The May Fannie May National Housing Survey, provided one of the most up to date snapshots of consumer perception and behaviour[i]. The bottom line is that consumers have become accustomed to expect rising house prices. What is interesting to note however, is that consumers are more aggressive sellers than buyers into the price strength. The motivated sellers are back. This was confirmed by Redfin’s latest “Bidding War” report, which found supply coming out to meet demand in May[ii]. More granular analysis of the Fannie Mae Survey yields important context.
There is a clear belief that mortgage interest rates have bottomed out. This seems to challenge the optimism on price rises; however it could explain why the sellers are more aggressive. People have articulated the end of the secular trend in falling interest rates; but only the sellers truly understand what it means for house prices.
The survey signals that the rise in rents is over. This is presumably why REIT IPOs and exit strategies for residential investors have become more aggressive of late.
Lending standards still appear to be tight; and consumers remain better buyers than renters. This is a headwind for the residential investors. It is also a headwind for home sellers, because it shows that demand has been pegged back by tighter credit standards. If interest rates where to rise, this would compound the credit standards hurdle.
The rise in house prices has made consumers more optimistic about the economy. This hasn’t really knocked on to individuals; as their own personal finances have simply not got worse rather than improved.
Household income is stronger; but this seems to be a product of deleveraging and economising. There is however no inflation on the horizon.
Putting it all together, the optimism on house prices is challenged by the declining rental driver and the continued consumer inertia. As the following graph shows, borrower behaviour has changed.
During the crisis and recession, Americans deleveraged. A falling home value was accompanied by falling aggregate mortgage debt levels, as borrowers paid down debts. The recovery in house prices has not seen any increase of mortgage debt by comparison. On aggregate, Americans have not gone further into debt to finance the rising home prices. One can therefore say that the recovery in house prices is not born out of a new debt bubble. It may however still be living on top of an old legacy debt bubble. More cash and less leverage has chased the recovery in prices. This means that any fall in prices can be worn with less new financial stress on the banking system; the legacy stress still remains however. The pain will be more acute for private capital this time; from houses bought at the bottom of the recession with larger cash down-payments. There is however still finanical stress on the banking system in relation to houses bought before the bubble burst.
The uptick in foreclosures and short sales, as fears grow for the interest backdrop, speaks to the existing legacy of stress. The banks have decided to speed up their exits, before the rise in interest rates starts to hurt prices. Realty Trac saw a significant acceleration in the pace of foreclosures and REO sales in May[iii]. Zillow confirmed that more inventory appeared on the market in June than in May[iv].
In Housing Smoke and Mirrors (6) “Schizophrenic US Housing Market” (“It was the best of times, it was the worst of times”), it as suggested that the Fed and the GSEs were in collusion to allow the GSEs to modify mortgages and then pass them onto the Fed as MBAS[v]. We asked:
“If the Fed is really trying to save the Housing Market, why would it not want to buy the very MBAS that are associated with the problem?”
This question has just been asnwered by the New York Fed in their paper entitled “Paying Paul and Robbing No One: An Eminent Domain Solution for Underwater Mortgage Debt”[vi].
The latest CoreLogic delinquency survey reports that more than 8% of outstanding mortgages have a Loan to Value Ratio greater than 125%[vii]. This is where the Fed would get the most Bang for its Buck. The graph provided by CoreLogic also shows this stubbornly high Fat Tail, which is not progressing through the belly of refinancing python. This suggests that this Fat Tail is located somewhere illiquid, that currently cannot be digested. We would suggest that these are the RMBS that need remedial action from the Fed.
In Housing Smoke and Mirrors “Exit Rush” it was observed that most of mortgages that can be modified and refinanced have been addressed. This leaves only 18% of available mortgages that can be modified and refinanced. Clearly the Fed and the GSEs have been active; and are running out of mortgages to be stuffed onto the Fed’s balance sheet. This means that the MBAS market itself must be sourced, rather than the primary mortgage market. This is where the New York Fed’s study comes in.
Since the mortgages underlying MBAS are pooled and then distributed across different investor territories, there is no single collective action authority associated with restructuring the underlying mortgage assets. To overcome this legal and operational hurdle, the New York fed suggests the use of Eminent Domain. Using Eminent Domain, a central state or municipal authority would set up a vehicle to acquire the distressed mortgages that were applicable to the residences in its jurisdiction. These mortgages would be picked up at “fair value”; and the New York Fed does not say that this is a market price but it is implied. The financing for these transactions would be Federal and/or Private Capital. The suggestion for Private Capital is even more interesting; as the New York Fed actually suggests issuing vouchers to those banks who tender their MBAS. This sounds suspiciously to us like the liquidation of the MBAS holders, along the same lines as what are known as “Bail Ins” in Europe. The holders of these vouchers will then be entitled to an income stream from the modified mortgage. The can of worms of the distressed MBAS has been opened. Moving in parallel is an initiative from the Fed to induce banks to apply Basel III asap; and to raise more balance sheet capital. This move has been spearheaded by the Fed’s Bloom Raskin[viii] and Plosser[ix]. In the context of Eminent Domain, Bloom Raskin and Plosser’s initiatives make perfect sense. They are preparing the banks for the double whammy of Eminent Domain and rising interest rates.
We suspect that the Fed is now going to force the MBAS market out into the open, on-balance sheet as opposed to off-balance sheet. The Eminent Domain initiative is the tool that will be used to flush the MBAS out. If the banks aren’t holding enough capital, it is going to get nasty. It is going to be especially nasty for foreign banks that are “capital light”. It is now clear why the Bank Lobby in Washington is using the issue of loss of international competitiveness by the application of Dodd-Frank to push back against the Fed’s capital agenda. The real issue is that both the US and Foreign Banks are fearful about having to come clean on their MBAS portfolios. It looks like they are about to be “Bailed In”.
The Rating Agencies smell blood. JP Morgan’s outlook was moved to negative by Standard and Poor’s[x]. The key signal is that the implied Federal Bailout has gone. We would suggest that the Eminent Domain and MBAS are involved in SandP’s thought process also. Fitch also issued a nuanced update on Residential Mortgage Backed Securities (RMBS)[xi]. According to Fitch, post-2010 Vintages are healthy; and those issued between 2003 and 2005 are also in good shape. It is economical with its words about all those vintages between 2005 and 2010 however; but is careful not to say that they are as healthy as the others. Reading between the lines, we would say that Fitch sees problems with the 2005 to 2010 Vintages. We would also say that Fitch also sees this issue being amplified by Eminent Domain, as the Fed moves into gear. The distressed vintages equate to the 125% LTV Fat Tail in the CoreLogic graph above, which lies off-balance sheet as collateral for distressed RMBS. It is reassuring to see the Rating Agencies getting ahead of the mortgage market problems this time around. Their interest is clearly aligned with the regulators, rather than Wall Street this time. It is also clear that they don’t see a “Bail Out” of those banks, unwilling to follow the prescribed course of action on capital adequacy. This time around it would seem that the “Bail Out” is going to be of indebted Americans, with mortgages that have been securitised and sold on. No doubt the banks will cry Socialism, but they were the first to have their faces in the Federal Trough.
We would not expect the banks to stand like startled rabbits in the headlights of this oncoming juggernaut. In addition to employing stalling tactics through their Lobby, they will also speed up the foreclosure and REO short-sale process on their housing inventory; as the latest RealtyTrac data shows. The stampede is not just to avoid rising mortgage interest rates; it is also to avoid rising capital requirements for these assets. This stampede may itself trigger a fall in house prices, which then snowballs into something more worrying for the Fed. The Bankers may call the Fed’s bluff again; and ask if it really wants another housing crisis. The Fed has set out its stall to let them fail however; so it’s going to be an interesting poker game. In the meantime, capital markets volatility does the damage to the real economy. If the bankers play smart, they can trigger another recession; so that the Fed is forced to remain easy for even longer. The problem is however that the creation of such a crisis destroys the balance sheets of banks playing the game; and there will be no “Bail Out” for them to fall back on this time.