Week of August 11--BANKS ARE INCONSTANT LENDERS

The debate over the housing bill and backstopping of Fannie Mae and Freddie Mac highlight a major fact. Commercial banks are inconstant lenders. This became evident in early 1980s when then Fed Chairman Paul Volcker hiked the fed funds rate to 19 percent in 1980-81. It caused many Savings & Loan Banks, who were the major mortgage lenders of that time, to stop originating mortgages altogether.

This was particularly true in California, where the biggest mortgage lenders of that time—such as Home Savings, Great Western Savings & Loan, Security Pacific Bank, United California Bank—found that their cost of funds exceeded the income from existing fixed rate mortgages.

And it was the secondary market for mortgages that stepped into the breach, of which Fannie and Freddie played a major part. So-called non-traditional investors, such as mutual funds, life insurance companies, and pension funds, funded 42 percent of the growth of mortgage lending during the 1990s, versus just 19 percent during the 1970s, according to a 1992 Fannie Mae report.

Today the share of mortgages insured by Fannie and Freddie has ballooned to more than 70 percent of total originations. This is because the mission of these Government Sponsored Enterprises (GSEs) has not changed; to supply liquidity to mortgage lenders when commercial banks would not, or could not, do so.

The Reagan Administration attempted to shore up the S&Ls’ balance sheets with the 1982 Garn-St. Germain bill that gave them broad latitude to make money by acting like commercial banks—making commercial loans, borrowing from the Federal Reserve discount window, issuing credit cards, and even investing in real estate—which in turn precipitated the S&L crisis of the late 1980s and the federal bailout of same.

The banks’ inconstancy is again an issue with the bursting of the real estate bubble. It is not the province of this paper to discuss its origins, but rather the fact that once again, damage to their balance sheets and capital base has caused the banks to pull back from their lending activities. In this case, it is almost any loan not guaranteed by Fannie Mae, Freddie Mac, the Veterans Administration (for Vets) and Federal Housing Administration (FHA).

Has dependence on the GSEs caused a severe strain on our financial system? Not according to a study by R Glenn Hubbard, George W. Bush’s first Chairman of his Council of Economic Advisors that was commissioned by Fannie Mae in 2005. Dr. Hubbard’s study found that in fact Fannie Mae had half the risk of insolvency of commercial banks—in large part because of a more conservative mix of loans. The GSEs do not buy or insure either credit card or installment loans, as well as riskier commercial mortgages (other than apartment loans) of commercial banks.

In fact, Hubbard’s report maintained that if Fannie Mae failed, its bondholders could expect to lose just 8.9 percent of its assets, whereas commercial banks stood to lose 22.3 percent of their assets.

Of course, critics of the GSEs, including Alan Greenspan, have maintained that because of a implicit government guarantee the GSEs would not be allowed to fail, and so could offer interest rates below comparable commercial bank loans. But what critics fail to take into account are the stricter government-mandated underwriting standards that require income and asset verification to determine a borrower’s ability to repay their mortgage.

This has resulted in default rates just one-quarter of those for all conventional mortgages. Freddie Mac’s CEO said in a recent press release that there is ample evidence that the GSEs have helped to keep a bad situation—i.e., the worst housing crisis since the Great Depression—from becoming even worse. And, they have managed to maintain their mission of improving housing affordability in the process.

© Harlan Green 2008

Week of July 28, 2008--IS THE ECONOMY IMPROVING?

The first ‘advance’ estimate of second quarter economic growth was 1.9 percent while prior quarters’ growth estimates were reduced slightly. The fourth quarter 2007 actually showed a 0.2 percent contraction in growth. So does that mean that we are in fact coming out of a recession? Real estate seems to be bottoming out, at least in some regions of the country.

If so, it is because a tremendous amount of stimulus has been put into the economy, not only by the Federal Reserve. The federal budget deficit is also stimulative. In fact, next year’s projected deficit of $482 billion—due in part to the rebate checks being sent out—is the total annual Gross Domestic Product of Belgium, according to one commentator. This means the government is spending more than it is taking in receipts, hence it is putting more money into the economy.

And more money in circulation should lower interest rates and stimulate businesses. Too much money in circulation also stimulates inflation, however, hence the tightrope the Federal Reserve is walking between its twin mandates of maintaining long term growth with low inflation.

The increasing unemployment rate—it rose from 5.5 to 5.7 percent in July—may belie any relief, but that is because more workers were kept on the unemployment rolls. Congress extended unemployment benefits for another 13 weeks, which has caused consumer confidence to increase in both the Conference Board and University of Michigan surveys.

The new housing bill may also provide some relief, though housing only accounts for 7 percent of economic activity. The conforming limits for loans insured by Fannie Mae and Freddie Mac that were boosted to $729,750 for a single unit this year, but will be permanently reduced to $625,500 as of January 2008. A $7,500 temporary tax credit for first time homebuyers should also help, given the fact that first-timers now make up 40 percent of homebuyers, according to the National Association of Realtors.

And the housing sector is beginning to work off excess inventories with new-home inventories back down to a 10-month supply, even though prices continue to decline. The good news is that some regions are showing price increases, after falling a cumulative 15.8 percent since last fall, according to the latest S&P Case/Shiller price index. Its survey showed that existing-home prices had actually risen in seven major metropolitan areas—but none yet in California.

Even the higher unemployment rate held some good news. The past 2 months showed 26,000 more jobs were created than originally estimated. And a major reason for the jobless increase was the temporary flood of summer youth 16-25 years old into the job market, with fewer able to find work. So the jobless rate could stabilize in the fall. The real estate bust has caused problems with our financial institutions that had over expanded into residential loans. Financial sector activity in general—including the activities of hedge funds, pension funds and the like—had ballooned to more than 25 percent of domestic (GDP) economic activity. It is now shrinking back to a more sustainable size. This will take time.

© Harlan Green 2008

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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