Archive for January, 2010
"The housing crisis is at the center of the economic crisis, and if we don't address housing head on, we can't fix the financial crisis.” – Ara Hovnanian, November 2008
By now, the real estate industry’s battle cry has become accepted and common knowledge: accepted by consumers, commentators, and politicians alike. We must fix housing, in order to fix the economy! We’ve heard this refrain from the National Association of Realtors, the National Association of Home Builders, the Mortgage Bankers Association, and a chorus of community and consumer groups, too – not just the CEO of a large national homebuilder, lest you feel I’m singling out Hovnanian.
But what if our common knowledge on the subject is flat-out wrong? What if – and here’s a world-changing idea – housing isn’t central to economic recovery, at least this time around? Imagine, for a minute, if we actually allowed banks the ability to enforce their legal rights on a non-paying borrower? What if we let the loan terms borrowers agreed to when they took out a mortgage actually mean something?
Would it be the end of the world as we know it?
Consumer groups, of course, are busy bombarding Congress on this very issue. But at least one study is turning conventional wisdom on its head, suggesting that economic recovery will largely proceed with or without a housing rebound.
In a report released last Friday, a cross-functional research team at FTN Financial took a look at key regional U.S. economies in the second half of 2009, and asked whether consumer spending was held back in those states with horrid housing credit. Their findings? Housing performance was completely uncorrelated with consumer spending.
This should give a reason for pause: If housing is central to economic recovery, as we’re being told, why is it that consumer spending seems to have so little to do with the state of real estate?
A little about the study, for those curious to know: consumer spending was measured using trending in sales tax receipts in key metropolitan statistical areas, and then compared across MSAs that were characterized as having horrible versus more stable housing performance. The idea is pretty simple – if a battered housing market is a drain on the consumer, then areas where housing is relatively worse off should demonstrate a strong negative impact on consumer spending as measured via sales tax receipts.
But that’s not what was found. Instead, trending in consumer spending within some of the hardest-hit areas of Florida mapped directly onto consumer spending trends seen in healthier housing markets, including Nashville and Raleigh, North Carolina.
“[T]he best conclusion is consumer spending recovery patterns are not necessarily worse in regions with the worst housing markets,” lead analyst Jim Vogel and his team write. “Instead, it is smaller economies that were overly dependent on housing during the boom that remain sensitive to housing credit indicators.”
While there are always caveats to a descriptive study such as this one, the import of what is being suggested here is huge: maybe we don’t need to fix housing, after all, in order for the nation’s economic picture to improve.
Maybe we can – gasp! – let foreclosures proceed as they usually would. After all, consumers don’t disappear from the economy when they lose their house – they usually become renters, and continue to put food on the table for their families and buy school supplies for their kids, just like the rest of us. (Because they are the rest of us.)
Consumer spending typically drives us forward out of a recession; but consumer spending during the last three economic recoveries, as Vogel and his team note, have largely been the result of so-called MEW, or “mortgage equity withdrawal” in the form of refinanced first mortgages and new cash-out second liens. It’s pretty clear that more organic growth in consumer spending will need to lead the charge out of the Great Recession, since mortgages are harder than ever to come by, and we can all but rule out anyone’s ability to obtain a second.
And that’s the telling aspect of this reaseach: the study finds evidence that such ‘organic’ consumer spending isn’t strongly dependent on a consumer’s ability to pay their mortgage – meaning Florida is seeing roughly the same growth in consumer spending as Tennessee is, for example, irrespective of the level of foreclosures seen in the state.
All of this, then, begs a pretty a important question: are all of the breathless billions that have been spent on foreclosure prevention and mitigation – in the name of promoting economic recovery, no less – really nothing more than political pandering?
And here’s an even more interesting thought: are we doing more economic harm than good by tinkering with the foreclosure process?
After all, we know that many HAMP modifications are failing, for reasons that have nothing to do with the HAMP program itself – but the program is succeeding in changing borrower’s expectations of what they are entitled to when they find they cannot make a scheduled mortgage payment. (I can’t tell you how many emails I get from irate borrowers claiming that their servicer refused to consider a “reasonable” principal reduction on their loan, a reduction they feel they were entitled to receive.)
Rather than keeping consumers in homes they cannot ultimately afford, and setting consumer expectations at untenable levels, would we all be better off by simply allowing a foreclosure to happen, thereby putting the consumer in a position to contribute more of their disposable income back into the ‘real economy’ – and maybe even boosting consumer spending in the process?
The questions here are tough ones, to be sure. And the research here is but a start in what should be a more in-depth inquiry over time, too. But the answers to these tough questions just might shed light on a more rational way for us to manage our way out of housing’s darkest days.
Paul Jackson is the publisher of HousingWire.com and HousingWire Magazine.
Declines in house prices mixed with increases in foreclosures are not showing a hugely negative knock-on impact for the nation's overall economic recovery, according to a weekly report by FTN Financial, a portfolio manager and analytics provider for the investment and banking industry.
The announcement comes as recent housing data speaks otherwise and appears to fail to fulfill hopes of a broad recovery.
FTN reached its conclusion based on an examination of local sales tax data, which shows that even in the absence of available housing-backed capital, such as the once-popular home equity lines of credit, consumers are still buying in a way that can't be measured against the backdrop of local foreclosures and price declines.
"Local housing prices and poor credit by themselves do not solely determine participation in the recovery so far," said Jim Vogel, a financial analyst at FTN and author of the weekly report. "While housing contributed to the downturn, it is not an absolute roadblock to recovery."
Vogel notes that economic growth in the past three business cycles was led by confidence in consumer spending, and supported by gains from refinanced first mortgages and new second lien home equity loans. But the extent of the decline in the housing and mortgage markets from 2007-2009 calls into question the speed and sustainability of the current recovery.
For the report, FTN analyzed state sales tax receipts in the second half of 2009 in particularly hard-hit metropolitan areas, and compared the data with more stable housing economies. FTN concluded that spending recovery patterns are not necessarily worse in regions with the worst housing markets.
The housing market in Florida, for example may have high foreclosures and mixed with dropping home prices, but when it comes whether or not this impacts the spending habits of the state's inhabitants, there appears to be a "zero correlation," the reports states.
"[S]ales tax receipts were uncorrelated in 2H 2009 with housing misery," Vogel said. "That has led to a tentative conclusion that continued home price declines and foreclosures are not fatal to the overall economic recovery."
FTN also concluded the economy grew in the second half of the year despite tight mortgage lending standards. The growth was largely driven by federal stimulus, although consumer spending contributed as well.
"Housing will not be an early contributor to the recovery, but that has not prevented a contribution from consumers," Vogel added.
Write to Diana Golobay.
"We did what we thought was necessary to stabilize the market, but we don't think the government should continue special efforts forever," said Michael S. Barr, an assistant secretary at the Treasury Department. "As you bring stability, private participants come back in. We do expect this now that the market has stabilized. I'm not going to say there will be no effect on rates, but we do think you are seeing market signs and market signals that there should be an orderly transition."
A few federal officials and many industry advocates disagree, saying the government is exiting too soon. They offer dire warnings of higher rates and a slowdown in home sales. Fed leaders say they will end a marquee program supporting the mortgage markets in March. Obama's economic team, led by Treasury Secretary Timothy F. Geithner, has decided not to replace it and has been shutting down its own related initiatives.
"You are going to see the builders that continue to survive, the ones that are determined to make it," David Crowe, chief economist of the National Association of Home Builders, said ahead of the trip to Nevada. He said many of his colleagues were comfortable that their business had "turned the corner".
Yet the fate of Mr Crowe's industry remains in limbo. Recent housing data have been considerably softer than towards the end of last year, when hopes were high that the market had finally bottomed out.
Vast swathes of America are still suffering from high foreclosure rates, high inventories of unsold homes and weak levels of new construction, the latter highlighted last week by news of a 4 per cent drop in December housing starts.
Cities such as Las Vegas are suffering: house prices there have fallen by 27 per cent in the past year, and by 55 per cent since the crisis began, according to the latest Standard & Poor's Case-Shiller index.
Watching the President announcing the proposal championed by former Fed Chairman Paul Volcker to forbid commercial banks from engaging in proprietary trading or growing market share beyond a certain size, we are reminded of the reaction by Washington a decade ago in response to the Enron and WorldCom accounting scandals, namely the Sarbanes-Oxley law. The final solution had nothing to do with the actual problem and everything to do with the strange political relationship between the national Congress, the central bank and the Wall Street dealer community. We call it the "Alliance of Convenience."
The basic problems illustrated by the Enron/WorldCom scandals were old fashioned financial fraud and the equally old use of off-balance sheet vehicles to commit same. By responding with more stringent corporate governance requirements, the Congress was seen to be responsive — but without harming Wall Street's basic business model, which was described beautifully by Bernard J. Reis and John T. Flynn some eighty years ago in the book False Security.
At a late January meeting, Federal Reserve officials signal to the market that interest rates are due to rise soon. The move catches investors off guard. Stock and bond prices plunge, while the U.S. dollar surges.
That isn't a forecast for this week's meeting of the policy-setting Federal Open Market Committee; it is the scenario that played out six years ago this month. Today, no one expects the Fed to veer from its commitment to keep rates low for an "an extended period."
Repo was a key source of funding for leveraged investors in private MBS and a host of other "rates" products before disaster struck capital markets. That it dried up with the crisis helped drive the prices of subprime MBS and other structured products to levels well below "intrinsic" value.
Now, there are signs that repo financing is reviving, improving 2010 prospects for private MBS markets.
First, a Little Background
'Yuck,' ordinary citizens might be thinking, 'Why would I want risky investment practices to return?' So, let me provide a little background, starting with some nomenclature. From the point of view of the party seeking financing, repo is a sale and repurchase, at a later date, of the same security. Ownership passes to the lender/buyer, but normally the borrower/seller continues to receive the coupons.
The sale price is today's market value, and the repurchase price reflects the implied financing rate of interest. In addition, the lender "haircuts" the face amount it is willing to lend against to protect against a decline in market value of the collateral (the haircut amount is equivalent to borrower's equity). In effect, a repo is a secured financing, as the lender/buyer keeps the security if the investor doesn't buy it back.
Repo, in which the identical underlying bond is repurchased, would be used to finance investments in non-agency MBS. An investor looking to finance with repo would buy the security and, at the same time, arrange to repo it with the broker/dealer. Most repo transactions are short term, not a problem as borrowers with good credit and collateral can roll the transaction so long as they want to own the bond.
A related mechanism called a "dollar roll" is used to finance TBA agency MBS (the same amount and coupon of MBS are repurchased, but not necessarily the same pools). Dollar rolls are not our subject. Because the dollar roll market is sustained by the deep liquidity of TBA markets for guaranteed MBS, it continued to function relatively normally during the crisis.
Leveraged Investors Provide a Floor on Prices
The use of borrowed funds also gives us a convenient way to think about investors in MBS (and other kinds of bonds and "rates" products) is to divide them into two main categories, real money investors and leveraged investors.
The real money players are insurance companies, mutual funds, pension plans, foreign governments and so forth. Banks in truth are leveraged investors – the money they invest is borrowed (deposits and such), but for various reasons (including the stickiness and social utility of deposits) they are often lumped in with real-money players. For that matter, Fannie and Freddie are also leveraged MBS investors. (Complaints about the enterprises' low cost of funds, from banks and foes of government involvement in free markets, tend to ignore the fact that bank deposits are cheap financing as well, and also reflect explicit government support, e.g. deposit insurance, and implicit government support evidenced by the host of measures taken to prop banks up as well as the solidification of the too-big-to-fail doctrine).
In contrast, by leveraged investors, we are usually referring to hedge and private equity funds, proprietary trading desks and REITs.
Leverage Adds Risk
It's tempting to dismiss leveraged investors as somehow dangerous to the markets' health. Leverage jacks up risk (in terms of both potential loss and, when lots of leverage is present in a market, of price volatility). It can (did) feed asset bubbles. For the guy or gal on the ground, who invests hard-earned dollars, being able to use somebody else's money to garner outsized returns can seem downright unfair. Worse, it seems that when the leveraged gorillas lose, households and taxpayers lose more.
What is not apparent to the average citizen is that leveraged investors play an important role as buyers on the margin. Before the crisis, by employing short-term repo financing to fund purchases of longer-term and or higher yielding securities, hedge and private equity funds leveraged relatively low market yields on highly rated securities into 15% – 25% returns on equity.
Leveraged investors will move to the sidelines when real money demand is so great that they can't meet those fat "yield bogeys." (This includes banks and the GSEs, though with less leverage, their thresholds are more comparable to real money yield requirements.) When prices soften in securities that can be leveraged, and yield bogeys can be hit, their demand returns. In effect, hedge and similar investors provide a floor on prices and help hold them in a tighter range than real money demand alone can achieve.
The Floor Fell Out
When mortgage (and other asset) performance began to deteriorate (and dealers' own sources of liquidity began to dry up), dealers raised their repo rates and haircuts, cut financing for many products altogether and pulled lines to floundering customers. Their demand shrank with permitted leverage. For example, in 2007 before the crisis, haircuts on triple-A subprime bonds were as low as 5%, but ballooned to 50% and more in the crisis.
The sharply de-levered funds that remained moved from buyers on the margin to the only buyers, adjusting their yield bogeys to reflect much lower leverage. Given the prices they were willing to pay, most sellers moved to the sidelines and the market froze. Many holders protested having to mark their holdings to onerous fair values, and there was much public babble that mark-to-market accounting was destroying bank capital and their ability, by lending, to save the economy from recession.
What a Difference Half- to a Dozen Months Can Make
That was then, but now, leverage is returning to the markets. Analysts heralding this positive for pricing and liquidity give much of the credit to TALF and PPIP. Indeed, as I wrote in a May 2009 HousingWire article "Save TALF," and here, last June the purpose of these programs was to offset, temporarily, the loss of repo financing and permit leveraged investors to raise the floor on "distressed assets."
Government-provided leverage visibly helped prices stabilize in 2009. A host of technical obstacles prevented TALF for MBS, but prices firmed on anticipation of PPIP demand and were further buoyed by re-REMIC buying. (That is, tranches of outstanding mortgage securities can re-securitized and re-tranched. It sounds as suspect as leverage, but, like leverage, in the hands of investors who know how to do their own due diligence – instead or relying on ratings – it's common sense relative value investing. And it realizes value that equilibrium market prices weren't reflecting.)
With the return of price stability dealers have been more willing to provide repo financing and third-party repo is reviving as well. Analysts at Barclays Capital noted in their December "U.S. Securitized Products Outlook 2010," an attractive option for money market investors "would be to provide repo leverage to buyers with more risk appetite. We have already seen a sharp rise in availability of third-party repo funding over the last 6 months."
Haircuts have shrunk accordingly. For example, haircuts once as low as 5% for some AAA private-issue MBS before the crisis, soared to 50% and beyond in the crisis (quoting myself, from May HousingWire magazine). At the end of 2009, BarCap analysts spotted haircuts for prime MBS at 15%-20%, current pay subprime bonds at 20% and last-cash-flow (last to receive principal and first in line for losses after credit support burns off) subprime bonds at 45%.
Lower haircuts means leveraged investors can pay more for bonds and hit their bogeys. In turn, real money investors see fair values rise on their holdings. Ultimately, the return of leverage and falling private MBS yields work their way back into securitization markets. Glenn Shultz in Structured Products Research at Wells Fargo Securities made this point in a report last week, "The Bootstrap Effect." Improved secondary pricing, he said, "suggests that the funding of nonagency loans in the mortgage capital markets is beginning to look economically feasible."
NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine.
Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.
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