The Importance of Fannie Mae and Freddie Mac

Fannie Mae, the Federal National Mortgage Corporation, and Freddie Mac, the Federal Home Loan Mortgage Corporation, are the 2 largest guarantors of conventional mortgages. Their importance was highlighted by the government’s rescue package, should they not have enough capital to continue to package and sell homeowners’ mortgages to investors.

Both Fannie Mae and Freddie Mac were set up by Congress for precisely the current situation, when commercial banks and investors are unwilling or unable to originate mortgages to homeowners. Fannie Mae saved thousands of home mortgages during the Great Depression, for example, without costing the taxpayers any money. That is why they are two of four Government Sponsored Enterprises—the other two being the Federal Housing (FHA) and Veteran (VA) Administrations that make loans to entry-level homebuyers and veterans.

They were also given a special status, such as tax exempt privileges for their debt that enabled them to keep costs low, as well as lower capital requirements. This was because they carried less risk than commercial banks who originate a mix of consumer and commercial loans that require more capital and loss reserves. And so their mortgage rates are lower than for comparable jumbo mortgage amounts.

The question is can they continue to do business given the current panic-driven environment that threatens to cut off all credit, which is the lifeblood of any economy? The answer of course is that the government will make sure they can continue to operate, given that they now originate more than 70 percent of all home loans, with safer underwriting guidelines that keep their default rate at 1 percent, less than one-quarter of the default rate for all conventional mortgages.

Most pundits continue to say we are not yet in a recession, even though 438,000 payroll jobs have been lost through the first six months of 2008. The unemployment rate held at 5.5 percent in June, as a shrinking labor force cancelled out the job losses in the Labor Department’s Household survey.

So can we expect a recovery this year? The job situation is one indicator. The Conference Board’s Employment Trends Index, which attempts to signal future hiring trends, has fallen 8 percent since July 2007. “The steep decline of the employment trends index in recent months, and the fact that its weakness is spread throughout all of its components, does not leave much room for optimism,” said its senior economist.

Another key to predicting a recovery are the twin manufacturing and service sector surveys put out by the Institute for Supply Management (ISM). Employment in both sectors plunged. What is the culprit? It was surging costs, with prices paid for purchased materials and services increasing for the 61^st consecutive month in the service sector. The rise in material prices from May to June was 7.5 percent.

Housing has historically been one of the first markets to recover after a slowdown or recession, according to UCLA economist Ed Leamer. But the backlog of unsold, vacant homes has to first decline. Harvard’s 2008 Joint Housing Task Force report estimates that there is an 800,000 “overhang” of vacant, for-sale units nationally that have first to be sold.

Fannie Mae and Freddie Mac will be in a position to help with a housing recovery. Their so-called ‘jumbo-conforming’ products with a maximum $729,750 loan amount now offer 30 and 15-year fixed rate programs, a 5-year fixed rate ARM with interest only option at just one-quarter percent higher than Fannie and Freddie’s conforming loan amounts. That could save the day for many California homeowners.

© Harlan Green 2008

Week of July 21, 2008--Are Home Prices at the Bottom?

On the latest Barron’s Magazine cover was a catchy title—“Home Prices Are About to Bottom”. It startled me, what with all the doom and gloom of late. But Barron’s does have a point. Existing-home sales have leveled out at about 5 million annualized units since last fall, though new-home sales and construction have shrunk approximately 50 percent from their highs.

The core of Barron’s argument is that some housing markets are beginning to show price increases, a combination of greater affordability and declining inventories. The S&P Case/Shiller Index for April showed that values in 8 of its 20 survey cities increased, versus just 2 of 20 in March, for example. And the rate of delinquencies in some of the worst sub-prime securities has been declining for the past 6 to 8 months, per the subprime indexes that track them.

House prices are continuing to decline, of course, but that has increased affordability in those same cities that are seeing sales’ increases. Case-Shiller measures affordability with a ratio of sales price to per-capita income. In Boston, for example, the affordability ratio has returned to a more normal 9 times, from its peak of 12 times per-capita income. This means that a home that once sold for $480,000 at its peak (12 times a $40,000 per-capital income), now has come down to $360,000 (i.e., 9 times $40,000). This is a 25 percent savings, and perhaps signals a bottom for prices in the Boston metro area.

Many coastal areas in Florida and California have not yet settled back to historical averages. Los Angeles, whose affordability ratio peaked at 16 times per-capita income, has come down to 11. But its longer-term average is closer to 8 times. So Los Angeles area prices may have another 20 percent decline before leveling out. The variation in affordability ratios just confirms the maxim that all real estate is local.

Other evidence of a real estate recovery is included in Harvard’s 2008 Joint Housing Task Force study, which emphasizes the inventory “overhang” of approximately 1 million unsold and vacant single-family and apartment units that has to be worked off. But household growth over the next decade 2010-2020 should actually increase to 1.4 million households per year. That and other elements should create a demand for at least 1.8 million new-home completions per year over that time.

Lastly, any recovery is dependent on the availability of credit, of course. And mortgage lenders are hurting at present. The so-called quasi-governmental agencies Fannie Mae, Freddie Mac, and outright government-owned FHA/VA agencies have become lenders of last resort that now account for more than 70 percent of originations.

© Harlan Green 2008

Week of July 7, 2008--Will Jobs Market Improve?

Will the jobs market improve this year at all? This could well determine when overall economic activity recovers, not to speak of housing. Consumer spending, the main driver of growth, was up just 1.1 percent in the first quarter 2008, while retail inflation is running at 4.1 percent annually, meaning real spending contracted by more than 3 percent. So consumers have little left over after necessities.

Most pundits continue to say we are not yet in a recession, even though 438,000 payroll jobs have been lost through the first six months of 2008. The unemployment rate held at 5.5 percent in June, as a shrinking labor force cancelled out the job losses in the Labor Department’s Household survey.

Another business indicator is the Conference Board’s Employment Trends Index, which attempts to signal future hiring trends. It has fallen 8 percent since July 2007. “The steep decline of the employment trends index in recent months, and the fact that its weakness is spread throughout all of its components, does not leave much room for optimism,” said its senior economist.

But employment sometimes behaves differently from the more general economic activity as measured by the Gross Domestic Product, according to the Conference Board. But “it has accurately signaled every rise and fall in employment over the last 35 years”.

And that is the key. Economic activity can pick up before jobs. Though the last recession was over in November 2001—yes, that’s just after 9/11 attack—jobs didn’t begin to recover until the second quarter of 2003. This may be a small consolation to consumers, however.

Another key to predicting when the jobs market will improve are the twin manufacturing and service sector surveys put out by the Institute for Supply Management (ISM). Employment in both sectors plunged. What is the culprit? It was surging costs, with prices paid for purchased materials and services increasing for the 61^st consecutive month in the service sector. The rise in prices just from May to June was 7.5 percent.

Housing employment has historically been one of the first job markets to recover after a slowdown, according to UCLA economist Ed Leamer. But the backlog of unsold, vacant homes has to first decline. Harvard’s 2008 Joint Housing Task Force report estimates that there is an 800,000 “overhang” of vacant, for-sale units nationally.

Historically, housing markets usually recover after an economic recession and a mix of falling mortgage rates and dropping home prices. That has been happening of course. But this housing downturn may take longer due to the high volume of foreclosures and the constraints in the credit markets, says the report.

© Harlan Green 2008

Week of June 23, 2008--Has the Recession Ended?

The Federal Reserve came out of its latest Open Market Committee meeting with interest rates unchanged. Its reasoning was convoluted, however, in that it believed the worst of the recession is behind us and that the economy is growing again. We therefore have now to worry about inflation, though it should moderate later this year, due to the current slowdown!

So which is it? We cannot have both. Either the credit and housing crunches—along with soaring energy prices—have seriously hurt consumers, which comprise two-thirds of economic activity. Or, the worst is over and consumers have enough spending power to continue to drive up prices—i.e., inflation.

The latest Q1 Gross Domestic Product revision tells us that consumer spending rose just 1.1 percent, half that of 2007’s last quarter, which means consumers are spending on basic necessities at discount prices, but nothing else. This will not drive inflation higher.

One glimmer of hope on the housing front was the 2 percent increase in existing-home sales, to 4.99 million annualized units. Sales have stabilized around a 5 million average since last August. The median-price is now down 6.3 percent in 12 months.

But Harvard’s 2008 Joint Center for Housing Studies report says that the “corrections” in housing starts, in new, and existing home sales rival the deepest slowdowns since World War II. Historically, housing markets usually recover after an economic recession that drives down interest rates and housing prices. But this recovery may take longer due to the high volume of foreclosures and shrinking of available credit, said the report.

May’s new-home sales seemed to confirm this prognosis, falling 2.5 percent with the median price down 5.7 percent in a year to $231,000. The current annual sales rate is 512,000, which is approximately 50 percent below the 1.05 million sold in 2006.

Another indication of weakening consumer demand was the plunge in the Conference Board’s Confidence Index to 50.4, from 58.1 in May. The Director of its Consumer Research Center said the Index was the fifth lowest ever, while its Expectations Index of future activity had reached a new all-time low. Consumers believe we are still in a recession, in other words.

So how do we know if we are in or out of a recession? Once last sign is the Conference Board’s Leading Economic Index (LEI), which rose 0.1 percent in May but is down -0.7 percent over the last 6 months. Its coincident index tracks the same 4 indicators used to determine a recession. And though those indicators also rose 0.1 percent in May after falling -0.1 percent in April., it was the first increase in seven months. The growth rate of the coincident index stands at -0.4 percent (a -0.7 percent annual rate) in the six-month period though May, down from 0.3 percent (a 0.6 percent annual rate) from July 2007 to January 2008, and the weaknesses among its components have remained widespread in recent months.

The predominance of evidence seems to be that we are still in a recession, with energy and food inflation wiping out most economic growth. But said inflation is driven by growth in the rest of the world—especially Asia, rather than domestic demand. So, paradoxically, we therefore must wait for the rest of the world to slow its growth before U.S. growth can resume, and housing has a chance to recover.

© Harlan Green 2008

Week of June 9, 2008--JOBS VS. OIL?

There was further evidence that jobs and oil don’t mix. It is not only the possibility of $5 per gallon gas, but food and most other commodities are also soaring, thanks largely to the fallen dollar. This is while May’s unemployment rate soared to 5.5 percent, as there were 861,000 new workers—mainly young 16-24 year olds—applying for jobs at the same time that there were 281,000 jobs lost, according to the Labor Department’s Household survey.

How high will oil prices rise? And how much will it affect the rest of the economy? That is the question for consumers who now have to spend more on basic necessities. The good news is that the 2 sectors most affected by the economic slowdown—auto and home sales—account for just 7 percent of economic activity and 3 percent of payrolls, according to Business Week.

In fact, it is the credit crunch and high oil prices, which are causing car and home sales to languish. But in line with increased housing affordability that we documented in last week’s column, there is evidence that home sales are already increasing in some parts of the country.

The National Association of Realtors’ Pending Home Sales Index (PHSI), a measure of existing home purchases under contract but not yet closed, surged 6.3 percent in April. It’s the highest index since last October, yet remains 13.1 percent lower than April 2007.

Lawrence Yun, NAR chief economist, said pending sales contracts have picked up notably in areas undergoing significant price drops. “Bargain hunters have entered the market en masse, especially in areas that have experienced double-digit price declines, but it’s unclear if they are investors or owner-occupants,” he said. “Sharp price reductions are leading to a quicker discovery of price equilibrium points. The West is already seeing year-over-year gains in pending contracts.”

In fact, without auto and housing, the U.S. economy grew 2.8 and 2.5 percent, respectively, over the last 2 quarters, close to the long-term average. It is being powered by the ever-growing service-sector, which now provides nearly 60 percent of GDP growth, according to Business Week. And export orders are at a 4-year high, according to the Institute for Supply Management’s May manufacturing survey.

But as oil prices continue to climb, Bernanke and the Fed are beginning to worry about inflation. This is why Fed officials have been hinting at a possible Federal Reserve rate hike in the fall. Such a rate hike would certainly damage any prospects of an economic recovery this year.

UNEMPLOYMENT—The May jobless rate of 5.5 percent was mainly due to students flooding the summer job market, according to some economists. But 49,000 additional payroll jobs were lost in the more dependable Establishment survey, bringing the total this year to 324,000 payroll jobs lost. We doubt the Fed will or can raise interest rates as long as jobs continue to be lost.

RETAIL SALES—Another indicator of consumer health was the 1 percent rise in May’s retail sales, which caused stocks to rally and interest rates to rise. But sales are unadjusted for inflation, which suggests that ‘real’ retail sales are falling when the 4 percent CPI inflation rate is taken into account.

Any hike in interest rates could harm a housing recovery, as we said, since default and foreclosure rates are still increasing, putting pressure on banks to lend less, which further exacerbates the problem.

The pending sales figures do give some hope that housing sales are in a recovery model. The PHSI in the West rose 8.3 percent to 98.8 in April and is 4.0 percent higher than April 2007. In the Midwest, the index jumped 13.0 percent to 83.7 in April but remains 13.1 percent below a year ago. The index in the South increased 4.6 percent to 88.8 but is 22.5 percent below April 2007. In the Northeast, the index declined 1.9 percent in April to 79.3 and is 12.2 percent below a year ago.

© Harlan Green 2008

Week of June 2, 2008--How Affordable is Housing?

Housing affordability has improved significantly due to the fall in both interest rates and home prices in the past year, which may be why home sales have stopped declining of late. Does this mean the housing market is beginning to recover? Yes, but only in regions where those prices conform to reasonable personal income or rent multiples.

As of the April stats, the typical existing home cost 3.4 times annual household incomes, while median new-home prices equaled almost 3.8 times family incomes. These are down from the peak of 4.2 times reached in the bubble year 2005, although they remain above the 2.8 figure that prevailed in the 1980s, when housing sold at a brisk pace.

Two housing price surveys highlight why some regions are recovering. The Case-Shiller index that tracks all same-home sales that include jumbo loans in 20 metropolitan areas has fallen 14 percent from Q1 2007 to Q1 2008, whereas the Office of Federal Housing Enterprise Oversight (OFHEO) saw it prices for homes with conforming loan amounts fall just 1.7 percent in Q1. These are homes that require a maximum $417,000 conforming loan amount, hence have lower prices.

The National Association of Realtors (NAR) has a Housing Affordability Index that corroborates this trend. It increased from April 2007 through this February, but has since reversed course as median existing-home prices have begun to rise again along with interest rates.

The index is still at 130, however, indicating that a household with a $60,185 median annual income can afford a home that is 130 percent of the median price, whereas a median household could afford one just 112 percent of the median price in April 2007.

There may be some improving economic factors buttressing the prospects of homebuyers as well, from higher factory orders (read exports), higher labor productivity that is also pushing up wages, and a service-sector in the expansion mode.

LABOR PRODUCTIVITY—So-called non-farm businesses’ productivity increased 2.6 percent in Q1 and is up a huge 3.3 percent in 4 quarters. This means workers are producing more at lower cost, but also making more money. Q1 hourly compensation was up 4.8 percent. Higher productivity raises the standard of living. Sustaining a productivity rate over 2.5 percent means a doubling of the standard of living every 25 years for a household.

ISM NON-MUFACTURING SURVEY—So-called service-sector activity increased almost 3 points in May, mainly due to a 5.5 point increase in new export orders. And this is with its financial services component (read ongoing credit crunch) weighing down the averages.

So given the enormous head winds generated by soaring food and energy prices, with banks cutting back on lending activities, we have to say that the ship of state is weathering this storm fairly well.

But banks’ profits are still hurting from all the credit losses, and new banking regulations are slowly wending their way through the congress. Until those issues are resolved it will still be a bifurcated real estate market, with some high-priced areas in Florida and California taking longer to recover.

As a footnote, it is generally agreed that sloppy underwriting and regulation led to the sub-prime debacle. A new NBER study highlights why. It was in fact those loans sold to so-called “unafilliated” entities that had the higher default rates—meaning hedge funds and so-called ‘shadow’ banking entities not regulated by the Federal Reserve and Treasury Department. So look for greater regulation of financial markets down the road.

© Harlan Green 2008

Week of May 26, 2008--Real Estate's Future

“The future ain’t what it used to be,” said Yogi Berra, famously. So how can we even hope to predict future housing activity? Certainly we know several factors that helped to inflate the real estate bubble—record low interest rates and deregulation of the financial markets that allowed for rampant manipulation of securitized mortgage credit ratings, among others.

And we know that regulators are now overreacting as property values continue to decline, so that higher credit scores and larger down payments are now required for most purchase and refinance transactions, even with verified incomes.

But we also know that both existing and new-home sales have stabilized somewhat. Annualized existing-home sales have been in the 5 million unit range for the past 6 months (4.89 million in April from 4.94 million in March), while new-home sales just jumped 3.3 percent in April.

One comparison is the last housing recession—which lasted from approximately 2001 to 2006, before prices returned to prior levels. But banks were dropping like flies then due to the S&L debacle, and the Federal Reserve wasn’t much help. In fact Alan Greenspan, et. al., began raising interest rates in 2004 without much warning, causing Orange County’s bankruptcy, for one.

The Fed is playing a different game this time, injecting all kinds of money into the system by holding as collateral many of those prime and subprime mortgage-backed securities that banks haven’t been able to unload.

The Fed has also lowered their over night rate 3.25 percentage points since last fall, bringing the Prime Rate down to 5 percent and the indexes that control adjustable rate mortgages much lower.

This has flooded the financial markets with money, raising fears of higher inflation down the road. Be that as it may, inflation has always helped property values. Also, Fed Governor Janet Yellen believes the Fed’s “liquidity-enhancing” actions “are having a beneficial effect on financial markets”.

Reinforcing Yellen’s optimism is that first quarter Gross Domestic Product growth was just revised upward to 0.9 percent from 0.6 percent, mainly because of higher export growth. Its so-called PCE inflation index that the Fed uses also was lower. In fact the core index without food and energy prices was up just 2.1 percent in Q1 and is up just 2 percent in a year.

But perhaps the best gauge of housing values is the so-called housing price-to-rent ratio. It is the ratio of a home’s value over annual gross rents. Its national average is currently 25 times annual rents, according to the San Francisco Federal Reserve Bank, meaning that a home that rents for $30,000 per year is now worth approximately $750,000. Its long-term average since 1970 is about 21.5, which means that average prices may decline another 14 percent. But values could fall even further, of course, since the price-to-rent curve is not a straight line, but fluctuates around its average value.

So what is the future for both housing sales and values? Sales of new and existing home will probably stay in the same narrow band this year, simply because for sale inventories are bloated by newly foreclosed homes replacing those that were sold.

And values will eventually return to the long-term 21.5 housing-to-rent ratio average. This ratio has taken 10 years to return to its historical ratio over each of the last 2 housing cycles—from 1980 to 1990 and 1990 to 2000. This is of course unless the future “ain’t what it used to be”!

© Harlan Green 2008