In Housing Smoke and Mirrors (4), it was suggested that the bad eggs in the 2005 and 2009 Mortgage Vintages were hatching; and creating a growing systemic threat.
The Federal Reserve and the Federal Government were observed to be running swiftly into the housing market, to confront this threat. This threat was however being manufactured and accelerated by the behaviour of the commercial banks, through the process of “Zombie Home” creation.
Of the “Zombie Homes” it was said that:
“It is here in the “Zombie Homes” that we suspect that some of the great frauds, that have so far gone uninvestigated, are to be found. These are the bad eggs that are currently hatching; and causing the counter-trend worsening delinquency pattern in the chart. America is a big place, so the physical manifestation of this issue, in dilapidated homes and run-down neighbourhoods, has been hidden at the national level. As it festers and grows, at the neighbourhood level, it will however become a visible issue; that will cause a national outcry, especially if house prices in general begin to fall.”
Of the behaviour of the banks it was said that:
“If the banks are lucky, they will have transferred a lot of the risk to the Taxpayer before the stick is applied. If they are unlucky, this big stick will come during another housing crisis, in which there are no Taxpayer funded bailouts for them. The problem is that the banks are now in a hurry to get away from Government and the Fed. As a consequence, they have cranked up the foreclosure process; and in doing so, they have accelerated the upward slope of the 2005 and 2009 Vintage default profiles to become systemic threats. The banks are therefore driving the next crisis closer faster, just as the Federal Government and the Fed are trying to postpone it. Government and the Fed need to jump in quickly, before some of the banks have the great idea of going the other way and getting the “Big Short” on again”.
Recent data on credit suggests that we are nearing a point at which the Federal Reserve will have to assume all of the risk in the 2005 and 2009 Vintages onto its balance sheet.
Bank mortgage lending is erratic, but generally flat. This reflects the fact that banks are raising lending standards; and getting out of what is perceived to be a risky business that does not adequately compensate, in terms of yield, for the risks that a bank is taking and the extra capital it must deploy.
The Quarterly Net Issuance graph (above) clearly shows the banks busily getting the mortgage risk off their books.
The Federal Reserve is readily acting as the warehouse for these securitized mortgages. The Fed is therefore driving healthy securitization fees to Wall Street, at the same time that it is taking the risk off Wall Street’s books. Once again, observers may see the asymmetrical pattern of risk and reward that the symbiotic Fed and Wall Street ecosystem nurtures. In addition to taking the risk and paying to take this risk, the Fed takes the further generous position of replacing the bad mortgage credit risk with allegedly “AAA” Federal Reserve credit risk in the form of Reserves. The reader will see that the pace of Fed mortgage buying is back to where it was at the peak of the crisis in 2009. The reader may also further conclude, with some justification, that there is a crisis of the same magnitude now unfolding. This crisis is however “Bank-to-Fed” (B2F) rather than “Bank-to-Bank” (B2B).
Not only is this crisis going unnoticed, but there are those, who are ignorant of it, opining that the housing market is strong and recovering. There is even data, to back up the constructive view; as shown above in the latest Case-Shiller Index. How can one argue with data like this? An intuitive mind would say that the last time the Case-Shiller looked like this, was just before the last bubble peaked. This cynical view is consistent with the observation of the previous chart that shows the change in the Fed’s balance sheet mortgage holdings.
The latest foreclosure data for March (above), shows a major improvement from 2008. The improvement has been driven by falling foreclosures, rather than by rising mortgage originations. The big improvement came in 2010, when the Fed embarked on its mortgage backed asset purchase QE programme. The latest improvement began in Q4/2012 when it was announced that QE would be increased and extended. It is therefore clear that it is the Fed that is driving the housing market; and not the economic recovery that is the driver.
If the contrarian view still fails to persuade, the reader should then try asking how it is possible that house prices can rise, if unemployment is still as high it was during the crisis and salaries have not risen in the recovery. Taking all this into account, along with the fact that banks aren’t lending and have raised lending standards, the rise in house prices back to bubble levels is tenuous to say the least. The “Smoke and Mirrors” have done their jobs admirably for those who accept and don’t question.
Just for good measure, the Fed then also pays interest on these Reserves. Critics may rightly claim that the Fed only pays interest on Excess Reserves; but as the next graph shows, since bank lending has been flat, there are only Excess Reserves in the system.
Because there is negligible real bank lending going on therefore, the only net addition to bank lending assets are in fact Reserves. These Reserves are de facto in “excess” therefore; so that they receive interest payments from the Fed. “Zombie Banks” are thus just really lending to a “Zombie Fed”. The Fed has also generously hedged the banks for the next life, in a rising interest rate environment. The Fed line is that when the time comes to exit, interest rates will rise by the trigger of the raising of Interest Paid on Reserves (IOR). Thus when interest rates do rise, the banks will have the cushion of a floating rate asset provided by the Fed, to hedge their books with, as other fixed interest assets on their books take a hit.
So what becomes of the 2005 and 2009 Vintages that the Fed is warehousing? Is the Fed really going to take a capital loss on them? Possibly, but not probably.
These Vintages will then get modified by the Federal Government modification programmes; so that the borrowers now have the ability to stay in their homes, rather than be ejected as the mortgage servicing company creates a new “Zombie Home”. In effect, the Federal Government (the Taxpayer) is now bailing out the Federal Reserve; by making sure that these mortgage assets can remain current. We’ll call this “Federal Government-to -Federal Reserve” (F2F). The great thing about this system, is that the Federal Reserve is really the one bailing out the Federal Government through QE. The whole system thus becomes a huge netting off process on a computer spread-sheet. No real money is created, so there is no inflation. It’s rather like a Federal version of Bitcoin. If anyone is confused, they should be. The observer is supposed to draw the curtain back over this perpetual money making machine; and swiftly return their gaze back to the “Smoke and Mirrors”. The “Smoke and Mirrors” have worked so well that even the doyens of the Hedge Fund community want to get in on the action. Seeing how the perpetual liquidity machine works, to bail out both the Fed and the Treasury, they are crying to get a piece of the action by converting their preferred shares in Fannie Mae into full private ownership[i].
The famous line, from the first Wall Street classic movie, has now been adapted to say that “Blue Horseshoe loves Fannie Mae!!!”
This system only works for mortgages that have not yet foreclosed; so the future pipeline of foreclosures has a modified future in the Fed’s balance sheet warehouse. But what happens to the 2005 and 2009 Vintages that are already “Zombies”?
They must exist somewhere, on or off balance sheet, at the banks. This raises the important legal question of who takes the losses on the existing “Zombie Home” mortgages. Clearly the banks are trying to unload these onto the Fed’s balance sheet as fast as they can. It will be interesting to see if the Fed accommodates this fraudulent behaviour. There are clearly some Moral Hazard issues here. If the Fed does not accommodate this action, then there is the risk that these Vintages have to be marked to market; and blow up the banks’ balance sheets. If these Vintages were to blow up, then there would be a risk of another “Lehman Moment”. The Fed therefore must choose its poison carefully; and must also pay close attention to its legal position as an agency. Furtherance of a fraud, with the intention to save the US Economy, was not something that the Founding Fathers had foreseen. The Fed may have to observe its Constitutional Rights and take the Fifth, if the “Smoke” thins and the “Mirrors” crack enough for the American People to see what is really going on here.
Professor Jeffrey Sachs has clearly seen through it; and is making sure that the public are aware of what is going on. He recently opined that -
“what has been revealed, in my view, is prima facie criminal behavior.”[ii]
He succinctly described the “Zombie” environment as being nurtured by -
“a docile president, a docile White House and a docile regulatory system that absolutely can’t find its voice.”
Then he combined Wall Street professionals who -
“are tough, greedy, aggressive and feel absolutely out of control in a quite literal sense” and who “have gamed the system to a remarkable extent.”
His comments have set the context of what happens next.
The “docile president, docile White House and docile regulatory system that absolutely can’t find its voice” seem to be deaf to Sachs also; perhaps deliberately so. The latest official “voice” that has been nominated, to replace the strangled voice of Ed DeMarco at the FHFA, has some very interesting less-than-arm’s-length connections to the Voodoo practitioners in the financial sector who have created the “Zombie” issue. Mel Watt[iii] would seem to be an individual with the ability to sweeten the bitter taste of the rotting 2009 and 2010 Mortgage Vintages, before they can be tasted by the Taxpayer. We smell a cover up and so does Congress; so this nomination is going to be challenged. The classic signal of a White House cover up has been given by the President’s response to this issue. Presidential Investigative Commissions are famous in American history, as the vehicles by which official cover ups are undertaken in issues of national political and economic significance. The announcement, by Congressman Elijah Cummings, of an independent review board has all the hallmarks of such a cover up[iv]. The new monitor, that Cummings suggests, will not pursue the frauds; it will simply make sure that those who have been defrauded are paid-off for their silence. Many of those who have been defrauded are Veterans and heroes, so it is clear that the optics of this situation require a soft political touch.
In relation to the hedge funds, that made outsize gains with inside knowledge during the “Big Short”, it would be amusing to observe the Federal Government and the Fed put on their own “Big Short”, by loading Fannie and Freddie with “Zombie Mortgages”; and then letting the Barbarians at the Gate take them private. Possibly, but not probably.
In real life, due diligence would reveal the problem 2005 and 2009 Vintages; and the hedge funds would swiftly go the other way causing the next crash. It is far more likely that the hedge funds will cherry pick the mortgages they want in the “Big Long” Fannie Mae/Freddie Mac privatization, as they did when they put on the “Big Short”; and the leave the worthless “Zombies” on the Fed’s books. Out of work, former Treasury Secretary Geithner would then become the well compensated CEO of the newly privatized Fannie Mae/Freddie Mac combo. This issue, like many other American state secrets, must therefore lie buried until the “Zombie” mortgages mature; and they still miraculously appear to redeem at par, thanks to the “F2F” financial model. The real story will then be read many years into the future, when the freedom of information law allows the archives of this shadier part of American history to see the light of day; and when those individuals involved have also been redeemed at par.
There is however one unintended consequence of life at the “Zero Bound” that everyone, with the exception of Bernanke, may have missed. This oversight has the potential to take markets by total surprise. This oversight comes back to observation made in “Housing Smoke and Mirrors” (1)[v], that the “housing market is therefore the hostage of economic growth and not the signal of economic growth”. There are signals that the speculators in the financial markets have put the cart in front of the horse, in relation to the housing market. The current wisdom is that the rise in house prices is the signal of a strengthening economy. The information that the housing market is rallying because banks are holding back inventory and the Federal Government and Federal Reserve are supporting prices, is ignored by the speculators as being insignificant. If one pauses and thinks about these facts, then the whole framing of the situation changes.
Evidence from the Mortgage Bankers Association (above) since 2011, shows that refinancing is driving the mortgage business. Mortgage rates have fallen, but the level of purchases has remained relatively flat, compared to refinancing that has increased. This means that the housing market has reached a level of interest rates and housing prices at which it can no longer clear. Borrowers are refinancing and holding out for higher prices, but it is now clear that higher prices are not attracting new purchasers. The very fact that interest rates are so low, is because the economy is so weak. The weak economy therefore does not generate the jobs and income to clear the housing market at these price levels. Suddenly betting on a rise in house prices does not look so good, unless one thinks the economy is strengthening. The fall in interest rates however signals that the economy is weakening, therefore there can be no further sustainable rise in house prices. Housing is therefore confirmed as “the hostage to economic growth”. It is ironic to understand that a rise in interest rates, because the economy is strengthening, will be the real signal that a rise in house prices is sustainable.
The market is currently fascinated with the bizarre notion that house prices can’t rise because there is no housing stock available to be sold at higher prices. What happened to the scenario in which the buyers raise their bids until the existing holders sell? It is clear that buyers won’t pay the higher prices to attract this wave of selling. The thesis that lack of stock is holding back transactions at higher prices is therefore not credible. The market won’t clear, because buyers and sellers can’t agree at this level. Either the buyers have to raise their bids or the sellers have to drop their offers.
In the current situation, in which the housing market cannot clear with purchase mortgage financing, only the cash buyer and/or the buyer who puts a large deposit down can play. We suggest that it is these people who have cleared the market in the recovery; and particularly from 2011 to date. Tighter lending standards have precluded the higher leveraged buyers from participating in the rising prices. The less leveraged buyers have been able to clear the rising market, because they have a lower interest rate burden, by nature of low mortgage rates and large cash down-payments. Rising rents have increased the positive carry, for buyers of this kind who are investors. We believe that it is these investors who have been driving the market since 2011. The market can therefore continue to clear at these levels, as long as rents remain at these levels or go higher. The recent signal, from the declining mortgage purchase data however, suggests that this situation has been challenged. Interest rates have been falling, but purchasing activity has also fallen. We may therefore be reaching the limit of sustainable rents. In other words, the housing market has reached a negative turning point, because of falling economic activity. This time around, the horse and cart are in the correct positions. Interest rates are low because the economy is slowing; and house buyers are staying away for the same reason. If this is the case, then the other Mortgage Vintages in addition to the 2005’s and 2009’s may be starting to go sour.
The latest academic research suggests that the rental sector is reaching a breaking point, in the absence of improved economic growth. The 2013 annual report from the Center for Housing Policy, Housing Landscape 2013, is appropriately entitled “An Annual Look at the Housing Affordability Challenges of America’s Working Households”[vi]. The conclusion is that “working renters” are having a harder time of it than “working owners”. We find the qualification “working” very important. Clearly the overall state of the economy is more important for those in work, than the level of mortgage interest rates that the Fed is able to manipulate. As with all the housing studies, this data is historic and ex-post. The reader should then extrapolate the rising rental/weakening economic trend lines, from the 2011 report datum forward to today and into the future, to get a good current and an ex-ante view of the situation. Clearly the situation for renters is worse today; and assuming that it has not already broken, it will get worse in the future until it does break or the economy improves.
The housing bulls would say that this study simply implies that it’s better to be a buyer than a renter; but they would be missing the point that “working owners” incomes have now fallen below their falling costs (see the bar chart below). As Disraeli said there are lies, damned lies and statistics; however there are also facts. Both “working owners” and “working renters” are distressed (the latter more so); and we don’t know of any other human constituency in the housing market to drive prices and/or rents higher.
If the Fed responds with lower interest rates, this will support house prices because the gap between rental income and falling mortgage cost will widen. The Fed will then attract another wave of buy-to-rent investors into the housing market. This however simply rewards investors, rather than stimulates the economy (a classic Fed problem). The rising “working renter” distress phenomenon is however an economic headwind, that is increasingly taking disposable income out of consumers’ pockets; and is holding back the economic recovery. If the rental home owners are kind, they will hold rents flat and simply earn the spread from lower mortgage costs. In practice however, they are more likely to see how far they can raise rents before subsisting on the lower interest cost. There will also be those owners who wish to protect themselves, from a turn in the interest rate cycle, by building a higher rental income cushion. In fact, the lower interest rates go, the higher the tendency to build-in this cushion; which is the mirror image of tighter mortgage lending standards. The Fed, through its good intentions, has once again rewarded investors and penalised the economy. The Fed did not think this through, it just made things up as it went along and its balance sheet grew. At this point, all the Fed is doing is creating another housing bubble; that will burst when the renters stop consuming other goods, to pay their rent, so that another recession comes. Tackling this next recession with low interest rates and lots of liquidity will not be an option however, because this crisis will occur at the “Zero Bound”. At this point, we suspect that the “Helicopter” will be seen and heard; however this is a topic for a related discussion called “Terminal Velocity”[vii].