In Housing Smoke and Mirrors “I’ll Be Back” reports starting in July began to signal the point at which the rise in interest rates started to erode the strength of the housing market. Equivocal voices have now begun to opine much of the same.
In July, private mortgage insurers announced a significant expansion in activity[i]; at the same time that Fannie Mae announced the largest shrinkage in its book of activity in the last two years[ii]. Fannie Mae’s compound annual growth rate was -32.4%. Ostensibly, private capital is expanding into the shrinking housing footprint of Fannie Mae; just as bankers and policy makers had said that it would. Equivocally however, the last time that Fannie Mae’s book dropped like this was back in 2010. A cursory look back at 2010 should remind the observer that this was the point at which the housing recovery stalled and unravelled. It was only the timely intervention of the Fed with QE2, announced by James Bullard, which saved the day. This time around, Bullard has already distanced himself from the “Taper” camp at the Fed over his position on deflation being a potent threat; so the liquidity tap is already primed.
Homebuilders are equivocating.
They reported that Residential Construction was strong in July. On the one hand they are trying to raise prices; but then on the other hand they are offering vendor financing to sustain these prices[iii]. The profits that they book today on sales are therefore funded by the future risk introduced to their balance sheets through vendor financing. They have replaced a hard asset (the house they built) with a financial asset (the loan they made to finance the sale of the house they built). It is impossible to create a true profit unless the homebuilders can lend to the homebuyers at a higher rate of interest than they borrowed to finance the building of the house. The only way this can occur is if the homebuyer takes on a loan that he/she cannot afford to repay. Accounting gimmicks therefore overstate the real position rather like the derivative books in financial institutions. The builders book the construction cost lower than the sales price; so they have their profit. The problem is what book-value to ascribe to the loan that they have just made to the buyer of the house they built. If the present value of this loan is lower than the sales price of the house they have incurred an unrealised loss. If the present value of the loan they make to the buyer is lower than the value of the debt that they have incurred to build the house they are insolvent. One suspects that all this can be hidden in the finance department whilst interest rates remain low and funding is cheap. Once interest rates trend higher, the losses will start to be realised.
American Homes 4Rent was identified in Housing Smoke and Mirrors “Exit Rush”[iv] as a weak signal; suggesting that insiders were trying to transfer housing investment risk through exit strategies via the IPO window. The latest signal from the company suggests that it has also had to resort to gimmickry that destroys shareholder value[v]. The common shares are now trading slightly below the IPO price. This suggests that they were overpriced at the IPO; and have since become a victim of rising interest rates. There is therefore no chance to follow on with issuance of more common shares. The opportunity to transfer risk to common shareholders within the capital structure has been lost. Raising debt capital and leveraging up the company to take cash out via dividends is also not possible against a backdrop of rising interest rates. The accounting trick, being employed in this case, is the issuance of a new class of preferred stock; which will have the option value to redeem at a premium to the issue price if the market value of houses from specific regions in the portfolio rises. Needless to say, this option has been priced with a high Gamma by the selection of houses from the regions where speculative investing is driving price increases the most. The option is therefore expensive in price; and collects a high premium, for the issuer, in the form of cheaper equity financing. If the regional house price momentum continues, existing shareholders will lose value if the new Preferred Class gets put back to the company. If the housing market cools and even reverses, the new Preferred Class shareholders will have paid a premium for nothing. This capital raising round dilutes the capital value of the company; since more shares are created; with the risk of being forcibly redeemed at a premium to their current value, or just remaining as a new dividend liability in the event that they are not redeemed. If the underlying rents in the housing portfolio are not raised, the dilution factor is even greater. The new preferred shares thus represent a bet on house prices rather than a real capital raising exercise. A new class of derivative on the housing market has been created, with the increased risk profile of a single stock.
CoreLogic reported home prices were up 12.4% in July. Ex-Distressed Sales, the increase was 11.4%. It is clear that distressed sales are continuing to drive the increase in prices. Distressed Sales by definition start at significantly lower prices than Non-Distressed, therefore the low base effect exaggerates the percentage price rise. The apparent strength in home prices therefore has an in-built statistical bias. An alleged strong housing market is therefore based on its inherent weakness.
The strongest signals of equivocation came from the mortgage market itself.
Recent MBA data showed prepayments falling as interest rates rose. Last week’s data showed that the most recent interest rate retracement lower, stimulated a knee jerk bounce in refinancing.
Purchase applications however fell; suggesting that the buying strength has finally been sapped. Even more equivocally, the Lender Processing Service data for July signalled that, had it not been for HARP modifications, prepayments would have fallen[vi].
This clearly shows the invisible hand of the Federal Government overcoming the invisible hand of the market in allocating financial resources. The net result is that the Federal Government, rather than the Federal Reserve, is currently driving the recovery in the housing market; until such time as the Federal Reserve can manage interest rates lower to make prepayments attractive without Federal Government support. Prepayments in the high Loan-to-Value (LTV) sectors have thus risen, driven by HARP, at the same time that lower LTV prepayments have fallen.
The invisible hand of government has had a strong influence in massaging the delinquency data.
The delinquency rate is far lower 12 months after HARP than other FHA and GSE mortgages that have high LTV’s.
The general picture is of declining delinquencies and foreclosures. The declining foreclosure data can be discounted as being manufactured by the combination of banks withholding inventory to support prices and various Federal modification programmes. The delinquency data, although improved, is not as good as the foreclosure picture; and therefore signals potential trouble ahead.
Drilling down through the data, one can see that the Alt A and Subprime delinquency picture is starting to deteriorate again; as it did leading up to the crisis of 2008. This signals that the high LTV borrowers desperately need to get under the umbrella of a Federal programme to prevent a repeat of the Subprime Crisis.
There is also evidence that wealthy homeowners, represented by the Jumbo Loan sector, have a stronger credit position than all the other sectors of the market. It is therefore no surprise to hear that Jumbo Loans now trade on a tighter spread over Treasuries than Conforming Mortgages[vii]. The Conforming Mortgage market has been destroyed by the rise in interest rates following the “Taper” talk. The banks perceive that the wealthy have been less impacted and are therefore willing to extend credit to them on better terms.
Given the different levels of delinquency and foreclosure in the subsectors of the mortgage market, one must therefore take RealtyTrac’s headline that 8.3 million homes are on the threshold of positive equity with a little grain of salt[viii].
The same position could quite as easily have been framed by saying that about 25% of the housing market still remains in negative equity[ix]. The glass is therefore currently 75% full or 25% empty depending on what happens next.
Based on what happened next in August, Trulia suggests that what may now occur is a gradual slowdown in price appreciation[x]. The real issue is whether this loss of momentum then becomes a reversal in price trend. The latest report was almost unequivocal:
Despite Rise in August, Asking Home Price Slowdown Continues Asking home prices rose 11.0 percent year-over-year (Y-o-Y) and 1.2 percent month-over-month (M-o-M) in August. However, a closer look at the quarterly changes in asking home prices reveals a downward trend that’s much less volatile than the monthly changes suggest. Quarter-over-quarter (Q-o-Q), asking home prices rose 3.1 percent in August, down from 3.2 percent in July and 4.0 percent in April. And this downward slope will likely continue as mortgage rates rise, inventory expands, and investor interest declines.
Fannie Mae’s latest National Housing Survey[xi] confirmed that the rise in interest rates had dampened expectations for rising house prices.
What was most interesting about the survey however was that interest rate expectations, for the next twelve months, do not foresee a further significant rise from here.
There is a growing feeling that interest rates have risen too high.