“The name says it best”. Any loan amount above the conforming loan limit as determined annually by Fannie Mae and Freddie Mac (currently $359,650), is classified as a jumbo loan. Historically, these loans carried an interest rate premium over the traditional conforming loans. Ten years ago, this interest rate premium was approximately 1/2 % to 5/8 % above a typical conforming interest rate. Since then that premium has been compressed to 1/8 % to 3/8 %. The essential reason for this is liquidity, increased liquidity. Liquidity in this sense is the amount of time necessary to turn an asset, in this case a mortgage, into cash. The faster this can be accomplished, the more liquid the asset.
Whereas the conforming loan market, Fannie Mae or Freddie Mac, has always purchased loans from lenders on a “spot” basis, that is, effectively one loan at a time, the jumbo loan market was quite different. A lender making a conforming loan today, could sell that loan to Fannie Mae or Freddie Mac tomorrow, thereby eliminating or minimizing interest rate risk. A simple explanation of interest rate risk would be the volatility of interest rates from the point of a lender making a loan to a borrower and the time the lender sells that loan in the secondary market (Fannie Mae or Freddie Mac). Again, with a conforming loan the fact that it could be made today and sold tomorrow creates liquidity and the more liquid a loan, the less interest rate risk associated with the loan hence the lower interest rate.
Years ago, a lender making a jumbo loan would have to “portfolio” (hold) that loan until such time that a buyer for that loan could be found. During this portfolio or holding period, if you will, the lender is exposed to interest rate risk. Hence, the longer the holding period the less liquid, the less liquid the more interest rate risk, and the more interest rate risk the higher the interest rate premium.
Many years ago, two of the more prominent buyers of jumbo loans, were insurance companies and big money center banks. Since a spot market (the sale of one loan at a time) did not exist for these loans, these buyers would buy jumbo loans from lenders in “bulk”. An example of this would be ABC insurance company would commit to buy in bulk, $50,000,000 of jumbo loans from XYZ lender at a certain price at a certain point in time. Generally the longer the delivery period for this bulk commitment, the more interest rate uncertainty or risk the lender would have to assume hence the higher the rate would be.
(Let’s add a reality twist to this “interest rate risk” thing discussed above)
Let’s assume in the example above. ABC insurance company was willing to buy $50,000,000 of mortgages with an interest rate of 6.00% from XYZ lender. If during the delivery period, say 60 days, interest rates decreased by 1/4 %, that is 6.00% to 5.75%, the value of the bulk deal would decline by over $1,000,000. That is, the lender would have to generate over $51,000,000 of mortgages @ 5.75% to meet it’s commitment to the insurance company, thereby losing over a million dollars as a result of interest rate risk.
With increasing real estate values and thus the need for larger loans, jumbo loans are representing a greater percentage of loans in the mortgage industry. As a result of this, a much larger secondary market for jumbo loans has emerged. Nowadays, there are many Wall Street firms such as Lehman Brothers and Beare Stearns, to name a few, who are actively purchasing jumbo loans from lenders, creating mortgage backed securities and selling these securities to investors. With the advent of this very efficient mechanism for mortgage backed securities, a lender no longer has to portfolio these jumbo loans for an extended period of time, hence, reducing their interest rate risk and reducing the interest rate premium associated with this risk.