 6%, affordability remains highly constrained, and most existing mortgage borrowers will continue to have rates well below current market rates. 

Even at a 6% mortgage rate, the ESR group estimated that 64% of outstanding Fannie Mae fixed-rate 30-year mortgages would have at least a 2% rate disincentive, and another 22% would have a 1% to 2% rate disincentive.

Fannie Mae downgraded its outlook for single-family purchase mortgage originations due to a downward revision to the home sales forecast. The ESR group expects purchase mortgage volumes to post around $12.4 trillion in 2023 and $1.35 trillion in 2024.