Players in the upscale housing market fear hard times ahead as the federal government prepares to downsize the amount at which they will guarantee a home mortgage.

With the past three years of relatively low interest rates, federal agencies were able to guarantee loans as high as $729,750 in high-cost states such as California, New York, New Jersey, Connecticut and Massachusetts. These big mortgages may have a slimmer look by the end of summer. In California coastal communities such as Monterey County, government-backed loan limits will drop as low as $483,000. [For more information on the current loan limits set by the federal agencies, see the December 2010 first tuesday article, 2011 FHA loan limits.]

In recent years, the government has acted the role of generous patron to large loans. However, deliberations in Congress now conclude a federal retrenchment of big mortgages is necessary. Both Democrats and Republicans agree taxpayer money should not be funneled into financing homes priced well above the national average.

Today, government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac have their arms full of bad mortgages and cannot handle further pressure – the burdened Fannie Mae has already requested nearly $100 billion in relief aid. This government curbing will be one of the first tests to see whether private mortgage insurers (PMIs) and Wall Street hedge funds will pick up some of the 90% market share of new mortgages which GSEs backed last year.

Challengers to the loan cutback worry shrinking government support of large mortgages will further depress home values and sales volume.  Buyers and sellers in upscale communities feel they are being unfairly treated for simply living in expensive regions.

first tuesday take: Yes, yes, yes. The government should be the lender of last resort, not the only lender (by way of guarantees) in the game. Its all-encompassing hand on the mortgage market in the form of Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) came about by government design after 1980, and its front line must begin to be drawn back for providers and Wall Street bankers to step in.

But not just yet. It’s still too early for the government to rip the band-aid completely off since government guarantees and housing policies created this mess in the first place.

Mortgage market reform is necessary – if not inevitable – but the government brought us to this point, and their phase-out ought only to take place when the nascent real estate recovery has a solid toehold. PMIs do not yet have the muscle to support the mortgage market and a government lowering of FHA-insured loan limits now will result in higher interest rates for homebuyers in high-cost communities. This in turn will discourage real estate activity and speed up the drop in prices in that already declining high-tier market.

Perhaps the government, spooked by the 25% further drop in prices predicted by Schiller of Case-Schiller index fame, will get out of the high-tier mortgage market before U.S. Treasury drains further. The most prudent time for the government to exit the high-end loan market will be when prices in California and across the nation have stabilized for at least two years – and once the current crop of bad mortgages has been cleared out and the shadow inventory foreclosed on and resold. [For more information on the Fed’s evolving role in the mortgage market, see the March 2011 first tuesday article, Mortgage market reform from the executive branch.]

Fed mortgage support remains necessary even for borrowers of high-tier loans, especially in California where we have a larger supply of expensive properties in comparison to the rest of the nation. Thus, a government cutback of big mortgages will hurt Californians disproportionately, particularly the employees of Silicon Valley tech companies born in the dot com Boom.

Lowering the mortgage threshold will raise interest rates on new loans originated above the threshold, classifying them as jumbo loans which are uninsurable by government agencies. This will send homebuyers to the doors of private lenders, many of whom do not yet have the stability or confidence in this shaky economic recovery to take on a loan not guaranteed by the government.

We look forward to having a flourishing and competitive private mortgage market to service Californian and American homebuyers – when the time is right.

RE: “Federal retreat on big mortgages may hurt upscale housing” from