Housing Smoke and Mirrors (10) – “ Exit Rush”

Written by , KeySignals.com

In Housing Smoke and Mirrors “Turning Point”, the rush to exit the Real Estate risk asset class was observed to be gathering momentum, just as the headwind from rising interest rates was getting stronger[i].

A larger image is available [Here]

A larger image is available [Here]

The rise in interest rates has been sharp; and Freddie Mac recently reported that mortgage interest rates are now at a one year high. Refinancings have been the hardest hit by the rise in interest rates. This fall in refinancings signals that the mortgage modification process has also hit an obstacle. The strategy for the GSEs to bundle together mortgages and then shift them off balance sheet to the Fed as Mortgage Backed Assets (MBAs) has therefore also hit an obstacle; which means that the Fed’s strategy to support the housing market has been undermined. In addition, the Fed may now be sitting on some capital losses, from recently acquired MBAs.

The timing of the Office of the Inspector General (OIG) for HUD and the FHFA announcement, that it will be increasing scrutiny and auditing of their Real Estate Owned (REO) portfolios and processes was interesting[ii]. The OIG did not start its auditing process until 2011, some two years into the alleged recovery from the crisis; so it is generally well behind the times. The latest move signals that the OIG is trying to get ahead of events. The sudden rise in REO inventory is signalling that risk is once again starting to build up. The OIG also warned that there is a looming Shadow Inventory that is even larger than the existing REO inventory. The OIG wishes the expedite the process by which the REO Inventory gets sold, so that HUD and the FHFA don’t get overwhelmed by the rising Shadow Inventory and unsold REOs. Clearly the OIG would like to quantify and qualify this risk; and understand how HUD and the FHFA intend to mitigate it. Policy makers are worried.

This worry was also reflected in the tone of the minutes of the meeting of the Federal Reserve Advisory Council Members with the Board of Governors[iii]. The Council Members are keen to push ahead with GSE reform; to shrink the Federal Government footprint and replace it with private capital. The ideal model is judged to be one in which private capital underwrites the mortgages that are repackaged, with a Federal guarantee as the backstop. The Council is worried that the Federal Government has become so big, that it cannot leave the mortgage market without destroying it. Given the capital requirements going forward, it is far from certain that private capital would be interested in replacing the Federal Government in any case; since equity capital is much more expensive than a simple Federal Guarantee which costs nothing. The GSEs have already opined that their multi-family businesses will not work as stand-alone privately financed entities[iv]; because the costs of doing business are too high without the direct Federal Guarantee. It is therefore logical to assume that this predicament also translates into the single-family sector, because the GSEs are the dominant players in this market. The only way they got dominance was through the Federal Guarantee. The Council however seems blind to this obvious deal-breaker to getting the GSEs private. The Council also opined that it was worried about the systemic risk created by the Federal Reserve’s expanded balance sheet. Clearly they believe that the Federal Reserve footprint is too large also.

The Council has therefore indirectly identified the biggest problem in the housing market from a structural perspective. The combination of Federal Government and Federal Reserve has created an interest rate structure that is artificially low. The Federal Guarantee lowers the risk premium on mortgages; and then the Federal Reserve lowers it some more through QE. As a result, the term structure of interest rates is so low that private capital cannot be adequately compensated for the risks that it is taking in the housing market at the current level of interest rates. There is therefore no incentive for private capital to increase its involvement. In fact private capital is actually using the artificially low rates of interest to exit the business at a profit. GE owns the latest “Real Estate Shadow Banking” operation to accelerate its exit through trade sales and potential IPO at GE Capital[v]. Clearly GE’s bottom line will no longer be driven by financial services in the future. The Federal Government and the Federal Reserve can thus never leave the housing sector, until interest rates are much higher. Higher interest rates right now however, would kill the housing market and the economy. The Federal Reserve is trying to manage the course of interest rates higher, so that private capital will engage again. The rise in interest rates must however not be too swift and violent; because it would do extreme damage to the economic recovery, which would then require more Federal intervention. The clumsy communications from the Federal Reserve represent the dangers associated with this managed exit strategy from QE. The only way for the Federal Reserve to get out without a loss, is to buy assets at a discount and allow them to mature at par.

The rating agencies have been stigmatized by their failures before and during the “Credit Crunch”. This time around, it seems that Fitch is determined to get ahead of the game without being the alarmist “Canary in the Coalmine” who triggers the next crisis. Its latest comments, from the report entitled “US Residential Recovery Too Fast in Some Local Economies”, show how it is walking this thin line of egg-shells:

“Recent regulations have limited the pace of foreclosure sales and the large percentage of underwater borrowers continues to hope for further price increases to be able to sell their homes at a profit.”

In relation to rental investors it said:

“supply-demand imbalance is even more pronounced”

“artificially high,”


Fitch is now positioned to start making the downgrades. It has specifically called out the rental speculators; and so it is actually helping the Fed deflate the housing bubble.

Advanced signals of the slowing in the housing market have also recently started to come from the construction sector itself. The latest April Construction Spending data clearly shows a slowing pace of activity.

A larger image is available [Here]

A larger image is available [Here]

Policy makers and regulators are right to be worried. There have been dangerous signals from the housing market that suggest that a bubble has been created again. When Lending Tree reports that down-payments have been declining, as house prices have been rising, one immediately thinks that lending standards are defaulting back to bubble norms[vi]. A more amusing, but nonetheless worrying signal came out of Martha’s Vineyard[vii]. One enterprising broker is offering properties with “zero down-payments”; exploiting the loophole that the whole island is owned by the Department of Agriculture (USDA) and therefore qualifies to get away with this. When brokers can use loopholes to bend the lending standards, this is symptomatic of a bubble. The most iconic signal of the slowing rental housing market was given in the announcement by American Homes 4 Rent that it will be heading for the IPO window soon; with the iconic bankers from the “Credit Crunch” (Goldman, Bank of America, JP Morgan and Wells Fargo) managing the exit for a fee[viii]. Perhaps the most amusing stress indicator came from the hasty postponement of the equally hastily announced IPO of the Colony American Homes Inc REIT[ix]. Investment advisers who have not been able to exit for their investors will need to start procrastinating. There were signs of this procrastination emanating from MemphisInvest.com and Premier Property Management Group[x]. The speculative rise in rental properties has effectively destroyed potential holding period returns that have been promised in the glossy Private Placement Memoranda to encourage investors to treat. As a consequence, managers are now scaling back their property purchases and extending their holding period projections to achieve the desired returns. Suddenly managers are talking more about the importance of rental income as a driver of return rather than capital gain. Rents are stagnating however and investment property prices are just starting to fall; suggesting that these managers have made a very high investment entry point. If their investors are smart, they will ask for the money that has not yet been committed back as soon as possible; and start reading the small print in the PPM’s  about early redemptions and liquidity windows.

Radar Logic reported that the rise in house prices was unsustainable in its most recent commentary on the March data[xi]. We are now into June and mortgage interest rates have risen; so by the time this current data filters through, in a few months’ time, commentators will say that the market has turned. The problem with the housing price data is that it lags.

A larger image is available [Here]

The latest CoreLogic data highlights this problem. The data is for April; and shows prices rising 12.1% year-on-year to give their best performance since 2006. The May data will now be critical in the analysis of determining if the market has turned; but this will have to wait until it is released July.

A larger image is available [Here]

The latest delinquency statistics (see graph above), which show a continued improvement, will no doubt be somewhere near the front of the REIT IPO prospectuses. This however would be comparing apples with oranges, since these REIT IPOs are really a form of Commercial Real Estate transactions.

When doing due diligence of Commercial Real Estate delinquencies, greater attention should be paid to the multi-family sector. There are some interesting anomalies here.

Against the general backdrop of improving delinquencies, Fannie Mae appears to be bucking the trend with a sudden uptick in delinquencies. Freddie Mac got burned in this sector, during the 1990 recession and is not going back there. Fannie Mae was far less exposed and less burned back then; so it seems that it has more of an aggressive risk appetite that is now starting to become a problem as the economy slows down again.

A larger image is available [Here]

The banks and thrifts are however seeing significant reductions in their delinquencies in the multi-family sector. They blew up in the 90’s and made the same mistake between 2005 and 2008. The improvement since 2010, although impressive, is much weaker than the rate of decay when they initially blew up in 2008. The risk profile is therefore asymmetrical; with it being easier to blow up than to improve. Banks and thrifts therefore look extremely vulnerable at this point.

The Life Insurance sector, stands out as the financial institutions that learned from their mistakes of 1990’s and avoided the bubbles of the 2000 to 2008 period. That’s the good news; but if they have been involved in the bubbles in fixed income (especially High Yield) of late then things aren’t so good. At least the Life sector has got more liquid assets that it can sell faster than illiquid property in a crisis.

The tip of the iceberg is however shown by Commercial Mortgage Backed Securities (CMBS). The delinquencies here remain elevated; which is not a good place to be in an environment of a slowing economy and the potential reduction in Fed liquidity. If these assets are not showing up on balance sheets, it can only mean that they are still in Special Purpose Vehicles (SPVs) off balance sheet somewhere. “Commercial Real Estate Smoke and Mirrors” would be a whole new topic of its own; so we will limit ourselves to Housing Smoke and Mirrors only, but raise a red flag on the CMBS issue.

The House Committee on Oversight and Government Reform, chaired by Darell Issa (R) attempted to see through the Smoke and Mirrors being used by the FHA[xii]. In a letter, dated May 29th and made public on June 4th written by the Committee, it was suggested that the FHA had been lowballing its stress test worst case scenario of the impact of another crisis on its guarantee function. The FHA estimated a $65 billion impact versus a figure of $115 billion suggested by the Fed itself. This information is not so much interesting because it shows the degree of window dressing by the FHA; but more because it shows the magnitude of the problem quantified by the Fed. If the Fed ends up owning most of the distressed mortgage debt (as we suggest), it is going to be asking the US Taxpayer to underwrite $115 billion of this.

Taking note of the wall of worry that is swiftly being built, it is instructive to look at the evolving debt position as rising interest rates start to impact. One clear risk is in relation to the competing forces of debt refinancing versus delinquency. Borrowers are currently rushing to modify and refinance their mortgages, to lock in lower finance costs before interest rates rise. The latest Lender Processing Service’s (LPS) Mortgage Monitor reported some interesting data about the internals of the refinancing market[xiii].

A larger image is available [Here]

The data showed that refinancing suffered recently as mortgage interest rates have backed up. What is termed “Burnout” was also observed in the post-2009 Vintages. Modification eligibility through HARP is limited to pre-2009 Vintages, which are seeing healthy use of this programme and refinancing. Post-2009 vintages have exhausted most of their refinancing possibilities. Pre-2009 Vintages are now most at risk from the backup interest rates. Even once they have been modified through HARP, the rate of interest may now be too high for the borrower to sustain. Risk is therefore growing in the pre-2009 Vintages; and there is also limited room for improvement in the post-2009 Vintages. The improvement in prepayments for borrowers with low credit scores may therefore be stalling out. The LPS estimates that there are 18% of outstanding loans that remain “refinancible” at the current level of mortgage rates. The race is now on to refinance them before the low interest rate window closes.

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