The race for the IPO exit, by early rental investors, was observed in Housing Smoke and Mirrors “Get out of Jail”[i]; and Lehman was observed trying to avoid its previous mistakes by selling its REIT shares in Housing Smoke and Mirrors (8). Ellington Management LLC has recently announced that it is joining the rush to the IPO window[ii]. The stampede to the exit in the real estate sector has not been without its casualties however; Armour Residential REIT and Javelin Mortgage Investment REIT shares have been amongst the biggest losers so far this year[iii]. More recently, selling activity has also been observed in Europe[iv]; where the banks are unloading their US subprime legacy.
Timing for all these exit strategies could not have been worse. Since the Fed’s equivocation in its recent minutes, about the “Exit” and/or the “Taper”, the US Treasury Bond market has sharply backed up in yields[v]. With the recent auction flop and the Ten Year yield punching convincingly through 2%, convexity sellers have been shaken out of the woodwork. This has had the knock on effect of raising mortgage interest rates[vi]; and in the global capital markets rising US real yields are attracting capital and driving up global interest rates[vii]. Suddenly the global economy is facing the headwind of rising yields, at a time when inflation is still falling. The fragile debt superstructure that underpins the global economy is now threatened again; even at this low nominal level of interest rates, because inflation is so low.
Despite these early warning signals from the capital markets, most of the US Housing Market remains oblivious. The latest Redfin Second Quarter Survey found irate buyers; angry but still willing to chase the offer side of a market, where inventory is being deliberately withheld by the banks[viii]. The latest “Housing Pulse” found investor activity slightly weaker in April than March, but still up year on year. Investors are now trying to buy “relative value”, in properties that need substantial renovation in order for them to be rentable[ix].
House prices are now hovering around a significant support line of the multi-decade uptrend. Some claim it’s been broken and the recent recovery is a dead-cat bounce; and some claim that support is holding. Clearly, the market is at a critical phase.
It appears to be supported by the fact that housing affordability versus renting is back at late 1990’s levels. Affordability is however more of a function of low interest rates and rising rents than incomes. A rising interest rate environment therefore invalidates this affordability thesis.
A picture is emerging of housing sellers into a rising interest rate environment. This is a recipe for disaster, as sellers suddenly start chasing falling prices in their haste to get out. It remains to be seen if the frustrated buyers, will be as aggressive in the face of the deteriorating fundamental and technical picture.
Fitch shed some light on the situation, in its latest report entitled “Short Sales Now the ‘Order of the Day’ for U.S. RMBS Servicers”[xii]. Between 2010 and 2012, loan modifications declined in favour of short sales. Fitch admits that this is because modifications have had a habit of becoming delinquent again. It also states that the improving equity position of borrowers, as house prices have risen, has led to a greater tendency towards short sales rather than modifications. Clearly servicers have been doing short sales as the home equity component went from negative back to positive. It can be concluded that the size of the home inventory therefore varies directly with the amount of home equity. It is possible to imagine that the current low supply of inventory is primarily due to the fact that there are still large numbers of homes with negative equity. Supply has therefore been a function of home equity in the recovery. Thus if prices begin to fall again, supply will decrease sharply also; as negative equity starts to increase. It can be concluded that the reluctance to take a liquidation loss has been the key issue causing the housing market to be dysfunctional. On the other hand, rising home equity also presents the pecuniary incentive to hold on to the assets; so that larger gains can be booked on the eventual sale. We suggest that the banks have latterly become greedy; and are believers in their own ability to control home prices higher by holding back inventory. Banks therefore don’t want to sell when home prices are falling; and they also don’t want to sell when home prices are rising. RealtyTrac recently confirmed this asymmetric dysfunctional behaviour in its latest report[xiii]. Daren Blomquist, vice president of Irvine, California-based RealtyTrac, said in a telephone interview that -
“Prices going up take away the urgency from banks and homeowners from having to do a short sale.”
Before selling, in an attempt to avoid losing money or damaging their credit scores, he also said that the negative equity owners -
“may be willing to stick it out a few more months or even years.”
The graph above clearly shows this dysfunctional asymmetric behaviour. The rising In-Foreclosed Days to Sale Line (orange) shows the banks holding the inventory back for higher prices. The falling Bank-Owned Days to Sale Line (red) shows the banks speeding up the REO sale on the homes with positive equity. These two lines have to diverge in order for the banks to support prices. Note carefully that the orange line has to rise more steeply and in outright terms, than the red line, in order for the price support to work. In effect, more houses are withheld than are sold, so supply is less than demand. These two divergent lines tell the real story of what is going on. The divergence of these two lines is a source of risk for the banks however, in the event that prices start to fall due to an exogenous shock from outside of the housing sector e.g. the capital markets. This divergence began at the end of 2008; which was the bottom in house prices. This game has therefore being going on since 2008. The Fed has supported this dysfunctional asymmetric behaviour, by trying to create positive home equity through its QE programmes. The banks seem to believe that this divergence is sustainable; however Mr Blomquist has a warning for them. He opined that,
“Short sales have been seen as an alternative to foreclosure, and some people were counting on that to continue in 2013, but we aren’t seeing evidence of that right now.”
The banks have now started to game the Fed; and thus the situation has returned to the status quo pre-Crisis. Moody’s seems to subscribe to this view, as it has recently just upgraded the US banks to stable from negative[xiv]. The FDIC has recently highlighted the financial performance commensurate with this dysfunctional asymmetric behaviour[xv]. It recently reported that -
“improvements in non-interest income and expense, plus broad-based reductions in loan loss provisions, outweighed declining net interest income and helped lift industry earnings to an all-time high of $40.3 billion in first quarter 2013.”
Moody’s clearly believes that improving home equity translation into declining loss provisions, justifies a stable rating; even when bank lending margins are falling. This seems premature, because as the graph below shows banks are still holding about four times the amount of REO assets that they had pre-crisis.
The new business model for banks has thus become that of housing supply oligopoly rather than lender. This situation is anything but stable. Admittedly it is better than the seven times figure at the height of the crisis, before the Fed started buying MBAs.
The Existing Home Inventory data suggests that the banks have slowed down the pace of their sales. This can be for two reasons. Firstly, there may not be enough homes with positive equity to be sold. Second, the banks may be holding back on homes with positive equity, to make greater gains to fund the losses on those still in negative equity. A combination of both reasons is more likely. What this graph shows however is that the banks are running the risk of being caught with the parcel again if/when the music stops.
The anticipated turn in the rental market, from Housing Smoke and Mirrors “It was the best of times, it was the worst of times”, also seems to be coming to fruition. The Hedge Fund Manager Bruce Rose, of Carrington Holding Company LLC, bluntly opined that -
“We just don’t see the returns there that are adequate to incentivize us to continue to invest.”
Of the “slow witted” buyers that were referred to in Housing Smoke and Mirrors “It Looks Ominous”, he also said that -
“There’s a lot of – bluntly – stupid money that jumped into the trade without any infrastructure, without any real capabilities and a kind of build-it-as-you-go mentality that we think is somewhat irresponsible.”
Carrington is now changing its investing strategy to replicate that of the GSEs. It is buying distressed mortgages in the hope of modifying them and keeping the tenant in the home. As investor style drifts in this direction, there will be less potential renters being forced onto the street, so that rental prices will fall. This will then knock on into a fall in home prices that were originally predicated on higher rental streams. In a related theme, the latest National Association of Homebuilders (NAHB) Multi-Family Production Index (MPI) signalled that builders were turning cautious on the prospects for the sector[xvi].
Martin Pring, of Pring Turner Capital Group, has created some brilliant lead indicator analysis that suggests that the housing market is rolling over[xvii].
In the face of these overwhelming headwinds, the Obama Administration has extended the Making Home Affordable Programme (MHA) and the Home Affordable Mortgage Programme (HAMP) into 2015. It would seem that this strategy also serves the dual purpose of creating some kind of fiscal support to the economy going into the next Presidential elections.