Schizophrenic U.S. Housing Market

Housing Smoke and Mirrors (Part 6)

“It was the best of times, it was the worst of times.”

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We thought it would be amusing to start this discussion with the latest “Smoke and Mirrors” from RealtyTrac. They clearly have an interesting perspective and “scale” in relation to measuring the housing recovery. If a picture can be worth a thousand words, hyperbole has just reached a new level. No prizes for guessing what the consensus view on the housing market is.

In Housing Smoke and Mirrors (5), the dilemma of what to do with the complex 2005 and 2009 Mortgage Vintages was introduced. It was suggested that there was a symbiotic relationship, between the Federal authorities and private capital; to address this issue in a way that was win-win and avoided dangerous litigation. Upcoming activity in the Mortgage Market this summer will provide evidence of this symbiosis. 20,000 FHA guaranteed, severely delinquent home loans will come to market through two HUD auctions.

On June 26th, investors will have the opportunity to purchase 15,000 mortgage “notes” from the “national pools”. On July 10th loans from the Neighbourhood Stabilization Outcome  (NSO) programme will be offered. The NSO loans come from pools that are concentrated in Chicago, southern Ohio, metropolitan Los Angeles, and the state of North Carolina. Both sales will be by competitive auction.

The conditions attached to the sales are nuanced. Purchasers must agree not to foreclose for at least six months; during which time they are asked (but not obligated) to work with the borrower to stay in the home. To incentivize the purchaser, these loans will be offered at a deep discount. The NSO loans come with even more small print attached. No more than fifty percent of the loans purchased can be put into the Real Estate Owned (REO) category. There is also some more obscure wording; which says that in the case where the servicer is unable to avoid foreclosure, that –

“the servicer achieve some other neighborhood stabilizing outcome, which may include holding the property for rental for at least three years.”

Servicers can put loans into the sale process, if the borrower is at least six months delinquent; and the servicer has exhausted all steps in the FHA loss mitigation process and has initiated foreclosure.

This is clearly a sale process for the “Zombie Homes” identified in Housing Smoke and Mirrors (4) – “The Zombie in the Room”[i]. HUD is expecting to unload 40,000 distressed homes in this way this year. Two auctions have already been held in March; selling 16,000 homes from the “national” and NSO pools. The “national” pools had an unpaid principal of $2.2 billion. The NSO pools came from Atlanta, Cleveland, southern California and several areas in Florida; with a combined unpaid balance of $635 million.

A pattern is emerging. On a quarterly basis, the FHA is bleeding out distressed loans (and properties) into the market. These properties are offered in small amounts, so as not to attract too much attention; and also to keep inventory tight and prices firm. They are also offered from diverse locations, where the main centers of distress are located. The deep discounts attached, presumably offer an immediate mark to market gain for the purchaser. The conditions attached also prevent the purchaser from immediately foreclosing, so that there is no sudden uptick in the foreclosure rates. Future foreclosures are then stretched out from a period of six months to four years after the purchase. In addition, the foreclosures are initially limited to half of the purchases, so that there is not a sudden foreclosure wave also. There is however, no obligation on the purchaser to keep the homeowner in the home in the long-term. Basically, the foreclosure can has been kicked down the road; and kicked back into the private sector. The fate of the borrower is quite clear; it is intended that he should become a renter ultimately. In Housing Smoke and Mirrors (5) it was established that the purchasers are going to be investors who want build a portfolio of rental homes. It is therefore logical to conclude that the occupants of the distressed homes, which have been kicked down the road into the private sector, are going to be kicked into renting; or kicked out of the house if they can’t pay the modified loan or rent. The FHA is therefore facilitating the private sector renting model. To compensate the private sector buyer, for not immediately making the homes rentals, they are offered a deep discount entry price. The FHA is thus dealing with the single-family component of the distressed home problem via the rental exit route.

The multi-family component is also under consideration. Both GSEs were asked by the FHA to consider their viability as stand-alone entities, providing loans to the multi-family sector only. The GSEs lend to a building owner, where there may be upwards of four residential units in the building. The multi-family business is a much smaller business line for the GSEs; and in addition it involves some kind of risk sharing with the private sector that is not the case with the single family sector. The multi-family GSE loans performed better than the single family loans in the crisis. In addition, the GSEs are a much smaller player in the multi-family market than their private competitors.

Freddie’s multi-family business is driven by economies of scale. It has yielded $4 billion in net revenues since 2010, from an average size of a $17 million building. Without the Federal Guarantee its business would have a smaller footprint, charge higher borrowing rates and produce less net income than today.

Fannie May opined that –

“NewCo could potentially raise start-up equity capital in the private markets as a stand-alone, unregulated specialty finance company; but our analysis suggests that the resulting company would be very different from Multifamily as it exists today and that its long-term survival would be uncertain”.

The bottom line is that the GSEs operating in the multi-family sector are only viable because of their Federal guarantee. Given that America is downsizing, the multi-family sector is going to take on greater emphasis going forward. Removing the Federal guarantee takes the GSEs out of this important sector of the future. Should the GSEs exit this sector, then interest rates will rise and funding will be volatile, as it becomes driven by private capital and the vagaries of the business cycle. If the GSE multi-family business is put up for sale, then it would also have to go at a deep discount to take into account its risky viability. There is no easy way out of the multi-family business for the GSEs.

The latest report on quarterly delinquencies from TransUnion sheds an interesting light on the current delinquency situation[ii]. According to the press release:

The national mortgage delinquency rate (the rate of borrowers 60 or more days past due) in Q1 2013 dropped 21% versus last year; and now stands at 4.56%. Since last quarter, the mortgage delinquency rate declined 12%. Both on a year-over-year and quarter-over-quarter basis, this is the best improvement in mortgage delinquency since TransUnion began observing the data point in 1992.

This means that Q1/2013 saw the biggest drop in 60+ day delinquencies, since the crisis occurred. Lending standards have risen in Q1/2013. The economy and wages have stagnated and weakened. Interest rates have fallen, but this has not been directly passed on by the banks. How therefore, could delinquency rates fall so dramatically over this period? Tim Martin, the group Vice President, attributes the improvement to:

“prices up, negative equity down and rates staying low,”

The level of house prices and hence negative equity does not affect ability to pay however; and “rates staying low” is not the same “as rates falling”, so delinquent borrowers still faced the same level of interest rates that they could not pay previously. We therefore suggest some other reasons for this quantum improvement in delinquency.

First, we suggest that the mortgage modification programmes have been working overtime in Q1/2013, so that borrowers can remain current. Second, we suggest that inventory which has been kept off the market has raised house prices, so that the level of equity in mortgages improves. Homes with mortgages that have been manipulated back into positive equity are then foreclosed on, so that they can be sold out as Real Estate Owned (REOs).  Sometimes the servicing agent forecloses but does not take the legal title, so that “Zombie Homes” and mortgages are created; which are delinquent but still appear to pay interest. In the Fog of War, the line between REO and “Zombie” becomes blurred, especially when the regulators are turning a blind eye. Mortgage Backed Assets (MBAs) linked to these mortgages become similarly obscured. This fact is important, because the Fed is now the main buyer of MBAs. Wall Street however pools everything together and quickly creates MBAs; which the Fed then buys and Wall Street earns fees on.

Third and probably most significantly the Fed has increased its buying of MBAs. As the two graphs (above and below) show, Wall Street and the Fed have been very busy in Q1/2013; which is exactly when the big improvement in delinquencies is alleged to have occurred. A forensic investigator would be attracted to this statistical correlation pattern; whilst reserving judgment on whether a crime had occurred.

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? Moral hazard prevents it from buying distressed mortgages; so currently it is only allowed to buy Agency bonds that have current mortgages as collateral.

As we said Housing Smoke and Mirrors (5):

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.

Mr. Martin alluded to an emerging new phase in the housing recovery:

“All housing data point to further improvements in the delinquency rate, though as in the past few years, this also will hinge on how quickly older vintage loans clear through the system. We do not know if the first quarter was a blip, or if it’s the beginning of a more rapid decline.”

Reading between the lines, we would say that he is indirectly addressing the issue of the 2005 and 2009 “Zombie Home Vintages”.

The two graphs above, show the last two TransUnion Quarterly 60-Day delinquency data. The first graph (Q3/2012 to Q4/2012) very clearly shows the problem 2009 Vintage being created as the long purple bar. This is when we see the Fed’s first big purchase of MBAs, between 2009 and 2010 (see graph Source: FRB above); as it reacts to the problem. Both TransUnion graphs also show some problems flaring up again in Q3/Q4 2011 as smaller purple bars; but this problem was stabilized without the Fed having to expand its MBA purchases massively (see graph Source: FRB above). The big TransUnion graph delinquency drop in Q1/2013, is where the Fed cranked up its MBA purchases radically in early 2013 (see graph Source: FRB above); which we believe is the Fed trying to get ahead of the evolving 2005 and 2009 Vintage problem. The Fed is not reacting, as it was in 2009, it is being pro-active to signs of economic weakness that it feels could cause a repeat of the 2008 crisis. To really get ahead however, the Fed needs to be able to buy the bad 2005 and 2009 Vintages.

This thesis implies that the Fed has to buy “Zombie Mortgages” via its MBA purchases; so that it is therefore complicit in the process that has created misery for so many. If this were found to be the case, the implications and repercussions would be profound.

The simplest way for the Fed to be removed from this compromising position, whilst achieving its mission to buy “Zombie Mortgages”, would be if the GSEs modified loans and then packaged them as Agency bonds that the Fed could buy. This is clearly the way everyone on the inside in Washington, with the exception of Ed DeMarco at the FHA, wishes to go. DeMarco is holding back on this step, which is why we believe that the knife is out for him in Washington. With DeMarco gone, the GSEs can be the conduit by which modified “Zombie Mortgages” can be transferred to the Fed’s balance sheet.

Using Freddie Mac as an example; its REO inventory is falling, however the rate of improvement is slowing. Freddie is unable to get rid of its REO inventory as swiftly as it was able to do. If it could modify these loans, it could then move them off its books to the Fed and keep the families in the homes. The Fed, in its defence, could then demonstrate that it believed that it was only buying MBAs created out of mortgages that Freddie represented as being current at the time of securitization into Agency MBAs. An investigator would have to be able to tie each MBA security to an individual mortgage. The whole process of pooling of smaller denomination mortgages, so that they can be packaged into larger denomination asset backed securities, conveniently breaks the link and scatters the evidence. There is a smoking gun, but there are no prints or serial number on it. This is the kind of grey area that needs to be obscured from public scrutiny and further investigation. We now suggest that this is another reason why the Administration has erected some elaborate infrastructure (aka the Presidential Investigative Commission) to obfuscate the matter[iii].

There is also a fiscal incentive to keep the GSEs within an enlarged Federal housing footprint. The recent earnings from Freddie Mac and Fannie Mae, especially the latter, signaled that the GSEs have moved from being Federal Black Holes to Federal Cash Calves, as they return the laundered proceeds of QE from the Fed’s balance sheet to the Treasury.

Fannie Mae’s fiscal importance is immense.

Based on its first quarter net asset value of $62.4 billion, the company’s dividend payment to the U.S. Treasury will be $59.4 billion; a massive $52.4 billion more than the comparable dividend reported by Freddie Mac.

Fannie Mae’s single family market share is almost half of the market. It is clear therefore that the GSEs are central to the Fed’s attempt to acquire all the modified mortgages. It is also clear that the GSEs are central to the Treasury’s revenue issues, as the Fiscal Cliff approaches. The combination of these two pecuniary forces makes it hard to imagine a life for the GSEs in the private sector.

The alacrity with which the Federal agencies and the private sector were coming together, to address the “Zombie Homes” issue and thereby avoid litigation, which would put the housing market and financial institutions at risk, was observed in Housing Smoke and Mirrors (5). Professor Jeffrey Sachs’s negative view of the behaviour of the banks was also noted[iv]. In Housing Smoke and Mirrors (4), The State Inspector General of TARP (SIGTARP) was on record, for saying that the situation was reverting back to the toxic status quo pre-crisis[v]. Further evidence of this degeneration was signaled in the announcement that the GSEs will use the standards of the lenders, to confirm mortgage loan qualification for their purchases[vi]. The GSEs, as of January 2014, will be “defaulting” to the banks’ qualification standards and confirmations. What is more worrying is that all this was achieved under the guidance of Dodd-Frank and the Consumer Protection Agency (CPA). In effect, the banks have captured Dodd-Frank and the CPA; so it’s business as usual.

The capital markets continue to discount a continuation of the status quo, where the Taxpayer is on the hook for everything. Recent analysis (see two graphs above) suggests that the Too Big To Fail Banks continue to get cheaper funding and higher credit ratings because they still have an implicit Federal Bailout option attached to them.

Perhaps the most egregious signal that it’s business as usual comes from the temerity with which the financial community demands an equity share in the GSE Cash Cows, by taking them private. Having leveraged the Fed’s QE programme, the bankers and hedge fund managers now want to leverage the Fed’s strategy to turn around the housing market.

The banks and the Federal authorities are not having it all their own way however. Some people are already doing jail-time. For example, a former mortgage servicer named Lorraine Brown was just sentenced to 40 months to 20 years, for her part in the kind of “Robosigning” that led to the “Zombie Homes” issue[vii]. As with the picture of “Zombie Home” neighbourhoods, America is a big place , these legal incidents appear isolated and spread out. A national pattern is however being created out of these accumulated neighbourhood issues.

Despite the efforts to limit the fallout, some notable litigation is starting to appear. Perhaps the most famous case to date is being lined up by the New York Attorney General Eric Schneiderman; who will sue Bank of America and Wells Fargo for violating a $25 billion mortgage foreclosure settlement that they signed last year. He is becoming another key figure in housing market saga. He has opined on the way to remove Ed DeMarco, so that the GSEs can be facilitated to move “Zombie Mortgages” to the Fed[viii]. His most recent direct attack on DeMarco referred to him as –

“a little-known but powerful Washington bureaucrat who has stood in the way of important efforts to end America’s foreclosure crisis”[ix].

Schneiderman also cryptically refers to the need for the GSEs to be able to reduce principles on mortgages; as failure to do so is the crime that DeMarco is guilty of. Clearly the next overdue step is to allow the GSEs to modify mortgages so that the Fed can go to work.

In Housing Smoke and Mirrors (5), it was suggested that the housing market was losing momentum. The investor component of the market was seen as the main driver; and headwinds were foreseen from rents topping out as the economy weakened.

The most recent (yet historic) data from CoreLogic shows that the speculative appetite was still very strong in March.

Zillow’s latest Home Price Expectation Survey (ZHPES) showed varying degrees of optimism out to 2017[x].

The average price increase expectation at 4.1%, is now comfortably back to where it was when the housing market advanced towards its 2007 peak.

An interesting developing divergence in prices can be observed in the latest CoreLogic data. Since mid-2011, distressed house prices had been able to keep pace with the broader market. However, as of March this year, distressed prices have started to lag. This signals that the banks, who have been inflating prices by managing inventory, are having less success with their distressed portfolios.

In addition, according to Fannie Mae’s latest (April) National Housing Survey, Americans are better sellers than buyers into the rising market.

It therefore seems that house prices are diverging into a two-tiered (possibly multi-tiered) market. Prices are lowest for those with the highest indebted owners and vice-versa. The development of this stratification in house prices, will serve as evidence that the American economy is once again running into the limits that debt puts on growth.

Evidence of this continued debt stress was provided by the latest FHFA Refinancing Report. The housing market is still dancing to the tune played by “HARP” (Housing Affordable Refinance Programme).

In relation to the speculative driver of house prices, that is a function of rents, there is further evidence from the Fannie Mae survey that headwinds are blowing.

The number of respondents who see rising rents is falling, whilst those who see flat rents is rising; and those who see falling rents remains flat. Rents are not turning lower however, they are just meeting economic resistance.

There is rising economic optimism, which may ultimately support rising rents; but this has a long way to go before it overtakes the general level of pessimism about economic performance over the next twelve months.

It is therefore fair to say that house prices are meeting resistance from a weakening economy and a legacy of high debt levels. Despite all the claims that the housing market is booming, the evidence supports the fact that there is a significant part of it that is still under extreme stress, at the same time that the other part is booming. It was the best of times, it was the worst of times; depending on how much debt was being carried.

Perhaps an inflection point has been reached, if the more up to date Existing Home Inventory data for May is a guide. Inventory has been building at quite a pace. The situation is not as bad as it was in 2010, when the Fed cranked up QE2, however the trajectory shows clearly that the pace of sales is not as fast as in 2011 and 2012. Applying the best of times thesis, rising inventory implies tight supplies and hence rising prices. Applying the worst of times thesis, rising inventory implies no buyers; and hence prices that need to fall. Both theses appear to be applicable in a developing two-tiered market.

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