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How a liquidity crisis could derail the U.S. mortgage market

Prolonged low rates and dwindling liquidity for loans on the secondary market could grind home sales to a halt again.

A mix of over-regulation and Federal Reserve missteps could imperil the housing industry and the financial services companies that depend on it, according to a report.

As U.S. central bankers convene in Jackson Hole, Wyoming, to hear Fed Chair Janet Yellen's updated description of the American economy, the Kroll Bond Rating Agency said that today's market is very different from the one in which the Fed committed to zero-percent interest rates. The market has shifted substantially, but regulations and policymakers aren't keeping the pace.

"Policymakers are not watching spreads," said KBRA senior managing director Christopher Whalen. "There is a liquidity problem this is a near-term concern."

Regulation is up, rates are down and widening credit spreads suggest a lack of demand in the market on which mortgage lenders depend. Even as home sales surge to nearly a nine-year high, Whalen said a combination of unnatural monetary policy and restrictive regulations could critically wound the mortgage market, at a time when central bankers are left with few levers to pull in order to sidestep a crisis.

A real estate agent places an ad for a house in the window display board.
Chris Ratcliffe | Bloomberg | Getty Images
A real estate agent places an ad for a house in the window display board.

It could grind home sales to a halt and put the brakes on a market that, Whalen said, is expected to generate $1.6 trillion in originations this year.

Mortgage lenders continue to see pressure on their margins from low interest rates. Liquidity for mortgage servicing rights has tightened, in part due to regulation limiting the number of players in the market, KBRA notes.

Similarly, secondary market liquidity for whole loans, mortgage securities and U.S. bonds is tightening. At a time when it's increasingly difficult for a mortgage servicer to turn a profit, Whalen said the next leg of the tightening scenario may mean higher fees for homebuyers.

"While many aspects of the 2010 Dodd-Frank legislation were well-considered and necessary, KBRA is concerned that the cumulative effect of monetary policy actions, and prudential and consumer regulations, may be creating the circumstances for a future liquidity crisis," the KBRA report said.