The Oser View

More Housing News

Reports released this week confirm that the housing market remains extremely weak.  The volume of home sales may have reached a bottom, but at a very low level and unlikely to rise in the near future.  Yesterday the National Association of Realtors announced data on existing home sales in February.  For the sixth consecutive month, sales were roughly on an annual pace of five million units.   In the four boom years, 2003 through 2006, the average pace of monthly sales was 6.6 million units.  The supply of existing homes for sales remains extremely high: 9.2 months for single family homes and a staggering 13 months for condominiums.  In the Chicagoland area, home sales were down 26.9% from a year earlier despite this February having a 29th and despite the fact that suburban Will County was the fastest growing county in the entire country last year. 

Home prices are falling drastically.  The national median price for an existing home dropped to $195,900, which, on an inflation adjusted basis, means that prices have fallen all the way back to March 2003.  The private Case Shiller Index of home prices in 20 metropolitan areas dropped a record 10.7% between January 2007 and January 2008.  Home values increased in only one of the 20 areas year-over-year, and prices have fallen everywhere in recent months.  In some places, the declines in home prices are truly mind-boggling.  Prices in sunny San Diego are down 16.7% from a year ago, 20.2% from two years ago, and 15.5% from three years ago.  Prices in Detroit, starting from a much lower base, are down 15.1% from a year ago, 20.9% from two years ago, and 18.6% from three years ago.  The Wall Street Journal reported this morning that the average sale price for a home in the city of Detroit was just $22,000. 

The bright spot is that prices may be low enough to begin attracting buyers, but even if the recovery is starting, it will take a long time to come to fruition.  The Journal also reports that nearly 500,000 foreclosed homes are on the market, more than double from a year earlier.  Foreclosed homes represent one in nine homes listed for sale nationally compared to one in 15 last year.

Fed Action

The Federal Open Market Committee (FOMC), the Fed’s policy arm, voted today to reduce the target for the fed funds rate by 75 basis points to 2.25%, the lowest level in more than three years.  In an accompanying statement, the FOMC cited weakness in consumer spending, labor markets, and housing along with tighter credit conditions as factors “likely to weigh on economic growth over the next few quarters.”  This is a sign that the Fed will keep rates low for many months to come.  But, the FOMC went on to warn that “inflation has been elevated” and “inflation expectations have risen.”  While inflation is expected to taper off in coming months, “uncertainty about the inflation outlook has increased.”   These worries about inflation kept the FOMC from cutting the fed funds rate by the full point predicted by fed funds futures.  In fact, today’s vote wasn’t even unanimous.  Two Fed governors voted against the majority because they favored “less aggressive action.”   Inflation is the last thing most market players are worried about in the current turmoil.  It’s as if the Fed is saying, “Don’t forget to carry an umbrella, it might rain,” in the midst of a drought.

e ≠ mc2

Human beings’ great intellectual talent is pattern recognition.  As Harvard linguist Steven Pinker notes, we think in metaphors.  Things and actions always remind us of other things and actions, allowing us to categorize and make sense of them.  Albert Einstein’s famous equation, e = mc2, is a preeminent example of this gift.  Energy equals mass times the speed of light squared.  Einstein saw that energy and mass are fundamentally equivalent.  He recognized a pattern where everyone before him saw two entirely different phenomena.

Einsteins are few and far between.  He found a pattern where others could not.  Most of us do just the opposite.  We assume there is a pattern where none necessarily exists.  We assume that because certain relationships have held for what seems a long time on our human time scale, they will hold indefinitely.  One such relationship that has held for decades in the bond markets may be expressed, with some license, by the following equation: D = T + x, where “D” stands for the interest rate of all types of debt—personal, corporate, and government—except for direct obligations of the US Treasury.  “T” stands for the interest rate of direct obligations of the US Treasury.  “X” can be any fraction or integer greater than zero.  The interest rate of all debt except Treasuries is equivalent to the interest rate of Treasuries plus some amount, given equivalent duration for both D and T.  The key to the formula is that “x” is always positive; other debt instruments always return a higher rate of interest than Treasuries.  (It is, of course, possible to charge a lower rate than the Treasury rate on a given debt; this is a human, not a natural law.  But, such undercharging is always unusual and is called “below market rate”.)

The observable pattern was that, for any “D” and “T”, “x” would remain in a fairly consistent range over time.  For example, 30-year Fannie Mae mortgage-backed securities (MBS), which are securitized pools of 30-year single-family mortgages made to creditworthy borrowers, have about the same duration as 10-year US Treasury notes.  The difference in the interest rates between the two securities, called the yield spread, has fluctuated between 110 and 150 basis points for many years.  In other words, an investor in Fannie Mae MBS could expect to earn 1.10% to 1.50% more than an investor in Treasuries.  Recently, the yield spread between the two securities has shot up to 230 basis points and even more.

Assuming you are not a bond market professional, your reaction is probably, “So what?”  This seems a trivial change, hardly worth getting excited about.  Nothing could be further from the truth.  Spread risk—an unexpected, unprecedented, and prolonged difference in yields between types of debt instruments—occurs when market participants become conservative regarding credit risk.  Spread risk is not the problem affecting the financial markets today, but it is essential to the problem, and for our purposes, a useful guide for understanding just how dangerous present conditions are.

The current disruptions in the financial markets have been described in various ways, first as the subprime meltdown, later as a liquidity crisis, and more recently as a credit crunch. In fact, the crisis is all of the above and more.  It is nothing less than a loss of confidence in the financial system, and it is by no means limited to Wall Street.  Every governmental unit, from the federal government to the smallest local park district, every corporation, and nearly every citizen in America is dependent on debt.  The issuance of debt is fundamentally based on confidence.  No confidence, no loan.  It’s that basic.

The widening of spreads between US Treasury securities and Fannie Mae MBS is one manifestation of eroding confidence.  It’s important both symbolically and practically.  As I have often remarked in these commentaries, the 30-year fixed rate mortgage, made to a creditworthy borrower, is the bedrock of the American financial system.  In their millions, these mortgages evidence trust between creditors and debtors throughout the country.  They provide millions of jobs, both directly and indirectly.  According to Citigroup research, 776,000 jobs in construction, manufacturing, finance, and real estate have been lost since early 2006.  The Wall Street Journal estimated that New York financial companies could layoff up to 20% of their employees, and that was before the Bear Stearns collapse.  Even more crucially, mortgages allow ordinary people to accumulate wealth in the form of home equity, and they provide the borrowing power that has kept consumer spending on the rise without a break for 16 years.  The Federal Reserve reported that household net worth declined for the first time in five years in the fourth quarter of 2007, and home equity dropped below 50% of mortgage amounts for the first time since the 1940s.

Falling Treasury rates and cuts in the fed funds rate have not produced any reduction in home mortgage rates.  Thirty-year fixed-rate mortgages that conform to Fannie Mae standards carry about the same rates now that they did when the fed funds rate was 5.25%.  This is not happening because (or just because) lenders are greedy.  Mortgage rates, despite what most people think, are set less by lenders than by MBS investors.  This market is beset by rising supply and falling demand, which, as in any financial market, is a recipe for lower prices and higher rates.  Today, fewer lenders, including Fannie Mae and Freddie Mac, are able to hold mortgages on their own balance sheets, because their capital and liquidity are under stress.  According to JPMorgan Chase research, net income for all US banks in the fourth quarter fell from more than $30 billion to less than $10 billion, while loan loss provisions soared.  Loans delinquent 90 days or more rose to 1.39% of total loans.  At 1.71%, non-current real estate loans more than doubled from the fourth quarter of 2006.  Not surprisingly, regulators are demanding higher standards, tighter risk management practices and more due diligence.  At the same time, they are urging banks to raise more capital.  For many banks, the fastest way to increase capital ratios has been to decrease assets by selling them.  The assets they are selling are their most liquid, including Fannie Mae MBS.  Borrowers, meanwhile, are increasingly drawn to 30-year fixed rate mortgages, as monthly payments on 15-year mortgages become more expensive and adjustable-rate mortgages are simply unobtainable.  The combination of these factors means that more 30-year mortgages are being securitized and sold just when fewer buyers are in the market for them.

But that’s only part of the story.  The financial markets make a distinction between “real money” and “fast money.”  Real money is invested by banks and similar institutions that have the intention and capacity to hold assets for a long time.  Fast money is turned over quickly and is highly leveraged.  It is borrowed short-term and collateralized by the assets it is used to purchase.  If the market value of those assets declines, two things will happen.  Creditors will demand more collateral and they will demand a higher percentage of over-collateralization.  For example, a hedge fund might borrow $1 million and use it to purchase a Fannie Mae MBS.  In normal times, the hedge fund might have to collateralize the borrowing with $1,050,000 worth of the MBS.  Wall Street calls this a 5% haircut.  If the market value of the MBS drops from par (100) to 98, the borrower must come up with another $20,000 worth of collateral.  And when the borrowing matures, the creditor may demand a 10% haircut, meaning the debtor must pony up another $50,000.  Now the hedge fund needs $1,120,000 to borrow $1 million, but the fund is highly leveraged and doesn’t have that much capital.  If it can’t get help, it goes under. 

Of course, a real hedge fund doesn’t borrow $1 million.  Real hedge funds borrow billions.  Carlyle Capital Corp, a real hedge fund that invested in MBS, defaulted on $16.6 billion of borrowed money on March 12.  Carlyle’s creditors will sell their collateral, which puts more strain on the MBS markets and motivates lenders to demand even bigger haircuts.  Bloomberg news reported last week that banks have raised the haircuts on AAA-rated residential MBS to 20% and on non-Agency guaranteed MBS to as much as 30%.

But again, that’s only part of the story.  Credit-default swaps are defined by Bloomberg as “financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt.”  The buyer of the swap will receive the face value of the debt should the debtor fail to pay.  Note the word, “speculate.”  One might think of credit-default swaps as insurance against a company failing to make good on its obligations.  It is, but it’s a negotiable insurance policy, and so it can be traded.  On Wall Street, anything that can be traded, will be traded.  Although they have only been around for a few years, credit-default swap contracts with a total notional amount of more than $45 trillion are now outstanding.  (To put this number in perspective, it’s about 3½ times our annual gross domestic product.)  Between January 1, 2005, and June 30, 2007, the premium for credit-default swaps on Fannie Mae 10-year senior debt averaged 19 basis points.  Since then, the average has been 45 basis points, and in the last month, it has soared to 78 basis points.  Whether justified or not, higher premiums on credit-default swaps add to the cost of Fannie Mae debt by increasing the spread between Fannie Mae and Treasury obligations.

Now for the bad news.  Credit-default swaps, like interest-rate swaps, currency swaps and a host of other derivative instruments are sold between counterparties, one or both of whom is typically a large money center bank or investment bank.  Because of its incestuous nature, counter party risk is the biggest financial risk we face today.  Here is The Wall Street Journal again, describing the linkages in the financial world, “With each firm intricately intertwined with others in a maze of loans, credit lines, derivatives and swaps, the Fed and Treasury agreed that letting Bear Stearns collapse quickly was a risk not worth taking, because the consequences were simply unknowable.”  Unknowable.  Not unknown for a while until the calculations can be made, but an unknowable maze that can’t be untangled.  An analyst for Barclays Capital estimated last month that if a counterparty with $2 trillion in notional credit-default swaps were to fail, it could lead to losses of between $36 billion and $47 billion for its trading partners.  But any such failing counterparty would have many other kinds of derivative exposure and so would its partners, so that Barclay’s estimate is surely low. 

The world financial system is facing a vicious self-reinforcing cycle of less and less confidence.  The biggest loser so far is Bear Stearns.  The Fed and the Treasury, by engineering a swift bailout of the investment banking company have demonstrated that they clearly understand the seriousness of the situation.  I am reminded of an anecdote repeated by Walter Isaacson in his biography, Einstein: His Life and Universe.  Following a lecture in the early 1920s, Einstein was approached by a young physicist who claimed that the equation e = mc2 implied that huge explosive forces were latent in tiny particles.  Einstein brushed the young man off.  It wasn’t until nearly 20 years later that he came to the same conclusion and wrote the letter to Franklin Roosevelt that sparked America’s development of the atomic bomb.  Sometimes, simple equations can have very far-reaching and profound consequences.

February Employment Picture

The Labor Department reported this morning that US non-farm payroll employment contracted by 63,000 jobs in February, the biggest drop in five years.  Payroll employment in both January and December were revised downward, bringing the total decline in payrolls for the last three months to 44,000.  Private sector job losses of 141,000 have been somewhat offset by an increase of 97,000 government jobs, mostly at the local level.  Jobs in construction and manufacturing continue to evaporate at a rapid pace, joined now in their long losing streaks by jobs in the financial sector and in temporary help.  The last is an important forward indicator, because employers often bring in temps as business starts to increase before committing to permanent workers.  The current decrease in temporary hiring—a loss of 44,000 positions in the last three months—indicates that fewer firms are experiencing increased demand.

In a separate survey, the unemployment rate actually declined, but the decrease to 4.8% is attributed to more potential workers simply giving up and dropping out of the labor force.  In the last two months, 492,000 people have left the labor force. 

Today’s reports increase the probability that the Fed will continue to reduce its target rate for overnight loans between banks.  Any further reductions, however, are unlikely to have much impact on credit conditions.  Many non-bank lenders have gone out of business, while banks and others have initiated a radical repricing of risk.  Essentially, every type of credit with the single exception of direct obligations of the US Treasury, has become more expensive and more difficult to obtain.  The Federal Reserve has responded by significantly increasing the funds it makes available to banks.  But the crisis in credit and liquidity has proven extremely difficult to overcome since it erupted last summer.  More than once, it seemed to be resolved, only to revive more virulently than ever. 

Mortgage Delinquency Still Rising

The Mortgage Bankers Association (MBA) released fourth quarter 2007 home mortgage and delinquency data today.  Mortgage problems continue to worsen with no sign yet of relief.  The national delinquency rate for all mortgages past due 30 days or more climbed to 5.82% from 4.95% a year earlier.  It’s now the highest in 22 years.  Subprime delinquency rocketed to 17.31%.  MBA statistics on foreclosures were equally disheartening.  More than 2% of mortgages are in foreclosure, the highest percentage by far since the MBA began counting in 1979.  The rate of foreclosure starts in the fourth quarter was 0.83%, similarly an all-time high.  An incredible 13.43% of subprime loans nationally are in foreclosure.  In Michigan, 28% of subprime loans are seriously delinquent and 17% are in foreclosure.  For Ohio, the percentages are 29% and 21%.  Here in Illinois, it’s 22% and 15.8%. 

In a separate report, the Federal Reserve announced that household net worth—in effect, the wealth of American citizens—declined by more than $500 billion.  It was the first such decline since 2002.

Tomorrow, the Labor Department will release February employment data.  Against the housing backdrop, it’s difficult to maintain confidence in an official unemployment rate that’s still reported below 5%.