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Recent news on the national housing market is mixed at best. While off their lows, new and
existing home sales are weakening again as are new home starts and permits. The good
news is that home prices continue their very modest rebound. But questions abound
regarding the near future. The most cited worry is that the housing market will head south
again once the new homebuyer credit expires at the end of April. But that is certainly not
the only threat to a housing market recovery in 2010 and 2011. [See Graph 1]

                                          Graph 1

First, however, it needs to be pointed out that home prices shouldn’t rise much more, and in
fact, need to stay at or near current levels. That’s because the decline in prices was a good
and necessary phenomena. Home values rose over the past 10 years far above a
sustainable level of affordability. For some time, median home prices nationally have
averaged between 2.75 and 3 times median incomes (actually in the 1960s and 1970s the
ratio was closer to 2.5). Then, beginning in 2002, they began to soar, primarily because of
the extremely low interest rates orchestrated by the Federal Reserve Bank to stimulate a
recovery from the recession of 2001-2002. By middle of 2005, the price-to-income ratio
had risen to over 4, meaning that on average Americans with a household income of

$100,000 were buying homes costing more than $400,000 and were making the stretch in
part by utilizing adjustable rate mortgages. [See Graph 2]

                                           Graph 2

In past presentations I’ve reiterated many times that every recession has purposes that
must be fulfilled before an economic rebound can permanently take hold. This correction in
home prices was one of those purposes. The good news is that we are now where we ought
to be. The bad news is that prices can’t rush back up to 2005 levels any time soon, but
must now grow no more rapidly than the growth in household income, which at present is

The good news for Houstonians is that such a painful correction was unnecessary with home
prices here among the cheapest in the nation, never exceeding 3 times incomes. As a
consequence, most Houston area home prices have lost little over their 2007 levels.
However, Houston has been impacted by high levels of foreclosures because this region
participated in the flurry of Subprime and Alt-A mortgage lending as did the rest of the
nation. Among foreclosed homes, values are down as much as 25% off their 2007 peak.
Here I stress the term value instead of price, because a large portion of the decline is due to
the deteriorated condition of many foreclosed properties. That is partly why the sharp
decline in the sales price of foreclosed homes has not had a dramatic impact upon the non-
foreclosure market. The two types of properties are just not the same. [See Graph 3]

                                         Graph 3

Nonetheless, home building has experienced a sharp decline within the Houston region. New
home permits have fallen from over 5,000 per month to a level that is under 2,000 per
month, a 60% reduction in activity. This has been prompted by the difficulty of getting
credit for both buyers and builders and more recently by the significant amount of lost
regional jobs. Obviously, this is bad news for local builders, but for the regional market’s
future it is good news. Compared to the mid 1980s when builders just kept building at a
high price despite the collapse in Houston’s energy sector, this go-round building activity
declined even before the economy turned downward. This will leave Houston with much
less excess supply than it suffered in the late 1980s. [See Graph 4]

                                          Graph 4

But returning to the overall national housing market, past troubles do not seem to be going
away quickly. Mortgage defaults are still very high, even though there are some initial signs
that they may have peaked. Everyone expected that the default rates for Subprime and Alt-
A mortgages would be astronomical. What is most worrisome is that default rates for prime
mortgages are at a modern day high. [See Graph 5]

                                          Graph 5

This suggests something that we should have known some time ago. Mortgage debt is not
the only problem facing Americans. Household debt relative to income peaked in 2007 at
record levels, and little progress has been made in bringing it back down to rational levels.
That’s why many households with prime fixed rate mortgages are in trouble. They are
swamped by all sorts of debt. It is also why in many cases mortgage modifications are not
going to help these families. They need overall debt modification - in normal times called
bankruptcy. The problem of over-extended families will be one of the major drags on any
national recovery that emerges over the next several years. [See Graph 6]

                                          Graph 6

But the most significant change coming for the housing market will be a major change in
monetary policy in 2010, not the expiration of the first time homebuyer credit. To
understand what lies ahead, one must first understand the significant change in monetary
policy that has occurred over the past few years. The financial crises first hit in late
summer of 2007. Initially the Fed did very little to avoid the catastrophe that lay ahead. The
normal response would have been to flood the banking system with reserves to ameliorate
the tide the recession. By late that year the Fed did begin to come to the rescue, but in a
very unproductive way. To save the banking system they massively lent banks money, but
afraid of any inflationary implications (amazingly throughout much of 2008 the Fed Open
Market Committee (FOMC) continued to be preoccupied with inflationary worries), the Fed
countered all of their lending to banks by selling treasuries and thereby neutralizing the
effect of those banks loans on overall bank reserves. This left banks with adequate reserves
to meet legal requirements, but most of those reserves were borrowed reserves. Not until
the latter part of 2008 as the crisis both worsened and broadened did the Fed actually begin
to flood the banking system with reserves and it wasn’t until December of 2008 that non-
borrowed reserves actually turned positive again, coinciding with the drop in the federal
funds rate to nearly zero. Today, bank system reserves are 18 times the amount needed to
meet legal requirements and 85% of those reserves are non-borrowed reserves. [See Graph

                                            Graph 7

One might wonder whether this huge amount of excess reserves presents a threat of an
impeding explosion in inflation as those reserves are put into circulation in the national
economy resulting in a huge increase in the nation’s money supply. The answer is yes, they
do represent a threat for future inflation, but not immediate inflation. The reason is that
while banks are awash in excess reserves, they are not lending them out, and hence growth
in the U.S. money supply remains very subdued. Right now bank credit nation-wide
continues to contract, partly because banks find good loans hard to find and partly because
banks are still so undercapitalized that they can’t risk making new loans. Still, as the
recovery progresses, banks will eventually start lending all of those reserves out and the
Fed will have to pull out the excess quickly. In normal times, that wouldn’t be terribly
difficult. In the past when the Fed wanted to contract reserves they have simply sold
treasuries, “…bringing dollars back into the Fed’s coffers”. They could do this almost
overnight. But, this time the task of reversing policy will prove to be much more difficult.
That’s because the assets owned by the Fed which back those reserves are no longer
exclusively treasuries.

For virtually its entire history the Fed only held U.S. treasury issues - bonds, notes and bills.
That changed for the first time in late 2007 when the Fed finally awoke to the meltdown
that was occurring. To save money market funds and to get commercial credit flowing again

the Fed began to buy commercial paper, not just treasuries. Then in early 2009 to prop up
the sinking housing market, the Fed began to engage in the purchase of mortgage backed
securities primarily, from FNMA and Freddie Mac, even as they were beginning to unwind
their commercial paper holdings. Today the Fed owns over a trillion dollars in mortgage
backed securities and the amount is still growing. What this means is that the Fed has
almost single handedly been propping up the housing market by buying mortgage debt and
keeping mortgage rates unusually low. Without this intervention it is anyone’s guess what
would have happened to the housing market over the past 6 months, but it would certainly
have been worse than what we observe today. [See Graph 8]

                                         Graph 8

But the Fed can’t just keep adding reserves to an already bloated banking system and they
can’t stop this process without stopping their purchases of mortgage backed securities.
Furthermore, they can’t reverse it (which under normal circumstances would have been
much easier to do) without unloading huge amounts of those securities. Already, the Fed is
committed to ending the purchases of additional mortgage backed securities by the end of
March. That alone could have a major impact on housing market financing. But when they
start unloading the $1 trillion inventory of those securities the impact could be enormous.
Today the private sector market for such securities could in no way handle that amount of
supply along with the inherent risk that would go with it without a very major increase in

For a decade 30 year fixed mortgage rates have steadily fallen, primarily because of the
Fed’s overly accommodating monetary policy that kept rates too low for too long. But over
the past two years they magnified the decline through those purchases of mortgage backed
securities which greatly reduced the spread between mortgage and treasury rates. As the
Fed begins to pull out of the mortgage buying business and then ultimately sells off those
mortgages, the spread at minimum will return to normal. That alone should easily add
another 100 basis points to current mortgage rates and during the period of liquidating
those mortgages the spread could actually increase by 200 basis points. Thus, even if long
term treasury yields don’t rise, mortgage rates could increase to 6.5% or higher. But, don’t
count on 30 year U.S. yields to stay down this low either. Traditionally, 30 year treasuries
provide a 3% real rate of return, so in a world of 2.5% inflation, 30 year treasuries should
themselves be headed towards 5.5%, pushing mortgage rates up an additional 50 to 75
basis points. [See Graph 9]

                                          Graph 9

Thus, the housing market has a lot of head wind over the next 18 months. To the extent
that the U.S. economy experiences a recovery, this time it will not be led by the housing
market. Much more work is left to be done before this market can establish some sort of
new long-run sustainable equilibrium. And Houstonians can’t assume just because housing
is very affordable in the region that the local housing market won’t feel some impact from
the changes to come. The next two years are going to be “hold your breath” years for the
housing markets both here and nationally.


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