Hey guys. Sorry for the delay in posts, this week has been absolutely hectic and I’ve had no time at all to take a step back and take a breather.
As I mentioned to you in my initial post here on UrbanDigs, I will always try to give you a clear view of the mortgage market and will always do my best to keep you in the loop and offer an unbiased opinion.
That said, I introduce to you the “Mortgage Market Update”. This will be my weekly update on UrbanDigs as to the present day trends in mortgage industry - directly from the front line.
So here goes.
1) Fannie/Freddie raised their premiums. As per Noah’s latest post regarding the Fannie/Freddie situation, a bailout is in the eyes of many investors right now and the GSE’s have raised their premiums accordingly to sustain the new wave of loans rumbling in to their portfolio. These premiums are built into the rate and will result in a higher rate quoted to you by your lender of choice. Obviously if you have bad credit and are looking for the maximum amount of financing, this will come at a price and will not be a bargain.
2) Jumbo products are being retracted from the wholesale channel at many financial institutions. This means that many brokers will not be able to offer jumbo products to their clients and will force them to go directly to the lender for financing.
3) No more jumbo products on second homes. As a combination of an unhealthy balance sheet and a much more risk adverse environment, many banks will no longer offer financing on second homes because of falling home prices and an investor concentration that will not buy assets with declining collateral.
4) A lower cash back limit on cash-out refinances. Once again, due to a softer real estate market, banks will not offer as much equity out of borrower’s homes in a refinance transaction. At this time many banks will allow up to $500,000 cash back to the borrower at closing, however this will all change and might be slashed in half. All of you that are seeking to add a Unit to your CO-OP or Condo – make sure you ask you lender if they are able to provide the financing!
Rates pulled back a little this week and as result I am quoting the following at par (Par is industry talk for not loosing any money on the deal, from a pricing stand point. For example if I was to offer 6.875% I would be .125 points out, meaning that I would have to pay $1,000 out of my commission on a $800,000 loan, to the bank, after the loan closes):
1) Jumbo 5/1 ARM – 7.00% @ 0 Points.
2) Jumbo 5/1 ARM Interest Only – 7.50% @ 0 Points.
3) Conforming 5/1 ARM – 6.25% @ 0 Points.
4) Conforming 30 Year Fixed – 6.875% @ 0 Points.
All rates are based on a 60 Day Lock.
If the government steps in to bailout Fannie and Freddie, it will cause a lot of turmoil in the mortgage markets. In most cases, when the government steps in to rescue a private company it usually comes with some extended guidelines of their own. Here is what I think will happen:
1) As many predict, equities will rally causing a sell off in the treasuries. Giving mortgage rates a boost in the higher direction.
2) Premiums charged to banks for loans will be increased yet again.
3) The government will probably set a standardized conforming limit for buying loans in 2009. Remember the stimulus boost to $729,250 is expiring December 31, 2008!
4) FHA will probably increase its down payment requirement to adhere with current risk profiles and declining home prices. Currently it is at 2.75% minimum, I think this will be increased to somewhere around 3½%.
I also wanted to mention that I have been contacted by many borrowers from overseas looking to purchase property in Manhattan, most of them from Paris and London. The funny thing is whenever I ask how much they want to provide as a down payment, their answer is always “how ever much you want us to”. Just goes to show you how much the Euro has on the dollar - unreal.
Other than that, it has been relatively quiet for the past week but this is usually the case towards the end of summer, as many people are on vacation and back to school time is upon us.
A: I'll give you guys a quick take on what I see out there right now, and what I expect based on the view.
My business has slowed in the past few weeks, in terms of AGGRESSIVE NEW buy side demand. What I mean by this is that although I continue to get calls/emails from perspective buyers, I am finding that the motivation level is subdued. This is completely normal for this time of the year in Manhattan; I discussed Manhattan's seasonal market way back in DEC 2005:
"During the hot summer months of June, July & August most NY'ers want to jump from A/C filled work rooms to A/C filled cabs to A/C filled apartments. Being outside during these times with the heat reflecting off the building and streets, and brutal subway station waits, is a nightmare for all of us. Going out of your way to view apartments you might buy is usually not a priority. Rather, weekends at the hamptons and trips upstate or to VT/NH are the main thoughts in your head.This dynamic still applies, only in today's market, I think the savviest buyers out there are using the 'light traffic' pitch more forcefully when submitting a well-timed low ball bid.
Looking at it from a different viewpoint, humans are generally a group minded species. What does this have to do with it? Everything!
If you go to an open-house and see no one there, you will probably think LESS of the apartment and be in no rush to place a bid. However, if you go to an open-house and see a ton of people there with you, you will be MORE interested in the property and probably have a feeling of more time-urgency in placing a bid."
Over at TrueGotham.com, Doug pitches in his take on today's Manhattan marketplace, that I agree with:
"Overall, the Manhattan real estate market has changed drastically from the days of multiple bids on every property that hit the market. That said, those properties with incredible views, layouts, outdoor space or other unique features are still garnering a plethora of interest. The rest will also sell...it may just take longer than you had planned."Here is how I would dig a bit deeper:
BUYERS: As Doug says, are both 'anxious & cautious'. Understandable given the macro environment and the time of year. Buyers can no longer be fooled. They expect to negotiate, and they will negotiate. I don't see any buyers jumping into bidding wars or paying full ask unless the property was priced correctly to begin with OR aggressively reduced on the downside, overshooting market value in the hopes of a very quick sale.
Inventory is down about 10% in the past 3 months, and buyers are frustrated that with all the headwinds the economy is facing, the uncertainties, and the negative wealth effect of a falling stock market, that there is not fierce seller competition out there. Put another way, asking prices simply are NOT 10% below past years levels, battling each other to be the best deal on the market at any given time. That hope is leading many buyers to be more willing to wait for a market with more sell-side panic; whether it comes is a different story.
SELLERS: Its all about the buyers! The sooner you realize this the faster you will get your sale. Its in YOUR hands. Chances are your broker is doing all the standard marketing for your listing, and shooting out proactive E-blasts, which in my opinion lost a bit of its luster as a marketing tool (the reason why lies with any new tool, after a while, it gets overused and now I simply delete the 40 pieces of spam I get a day).
Again, as Doug says, unique/special properties with strong sell side features such as outstanding views, big outdoor space, etc., that separate them from the pack should still be able to procure a good level of traffic in today's market. But these properties likely are NOT immune to the psychological effect of declining buyer confidence, and will still experience bids come in lower than originally expected.
In the end, the broker must educate the seller on the state of the current market so that a strategy includes pricing the property ahead of the curve. If not, chances increase that your listing will simply sit on the market, stale out, and risk lagging the real time market should prices drop a bit. I mean, before accepting a bid 15% below your asking price, won't it make sense to drop the price 5-7% first and see the effect?
The seasonal effect is in place, and I'm sure many sellers removed their listing from the open market for this time of year; contributing to the drop in inventory over the past few months.
I have contracts signed for my sell side properties after implementing price reductions; my Brooklyn property was removed from the market. Most of my buyers either closed or are in contract waiting to close. All of them bid wisely taking into account the state of the current marketplace as I described above; pricing in some downside risk. If anything, it shows that sellers are coming down. The range of accepted price relative to the original asking price is about 2% to 40% off the original asking price. Most were in the 8-15% off original asking price range. The one deal that was close to the asking price, was a property in a great location, with high west open city views, and priced perfectly.
If you have any specific questions for me about todays market, comment below, and I'll try to answer.
A: A few new blogs that I want to share with UrbanDigs readers, especially for those more interested in the bigger picture, than on one specific real estate market. The Aleph Blog, by David Merkel, and Across the Curve, by 30-year bond veteran John Jansen. Both are very good reads on the macro economy and the bond markets. For today, I want to discuss David Merkel's piece on why he is concerned about the state of the banking system bringing him to the ultimate conclusion that the fed's next move will be to loosen; I agree.
First off, I publicly stated my dovish stance in regards to future fed policy actions on AUG 5th, after the fed kept rates steady. To me, the fed is talking tough on inflation for a number of reasons, mainly to support the dollar, correct commodities & inflation expectations, and allow them more room to cut rates in the face of an event; such as a rescue of the GSE's or a failure of a large financial institution. Both of these risks are very high right now.
David Merkel looks at Barry Ritholtz's post on US Banks notional derivatives exposure risk, and gets a bit nervous. Some of his conclusions from his piece titled, "Banking on Continued Risk in Lending Markets", include:
ON BANKS DERIVATIVES EXPOSURE
"I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause. There are two claims on surplus — losses from direct lending, and losses in the derivative books.
Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged. When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run."
ON LINK OF BOND MARKETS, SPREADS & BANK LENDING
"The bank loan and and bond markets are closely connected. Troubles in one tend to spill over to the other. Loans have a higher priority claim, so the yields are lower than for bonds. As it is, investment grade corporate bonds, particularly financials, are facing higher yields. The high yield market has slowed considerably.
So, what does this imply? The banks are hunkering down. They are scrutinizing all risk exposures. They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy. Credit is getting tough/sluggish. And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years)."
As I discuss often, credit deflation & deleveraging. Read Mish's site daily as he covers the debate between inflation & deflation often, and is consistently in the deflation camp. Folks, this is all very important stuff. Think outside the box, if banks are 'hunkering down', minimizing risk, deleveraging toxic assets, taking losses, forced to re-capitalize, etc., how will this:
a) affect near term economic growth AND
b) set the stage for a sustainable recovery in the housing market
ON FUTURE FED POLICY
"So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much."
Exactly. The fed can't tighten with so much trouble still out there and they can't ease when the dollar is at its low against other major currencies, oil is near $150, and gold is near $1,000; the commodity inflation and inflation expectations are just too strong. The ideal environment for the fed to use their limited remaining bullets, is on a correction of the dollar & commodities priced in dollars. I think this setup is happening right now and I think the fed's next move will be a rate cut, likely inter-meeting in response to some sort of event. We still have to deal with the economic after-effects of credit deflation and an economy that has gone through sharp tightening of lending; and this is likely a late 2008 and early 2009 story. Good stuff.
Mish's TOO BIG TO BAIL List of Troubled Financial Institutions
A: Just got back from a last minute 4-day trip to a B & B upstate, so sorry for the lack of content. I must admit it was nice to get away for a few days and listen to nothing but nature. I feel a bit out of the loop though, with no internet since Sunday, but couldn't help but notice that the markets seem to be trying to play the GSE hand for the Paulson & the Treasury. With Fannie under $4/share and Freddie under $3/share, life after these institutions gets closer and closer to reality. So, as I discussed two weeks as a matter of WHEN and not IF, what do you think the world will be like when we wake up to the news that Fannie & Freddie are rescued?
Lets keep this a simple audience participation post, discussing what the following markets are likely to do when we awaken to the news that Fannie & Freddie are rescued by the government.
WHAT WILL HAPPEN TO?
1) Stock Markets?
2) Lending Rates?
3) Lending Product Options? 30 YR Mortgage?
4) Gold & Other Commodities?
5) US Dollar?
6) IB's, Major Banks, Regional Banks; residual damage?
7) The Credit Cycle & Deleveraging Process?
8) Account Deficits & National Debt?
9) Other Dynamics?
My two cents? When it happens, I think the stock markets will open down but that the fed will likely do an EVENT RATE CUT to sooth the headline shock to the tradable markets. The dollar will get hit, oil & commodities will surge, and lending rates will likely rise. Lending options will be reduced and I wonder about the idea of the 30 year mortgage being around anymore? I don't really put myself into that camp, just thinking out loud here and wondering if that is in fact a possibility? I think the market will then rally as the perception of this event being behind us & the fed's rate cut, will bring in some buying after the initial selloff; only to fail once investors realize we still have to deal with the economic fallout from this credit tsunami and the institutions that died with it. However, I just don't know enough about collateral damage of an event of this magnitude, or in what form the rescue will take shape, to discuss what life may be like 3,6,9, or 12 months AFTER it happens.
Dig deep, open your mind, and share with me what you guys think will happen both immediately & near term AFTER the rescue of Fannie Mae & Freddie Mac?
The data on bank asset quality are out from the Federal Reserve Bank of San Francisco and are presented below in graphic form going back to the last real estate debacle in the early 90s. While the data are from federally chartered savings banks and are not for all banks, it is a large enough sample size to be representative of what is happening with banks overall. Please note that savings & loans and credit unions have traditionally had a much larger percentage of residential mortgage exposure and a much smaller percentage of commercial and industrial loans and commercial real estate loans. Recall that while these data points are lagging because most banks that are publicly traded have reported results for the quarter, including some version of the types of numbers reported here; we consider this information to be very important in this particular crisis. This is because so many banks were involved in the CMBS market, wherein they packaged loans for sale and these loans or pieces of these loans appear on bank balance sheets as assets held for sale or trading assets and must be accounted for on a mark-to-market basis. This means that their values have been impaired by trading action in the markets related to assumptions regarding losses, but they don't really tell the story of whether the actual borrowers are still current on the loans underlying the securities. The only way to get data on this is to go through the static pool data that is filed on securitizations one at a time to get a picture of what is going on. Additionally, these securitized assets tended to be the most poorly underwritten. In contrast, the data below relate to loans that are of the highest quality; after all, these are the loans banks chose to hold on their books, for better or for worse, until they mature or default. These data also give us a broad cross section of data points from across the country, and we have great historical information to compare it to. If you're a data nerd like me....this is exciting stuff, if not you may want to move on to the latest Olympics news. Please excuse the large charts but because it is over 10 years of data it is very hard to see the scales at lower resolutions.
Okay. Residential delinquencies are an outright disaster, even the paper banks chose to hold themselves and not package up for sale to unsuspecting bond and hedge funds. Not that surprising, but the trajectory is like the space shuttle taking off on a clear day. No slowdown in the rate at which this paper is going bad is in sight and we are now well above the levels hit in the early 90s.
Residential charge-offs tend to lag delinquencies by a quarter or two. It's no surprise that these have gone ballistic recently. Note that charge-offs are sometimes reversed at a later date depending on how much value the bank gets when it re-sells the underlying real estate that backed the loan. The "severtity" of its loss will vary based on what the loan to value was on the loan and how badly real estate prices have declined.
Credit card delinquencies actually declined slightly quarter-to-quarter. It is possible that this is seasonal, as people tend to have shopping hangovers from Christmas in q1 and delinquencies may settle back some in Q2. I take any improvement in consumer debt delinquencies to be a positive in this environment. Remember that credit card receivables tend to be outstanding for a shorter time than mortgages and credit card companies are aggressively managing how much credit they are extending to customers and what punitive rates and fees they impose to try to keep consumers from self destructing.
Credit card charge offs played a little catch up this quarter. My guess is that surging bankruptcies associated with real estate losses may be sending some customers straight to the charge-off counter, leaving no skid marks at the delinquency desk.
Perhaps most important are the commercial real estate statistics. This category is what practically brought down the financial system in the early 90s, as you can see from the mountain of problem loans evident in the early 90s period on the chart above. Thus far it has held up much better than the residential area. But delinquencies broke out of a long slumber in Q4 and surged in Q1. The Q2 commercial delinquency figure is up a little but not surging like it's residential cousin; this is very good news indeed. Delinquencies are still far below the dark days of the early 1990s.
To some degree I can only speculate on the huge surge in commercial real estate charge offs. It takes some time for delinquencies to move to the charge off bucket and there is probably some cumulative effect from this lag. Additionally it is possible that a couple of large project failures moved quickly from delinquency and into the charge-off bucket. Without a further big increase in delinquencies, I would actually expect this number to drop back some next quarter.
At the end of the day, the total number of delinquent loans as a percent of all loans is the most important figure in assessing risks to bank solvency. While this number is moving up, it grew .27 basis points in Q2 2008 to 3.16%; this is a slower increase than the last 3 quarters, which ranged from .33 basis points to .43 basis points since beginning to climb in Q207. Note however, that at 3.16% of all loans, this is the highest level of delinquencies registered since the 3.25% level hit in Q1 of 1994. At that time, the economic/bank recovery was driving delinquencies below the 4% plus level sustained during the S&L crisis and commercial real estate crisis period stretching from 1985 to 1993. My key takeaways are that we have not reached these crisis levels yet, though it seems like we have a fair shot of getting there. Notice that we are back nearing the levels seen at the depths of the dot com bust, despite the lay off picture being less severe thus far in the downturn. Additionally, it is important to note that these horrible levels of non-performing loans were sustained by the banking system for 8 years during the last real estate down cycle and we didn't fall into a depression. So maybe there is still some hope.
All loan charge offs as a percentage of all loans have surged. But like the commercial real estate case it is probably a function of lumpiness and the lag versus delinquencies. I think banks are just starting to get more serious about moving delinquent loans into this category.
All in all the data are more of the same thing we have been seeing. The surge in residential delinquencies is alarming, while the more sedate increase in commercial real estate delinquencies and the decline in credit card delinquencies is slightly reassuring with regard to the spread of the credit pandemic to other asset classes. I will start to really worry if we see a surge in commercial real estate delinquencies, and especially if overall loan delinquencies get back to the early 1990s levels. Take small solace in the fact that we are not quite there yet.
"There's so much money around!"
Every investor circa 2004 - ?????
Every day we read about new funds being raised to invest in distressed this or distressed that. The airwaves have replaced get rich with no money down real estate investing commercials with get rich with foreclosure and short sale investing commercials. My contrary nature tells me that all this bottom fishing is a sure sign that we are nowhere near the bottom. An Op Ed piece in Monday's Wall Street Journal by Ethan Penner called "How Low Interest Rates Contributed to the Credit Crisis" really gave me a framework for how to think about why my gut feeling actually makes sense in the real world.
Penner was a pioneer of the CMBS market, who watched an empire at Nomura go down the tubes in the 1998 CMBS debacle, and not only does he know from whence he speaks, but he has learned the hard lessons of investing through assets cycles. You can find a copy of the piece here. In it, Penner explains in very clear and concise language how investors struggling to obtain high returns in a low return world (when the Fed lowered Fed funds to 1% following the DotCom/Y2K/911 experience), ended up going off the deep end chasing private equity, leveraged debt hedge funds and all manner of other risque investments. He notes that "It can be argued that it was the low interest-rate environment that actually fueled the huge boom in the hedge-fund and private-equity world that we've witnessed in the past decade. A major flaw in all this was that targeted returns became disconnected from the risk-free U.S. Treasury yield benchmark, to which all investments are implicitly pegged." He goes on to opine that "The system became burdened with the need to produce high returns, with many investors chasing that magic 20%, in spite of the fact that yield targets had little to do with the realities of the low-rate environment."
Along the way to trying to achieve 20% returns, so many basic tenets of investing were violated it is simply amazing. Let's touch on a couple of them. The first is the one Penner focuses on:
Don't stretch for yield (or returns) - i.e., when assets generate a high return it is because they are high risk, regardless of their packaging, and while they may look cheap they are cheap for a reason, so be sure that the risk of failure is very low (even Graham & Dodd, who loved cheap, harped on this latter point).
Match maturities, don't use short-term debt to finance long-term assets. The values of long-term debt securities tend to move around a lot more than shorter-term ones. Don't leave yourself open to having to refinance short-term debt during a downturn in the value of your long-term asset. SIVs were a great example of this, as were auction rate securities and the funding of certain mortgage REITs and even Bear Stearns.
Don't leverage assets with highly volatile cash flows. Perhaps the best example of this was the leveraged buyout of Freescale Semiconductor. The semiconductor business is inherently cyclical due to the large capital investments needed to build plants and the long lead times. This also results in the companies having high operating leverage. It doesn't cost much to make one more chip and this generates a lot of incremental profit. It also really hurts profits and debt service ability if you have to make fewer chips. Why would anyone buy a company like this and load it up with debt?......a big smoking crater is the likely result.
Don't leverage illiquid assets. This is a tricky one. Lots of hybrid securities, CDOs and other funky debt products looked very liquid while markets were functioning well, but liquidity went to zero as soon as people figured out they were much less safe that previously thought. The takeaway here is that the more complex the security (and harder to value without market comparables), the more likely it is that the instrument will turn wickedly illiquid if something changes the outlook for its structure or the underlying asset it is based on.
Don't leverage assets particularly using short-term money on an investment with an initial negative equity carry. This one is too complex to explain in this post, but it's about to crush the commercial real estate market. More in another post.
Of course, violation of these basic tenets is a part of all financial cycles and this is the same as it ever was, but of course the players have to keep coming up with increasingly sophisticated ways to delude themselves. This of course makes the unraveling all the more painful....it's not just a case of bidding tech stocks up to the moon and then having them collapse. As Penner notes, "Ultimately as is always the case, there comes a time when someone rears his or her head and questions the sanity of a deal and by implication, the entire market. At that moment, when everyone is fully invested and market participants have become most complacent about risk-management concerns, everything turns and the party ends abruptly. And thus begins the reversing of the leverage-driven run-up in assets values, with valuations ultimately returning to a level that is sensible and not predicated upon either excessive leverage or pro forma assumptions that everything will work out just perfectly."
For my part I would add that the most ironical thing about financial markets is that just as these kinds of re-pricing begin to happen, for some reason the world usually goes through a wrenching change, which not only adds to the aversion to leverage, but also makes the assumptions that investors are willing to plug into pro formas become much more pessimistic as opposed to just correcting from rosy to rational. Maybe it's George Soros' concept of the Alchemy of Finance,where financiers actually change the outcomes in the real world due to their monkeying in financial markets - it actually looks like this time around it really has been financial players who caused the mess. Or maybe it's just that the problems that are building in the world are what stops the financial freight train's run just as the populous at large starts to understand them. Regardless, Penner's concept that asset prices have to fall to the point where investors are offered a reasonable return versus risk free rates sans any hocus pocus or use of outrageous amounts of leverage is spot on. But as he notes, this higher return spread versus the risk free rate may involve a higher risk free rate (in today's case he thinks this may be driven by inflation). I would add to this that the rate of return must also be calculated off of a more problematic fundamental, regulatory and tax outlook.
I doubt that those stepping in to buy distressed assets now have fully embraced the potential economic changes and likely regulatory and tax changes that may stretch out the time horizons on their investments so far that the annualized returns won't really be worth the risks they are taking. Maybe they do understand and they will keep their powder dry until price levels really do represent strong rates of future return, factoring in the realities of the changing world. With all the volume of home purchasing being ascribed to foreclosure buyers, I have trouble believing that returns in this market will be compelling for a long time to come.
From the Blogosphere
The Political Psychology of Debt - Getting Rich on Foreclosures
Real Estate Tips for the Intrepid Bargain Hunter
Discover the Hidden Fortunes in Foreclosures with Web 2.0 Marketing System
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Private Equity Funds Focus on Distressed Debt
A: 'The weak dollar is powering Manhattan real estate by bringing in foreigners looking to take advantage of currency trends and buy prime Manhattan real estate on the cheap'. Does anyone else recall this statement made by brokers, real estate experts, and the media over the past few years? I certainly have. In fact, I wrote about this last year in my piece, "Does A Weak Dollar Accelerate Foreign Demand". But now that the greenback caught a bid, and has experienced quite a rally against other major currencies, what does that mean for us? Well, lets just break this down the numbers.
Back in November, I stated:
"As the US dollar falls against the Euro, it is more THEORY than REALITY that demand will accelerate when so much surrounding the macro environment has changed towards the negative! In short, there is no evidence that for every penny the US dollar loses against the Euro, 'X' number of additional buyers will pour into our marketplace.The discussion back then was simple. I made the argument that confidence trumps the currency trade and that Manhattan has already experienced the peak of foreign buying, which was one ingredient helping to keep Manhattan inventory tight as much of the nation's housing supply surged. Rear view mirror analysis doesn't help us, as we MUST always look ahead to stay ahead of the curve. So lets do some creative thinking here, as the dynamic of a weak dollar causing foreigners to buy is yesterday's news. If a weakening dollar made US real estate more attractive to BUY, a strengthening dollar will make US real estate less attractive to new foreigners seeking to take advantage of currency trends alone - If the dollar rally is sustained, it could also make foreign holders of US real estate more interested in selling, to take advantage of the local currency strength against their home currency!
I'm not saying there is not an attractive trade here. There is, and there has been for some time. Thanks to foreign demand, many of our new development inventory has gone into contract, in addition to many existing resales; especially the higher end. The element of foreign demand has helped keep Manhattan inventory at such tight levels, which in turn helped keep our marketplace shielded from the nationwide housing slump."
Here is the math:
WEAKENING DOLLAR BEFORE THE PURCHASE
2 YEARS AGO (1EUR = $1.278)
500,000EUR buys $639,000 worth of US real estate
6 MONTHS AGO (1EUR = $1.56)
500,000EUR buys $780,000 worth of US real estate
**As you can see, the weaker the US dollar is against the EURO, the more house a foreign investor using Euros to buy the asset gets, simply on currency trends.
This weakening dollar trend has been ongoing for 7 years or so. In 2006, the trend really accelerated and the weak dollar trade for Manhattan real estate became front page news. It had an effect, and many foreigners stepped up and bought Manhattan property, mainly new developments and conversions. This ingredient to our buyer pool, helped to keep Manhattan real estate inventory tight, while outside markets saw supply surging.
Fast forward to today and the recent dollar rally, and lets do the same math using today's currency valuations compared to the low the dollar hit against the EURO in mid-July:
STRENGTHENING DOLLAR BEFORE THE PURCHASE
1 MONTH AGO (1EUR = $1.60)
500,000EUR buys $800,000 worth of US real estate
TODAY (1EUR = $1.466)
500,000EUR buys $733,000 worth of US real estate
**In the past 4 weeks as a result of the dollar rally, foreigners can now buy LESS house for their money.
So, we can see the change on new foreign buyer demand. As the dollar strengthens, US real estate becomes less attractive from a currency advantage standpoint, because they can buy less house than what they could have purchased in the past.
Now, lets proceed to foreigners who purchased real estate on the currency trade, and how the stronger dollar affects their asset from a currency standpoint. The simple translation is, as the US dollar strengthens, foreigners will have more incentive to sell and take advantage of the currency gains that their US asset has against their euros. The question is, can the asset be sold for a gain?
STRENGTHENING DOLLAR AFTER THE PURCHASE
**since the dollar only recently rallied, we must use a hypothetical example to explain to you the reality of how a stronger dollar affects a foreigners property in Manhattan
BOUGHT WHEN 1EUR = $1.60
500,000EUR buys $800,000 worth of US real estate
VALUE IN US DOLLARS IF 1EUR = $1.466
$800,000 US dollars now equals $545,000EUR (exchange rate of $0.6815 into EUR)
Get that? The above example reflects how much gain the foreigners US owned asset will now fetch in their own euros if they sold at the same price they bought; simply because of the rally the US dollar has had in the past few weeks alone! Now of course this is a hypothetical example because there is no way a foreigner could have purchased the asset at the very top 2 weeks ago, closed on the property, and then sell it at today's exchange rate; plus not calculating transaction costs. The purpose of this math is to simply show you that when the dollar rallies against other major currencies, it changes investment psychology & makes the foreign owned asset more attractive on the sell side to take advantage of the currency gain.
Now, this does not mean you will see a flood of foreign owned condos hit the open market here in Manhattan. Mainly because the purchases were done in the past few years and the EUR was valued lower at that time; so even with this recent dollar rally, there is not the above referenced currency gain. Other factors will determine whether a foreigner chooses to list their property for sale; such as weakness of their financial position, intention of flipping, or confidence in the asset's future value. But it does show you the dynamics of the currency advantage and trade that has enveloped Manhattan real estate in the past few years. The conclusion, a stronger US dollar has a two pronged effect:
a) it makes new foreign US property investment less attractive as a stronger dollar means they get less bang for their foreign money
b) it could make existing foreign property owners more attracted to selling the US owned asset to take advantage of any currency gain they may have from the time they purchased
A great currency discussion for the times.
It's open season on skinny dippers! As the tides go out worldwide, voyeurs are getting an eye full of who was swimming naked. It's all fun until someone has to mark-to-market. Investors all over the globe are facing a slowdown and now scrutinizing the risks they are taking at home, and questioning the returns they should be expecting in a low real interest rate environment that looks to be spreading. Note that real rates in the US and China are already negative.
Let's take a brief tour of the latest carnage in pictures and figures.
The Shanghai composite Index is an absolute bloodbath (excellent chart below from Bespoke Investment Group). Either you believe that markets are completely inefficient and express no actual information about the underlying company fundamentals, or something has changed radically in China. I'm not just talking about giving up some ill-gotten gains related to over-enthusiasm for the China investment theme and the Olympics. The 60% decline in this stock market, a give back of over 2/3 of a 502% up-move, is a shellackering you don't see very often. I will wager that millions of people in China are now sitting on losses, despite investing in a stock market that had underperformed the world for a decade before its meteoric rise. Why?
I personally believe that China has grown way too fast, as I opined in an April 2008 piece China Update - Olympian Challenges. In it I stated "Economic growth can be like heroin, though, you keep needing more and more and it gets pretty ugly when you get less. Due to imbalances in the Chinese economy, the country has grown to rely on high rates of growth." Folks appear to be more than a little worried about these imbalances. But regardless, China doesn't have to implode for Chinese stockholders or the world to notice, it just has to slow down.
Seperately, the first negative GDP quarter registered in the Eurozone since 2001 was reported yesterday. The linkage to the U.S. is definitely being felt here, but the Europe has it's own home grown problems as well, particularly in the countries that boomed in recent years. Here's a chart on growth in the biggest economies there from The Economist.
Check out this chart of the oil correction from Futures.TradindCharts.com. I say correction, because I am not making a bearish call on energy from these levels in this piece, although I had been expecting commodities generally to weaken for the last six months due to slowing world growth (so i was a little early).
The impressive thing here is how fast this freight train of a bull market has wilted. I am showing you a less dramatic-looking daily chart, so you can see that it took about 9 1/2 months for oil to rocket from $110 to $140, but only 4 1/2 weeks to give it all back. This smacks to me of a market which was run up by weak players, who all bolted as soon as it turned south. Is it any wonder? As Noah has mentioned here before, oil in particular and commodities in general were the last one way trade. Here's the vicious cycle players were depending on.
Higher oil prices (and commodity prices) sap consumer spending power; this pushes more homeowners into default on their rapidly imploding properties; which causes more losses for banks and tighter credit, further slowing the economy; the weak economy leads to a weaker dollar, which causes commodities and oil to inflate more. The Fed can't ease rates due to a weak dollar (and inflationary pressures that result from it), their easing isn't translated into lower borrowing costs anyway because banks can't afford to take on any more risk while their current loan portfolios are blowing up and the Fed can't raise rates to help cushion the dollar out of fear of killing the banking system and the consumer. PREFECTO! the ultimate one-way trade.
The only problems with this trade were: What if the entire world economy started to slow causing unemployment to rise, and the ability to pay higher prices evaporates? and what if high prices actually do what they are supposed to and kill demand? It's always a guess what the elasticity of demand for any particular item will be and necessities like food and fuel seem like things people might accept a big price hike on before they cut back their consumption. But, of course, besides demand destruction, there's always substitution and trading down, which we are seeing in spades. You can see the contrast between Macy's Q2 results wherein sales fell 3% and Wal Mart's. We have all heard about the switch from driving cars (gasoline) to mass transit (electricity/coal).
So what's the next great one-way trade? In my book there is none - there will be the occasional distressed fire sale, but it will take deep pockets and a very long-term perspective to participate here....no ETFs I'm afraid. It is going to be a long, slow grind for the imbalances worldwide to get worked out. I have always believed that the imbalances were worldwide, not just because of the scary things I was reading about the London commercial property market, the Spanish and Indian housing markets and Chinese fixed investments, but because money was incredibly cheap worldwide and when money is cheap people do dumb things....sort of like when alcohol is cheap. Now that money destruction has begun to spread around the world, we will find out just how far and how deep the "mal-investment" or mis-allocation of capital around the world went.
On the positive side, I don't see inflation expectations getting out of hand in this environment (see my piece Oh Behave Inflation - NAIRU to the Rescue). Additionally, with the US already facing up to its bubble and cutting rates significantly/monetizing the debt, the dollar will look somewhat more appealing than the currencies of countries that are just about to start cutting rates. Check the chart below of the recent dollar strength. I don't expect a straight up move and it should pull back from the recent pop, but I think the one-way trade is over.
So should we really be rooting for a global rout? It's not going to help our export growth and corporate earnings, but it's an improvement from the vicious cycle of dollar weakness/inflation/consumer devastation. The tide will come back in eventually, but until then, as the Brits would say, "Keep your swimming costume on!"
From the Blogosphere
Investors less worried about inflation - Merrill poll
The party is nearly over - Eastern European bubbles
The South Sea Bubbles Again
Economic slump hits Spain hard after 14-year boom
Japanese economy shrinks, adding to recession fears
Euro pinned down as euro area growth contracts
A: Hardly news, but just maybe a wake up call. As I and many others have said since 2007, this is not just a subprime problem. What starts at the lowest level, eventually climbs to near prime and ultimately prime. What started out as a mortgage problem, quickly spreads to auction rate securities, HELOC's, credit cards, auto loans, etc.. This is an overall debt problem. This is credit deflation and assets are being marked down as price discovery continues. The cockroach theory is in full effect, so we should all expect the banking woes to linger.
From Bloomberg's, "Banks' Subprime Losses Top $500 Billion on Writedowns":
Banks' losses from the U.S. subprime crisis and the ensuing credit crunch crossed the $500 billion mark as writedowns spread to more asset types.For those looking ahead, check out Calculated Risk's reference to Clayton's take on the coming ALT-A problems:
The International Monetary Fund in an April report estimated banks' losses at $510 billion, about half its forecast of $1 trillion for all companies. Predictions have crept up since then, with New York University economist Nouriel Roubini predicting losses to reach $2 trillion.
"It just keeps spreading from one asset to another, so it's hard to know when these writedowns will stop," said Makeem Asif, an analyst at KBC Financial Products in London.
Clayton's report suggests that we may have now seen the beginning of the end of the subprime meltdown, but we are only at the end of the beginning of the Alt-A wave that is following it.It wont stop there. Alt-a, then prime, then credit cards, then auto loans, then student loans, then lawsuits, then jail sentences, then regulation, and then we know what credit deflation and peak credit is all about.
According to Clayton, subprime delinquencies appear to have peaked in December of 2007, and subprime foreclosure starts may have peaked in January of 2008. The volume of foreclosures in process will remain elevated for a long time as these things work their way through lengthy foreclosure timelines, but the peak in FC starts is good news.
Unfortunately, Alt-A seems nowhere near its peak yet. Clayton's report, based on May data, indicates that both new delinquencies and foreclosure starts in Alt-A pools are still rising. Fannie Mae's recent conference call suggesting that Alt-A deteriorated even more sharply in July is yet more evidence that the Alt-A mess is still ramping up.
If Roubini is right, we are about 25% through the writedowns. This is globally, so it very well may reach that tally when we look back at this history making cycle in hindsight down the road. As we live through, it will just seem like the problem that won't go away. I think the US will lead out of the mess though, just like we lead into it; with foreign banks/writedowns adding to the tally when we exit the cycle. The question is, when?
In these times of great confusion and virtually no forecast of the mortgage market, I thought it would be a great time to take a step back and look at what is happening, present day.
The mortgage market has experienced substantial change over the course of the past year and a half or so; Guidelines are stricter, underwriting is tighter, credit is scarce, and worst of all it’s not over yet. Some of these items may not be of great surprise to you as they usually make financial headlines at least once a week, but I wanted to touch on a couple of items that, in my eyes, need to be addressed:
1. Home Equity Products are virtually non-existent and even if they are available, they don’t offer too much benefit. There are many reasons for this, one of them being that home prices are falling all across the nation, making these products very risky investments on the secondary market from a collateral perspective. Even if a bank does offer a Home Equity product, it will limit them to very low CLTV limits and very high credit ratings. The days of 80/20 and 80/10/10 financing are LONG gone.
2. PMI is the solution. Since HELOCS and HELOANS are no longer available as a way to offer subordinate financing, full 90% or 95% financing is achieved using one big mortgage with Private Mortgage Insurance. In this instance a bank receives insurance from a third party to insure the note (since it is above 80% LTV/CLTV) and the premium for this is passed on to you – the borrower.
3. The GSE’s (Government Sponsored Entities) are struggling. This is never good for any person working with/looking for mortgages, the GSE’s raised the premiums they charge to secure loans, they are not willing to securitize as many mortgages as they did before, and they do not want to keep a lot of risky/toxic assets on their balance sheets. Who would?!?!
4. FHA – The temporary band aid. You will hear these 3 letters used more and more often than usual over the next few years. FHA or Federal Housing Administration is a government entity that uses more lenient guidelines to offer more people mortgages. There are many variables to this program but in a nutshell, they generally do not have a credit score requirement, you need to have stable income and must be able to prove it, and you need to produce various types of documentation to prove to the government that you are capable of repaying the loan. This all comes at a price and is not cheap. Doesn’t it remind you of that little mishap we all want to forget? Subprime?.
5. JUMBO Mortgages – Most banks are not able to get them off their books and therefore are not able to write new loans at decent interest rates. It seems like the mentality is that since there is no secondary market for JUMBO mortgages, the banks will have to take more of a spread to keep the loans in their portfolio. As a result I am currently offering 7.375% on a Jumbo 5/1 ARM @ 0 points.
This is just a small piece of the puzzle and is how I see the mortgage market present day. Almost every Fortune 500 company which at some point in time offered or continues to offer conventional mortgages, is reporting huge losses and we are certainly not out of the water yet. The outlook is to remain positive and hope for the best, the damage has already been done. And as Noah has said many times before, there is no such thing as free lunch.
Before I forget, I am MortgageMan. I am a loan officer at a major financial institution in the NYC area and have chosen to use an alias to remain anonymous. My goal will always be to give you a clear view of the current market status from a lender’s perspective. I will try to post consistently, and prioritize discussions when the market that I work in sees a drastic change; either for better or for worse.
In late February, I wrote a piece titled, "Sometimes We Get Lost in the Dark", as a change-of-pace discussion on what I thought described the state of our economy at the time. Thinking back now (when Bear Stearns was still alive), February was certainly a very dark and mysterious time for our markets as they navigated through unchartered terrain. I mean, who expected Bear was going to die of that quickly!
Today, I want to temporarily embrace an idea of what I think is going on with the recent dollar rally, seemingly sparked by a concerned Trichet in the Eurozone. It does have an orchestrated tone to it, and that's fine as long as you all know that I am not a conspiracy theorist or paranoid about such theories. However, I am a believer that there is a co-ordinated effort going on between our federal reserve and overseas central bankers to attempt an orderly unwind of global holdings of toxic waste. It is in nobody's interest that the system fail, and because of this very unique environment, I think the idea that specific markets (credit markets, currency markets, commodity markets, equity markets) are being targeted for orchestration to allow the mass unwind to proceed with minimal event-causing disruptions, is worthy of discussion.
Off the top of my head, I see the following interventions for the following markets:
a) Paulson's backstop plan for GSE's allowing the treasury to buy preferred shares of stock for Fannie Mae & Freddie Mac, thereby placing uncertainty and more risk for those holding, and thinking of holding, short positions. It's hard to raise capital if your stock is below $5/share!
b) the temporary restriction of naked short selling for a selected number of companies
Credit Markets (rate cuts & facilities offered by fed)
a) 325 bps of fed funds rate cuts, 350 bps to discount window
b) $30 Billion for rescue of Bear Stearns
e) TAF & repos
a) talk of lifting moratorium on offshore drilling
b) talk of windfalls profit tax on oil companies that will limit research & development
c) US Senate proposal designed to curb commodity speculation (The Stop Excessive Speculation Act, recently blocked by Republicans)
Currency Markets (central bank dissenters & rhetoric)
a) dissenting votes on rate decisions
b) 'tough guy' act in issued statement
c) Trichet's recent comments on concerns over Eurozone growth
Thats what I want to discuss, that last one. The recent dollar rally (30-Day US Dollar Index chart on the right courtesy of FXstreet.com) seems to be sparked by comments from Trichet over risks of slowing growth. That statement changed the view that Trichet will hike rates another 1/4 point, and instead now gives the impression that rates are on hold and may go lower in the future. Massive short covering and new positions are being taken on the dollar, resulting in lower commodities across the board; which is what we wanted anyway right?
Lets put ourselves in their shoes? HOW DO WE STOP RISING COMMODITIES? As I said April 22nd, ANYTHING THAT WILL SUPPORT THE US DOLLAR:
I've said this so many damn times on this site: commodity inflation + housing deflation is NOT A GOOD MIX! Pipeline inflation is bubbling and we can expect future inflation data to be very troubling indeed.There is speculation in commodities, I have always stated that, and it wasn't only supply/demand forces driving oil to $145; speculation helped and a weakening dollar drove that as commodities were the only asset class working for the past few years. The $30 of speculative oil I discussed 4 months ago, is where we are right now with oil down about $30 from its high in only the past three weeks. Obviously this proves that speculative trading exists in the price of crude oil.
The fix? Here's a thought: ANYTHING THAT WILL SUPPORT THE US DOLLAR! We MUST remove the speculative currency trade that has driven commodity prices higher; arguably there could be $30/barrel in speculative trade in oil as an example. Even if this means the fed changes verbiage to put their bias into the fight against inflation, then so be it! That would be interpreted by traders that future rate cuts are in serious doubt, the US dollar will be supported, and it would remove a good portion of the speculative trade in most commodities. It doesn't fix the supply problem that has resulted from fast growing economies like China & India, but it will help by removing the bets made simply on the premise of a weakening US dollar.
Thing is, I think we still have big problems ahead of us and a few big institutions that are going to fail. If that turns out to be true, the fed will have to cut rates to calm the tradable markets, probably before they re-open for trading again. If the US dollar was in the dumps, requiring $1.60 to buy one Euro, and with oil at $145 and gold at $975, there was absolutely no way the fed could afford to cut rates to deal with such an event. That would have driven oil closer to $175, gold closer to $1200, and the Euro closer to $1.75 against the dollar; think about that environment. That would have also made foreign holders of our debt very unhappy, and we do not need to deal with ramifications of that dynamic right now.
Things that make you go hmmm. So what do we do? Lets have a chat with Trichet and co-ordinate a change in public bias (lets not do anything about!), to fix some of the major macro problems that may come from surging commodity prices and a continued imbalance of currency valuations. If we, the fed, act tough on inflation, and you, Trichet, mention a blurb about slowing growth (which is happening so credibility won't be hurt), that could buy us a cushion!
It has a two pronged effect:
1) by giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will appease foreign holders of US debt
2) by giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will reduce speculative bets on commodities, and cause a correction in the price of commodities priced in US dollars
These are both welcomed events. But a third effect can be the bulls-eye accomplishment!
By giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will give our fed MORE FREEDOM TO CUT RATES should our economy continue to deteriorate down the road. To me, this is the ideal situation for Ben Bernanke and it is this exact reason that I think a co-ordinated effort to cushion the dollar may be in place right now. Call me paranoid, but to slow down commodity inflation, or at least the perception of inflation expectations, without hiking rates is a major ingredient to soothe some of the problems we face! Ben wants to inflate, and in my opinion will not hike rates as long as there is housing/credit deflation, unemployment is rising, and the financial sector remains under distress. Hiking rates now will be counter-productive to fixing the financials/credit markets (which is so crucial for a housing recovery to take place) and an orderly unwind of toxic securities.
An outcome supported by this way of thinking, is if our fed does indeed cut rates as their next move (who knows when), and if Trichet holds rates at 4.25% for the foreseeable future. Should this happen, then the fed orchestrated it wonderfully; that is, if there was a stealth co-ordination in the first place (I have to assume these guys are talking to each other, on the same team, and working together on the problems both face). Clearly, traders are covering dollar shorts and selling Euro longs, and pricing in either a US rate hike or a Euro rate cut. Lets see what happens next!
In conclusion, I think the fed knows that it needs bullets if unemployment continues to rise, the economy goes into a deeper slowdown, the credit crisis claims a big institution or two, or if housing/debt problems continue to accelerate and spread to higher quality classes. To be able to cut rates, the dollar needed some resuscitation and commodities had to correct. If the fed was forced to cut rates with $150 oil, and the Euro at its high against the dollar, the problems would be compounded and fed ammo wasted. With the dollar strengthening and commodities selling off, the fed has more legroom to do what they might have to do to invigorate growth and calm any spikes in distress in the credit markets. Time will tell if this scenario plays out, or if the US is really leading the world out of this mess (helped by tons of fiscal/ monetary stimulus) setting up a sustainable recovery for the US dollar and the proven burst of the commodities bubble. You know where I stand.
Related Currency Read from March 11th, 2008, discussing the impact of a more dovish ECB on our dollar:
That means the US dollar may not become as weak as expected and commodities priced in dollars may lose a dose of steroids (rate cuts) that they were betting on. If you want to get real crazy, what if we assume that international markets are lagging the US and they are about to enter a period of financial distress similar to what we have been through for past 4-6 months? Our currency could bounce further if foreign cb's start easing at a time when our fed found a way to limit future rate cuts. Ehh, just a thought with many if's.
A: Something that will affect all of us, when it happens. I use the word 'when', because quite simply, the only way these institutions are saved is if the US housing market has bottomed already and is in the process of recovery right now. I don't think anyone believes this is the case. Add in the fact that these two have taken very conservative mark downs on their toxic assets so far, when the tradable markets value these 'hard-to-trade' securities at much lower levels, and I get the feeling that the problems are being delayed, and not resolved. On quick view, I see that FNMA 5-YR spreads to treasuries has now widened to about 93 basis points, as investors appetite for Fannie credit risk diminishes. Should this spread widen to 125-150 basis points, we may have a problem on our hands.
First lets get to the charts. Below is a chart comparing 5-YR FNMA Agency yields to 5-YR Treasury yields; showing you the 93 basis points spread, about 10 basis points wider than yesterday:
*table courtesy of Vanguard Bond Yields
Second, here is a chart showing us the rise in premium (+21.9 basis points, or 10.55% since yesterday) required for credit protection (CDS) on Fannie Mae:
*chart courtesy of CMAVision Top 5 Widening Spread Movers
I do not have a bloomberg terminal, nor am I a credit default swap trader, so my access to this kind of information is very limited. However, I'll explain to you what I do know as I understand it and you can feel free to correct me or add to the discussion if you are more knowledgeable of these markets.
The CDS trade is the cost of buying protection in case of default. It is compared to zero. if the entity is riskless then the spread should be zero. If you are talking about the change then it's compared to itself on the previous day, same as a stock price change, only here a positive change is bad.
This means that to buy protection on Fannie's subordinated debt you have to pay 230bps per year (times the notional). So for a dollar of notional it will cost you 2.3 cents to insure, hence higher is implying greater probability of default and/or greater loss given default (lower recovery).
The conclusion from this graph is that you can tell there is not much appetite for Fannie credit risk and it's about as bad as it has been in the past.
Both Mish & Calculated Risk have discussion's on Freddie Mac's awful report issued yesterday:
Anyone following Alt-A mortgages knows that Freddie's claim is simply preposterous. Freddie has $130 billion in subprime and Alt-A loans. Somehow CEO Richard Syron wants us to believe the problem will go away if left on its own.
From CALCULATED RISK:
This graph from the Freddie investor's slides shows the default rates of Alt-As vs. the rest of the portfolio.For those not in tune with the credit crisis, Alt-A is 'near prime' or those mortgages considered in quality to be in between subprime & prime. News reports of warnings inside Freddie Mac being ignored surfaced this week, and speaks volumes about this entire credit/housing downturn experienced thus far. In short, they wanted to keep the party going! Well, as in all long-lasting parties, the hangover will be great. From NYTimes.com:
As we've been discussing, the 2nd wave of defaults it just starting, and Alt-A will be ground zero this time.
The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others.Just unbelievable. Now, Bill Gross of PIMCO (who owns a ton of US Agency debt) is saying that the US Treasury will be forced to buy as much as $30,000,000,000 of Fannie/Freddie preferred shares to bolster investors confidence for the institutions. Why you ask? Simple. These two institutions borrow short & lend long. With their stock prices in the dump, they wont be able to raise capital so easily by selling shares. If they can no longer borrow short at reasonable rates, we have a very big problem. That is why I included a chart showing you the spread of FNMA 5-YR yields to 5-YR Treasury yields. In normal times, the spread is about 50 basis points. In distressed times, it rises as risk rises. Today, its around 93 basis points. If that rises above 125-150 bps or so, the credit markets as a whole will get very shaky and that is something we just do NOT want right now! Fannie & Freddie must be able to fund themselves and that means investors need to be willing to do so at somewhat reasonable levels!
That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health. In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that "would likely pose an enormous financial and reputational risk to the company and the country."
But as they sat in a conference room, Mr. Syron refused to consider possibilities for reducing Freddie Mac’s risks, said Mr. Andrukonis, who left in 2005 to become a teacher.
"He said we couldn’t afford to say no to anyone," Mr. Andrukonis said. Over the next three years, Freddie Mac continued buying riskier loans.
We truly are at a crossroads and the existence of these two overly leveraged, overly exposed institutions are at grave risk. I wonder what the world would be like if Fannie & Freddie were nationalized, and shareholders wiped out? Thoughts?
A: BRETT FAV-RA! As a long time J-E-T-S fan, today is a great day! For god's sake, we have ourselves a damn quarterback. Excuse me while I shed a tear of joy. Ok, I feel better now. Back to business, I am getting a number of emails and questions regarding the state of Manhattan real estate right now. All I can say is this, the generally slow summer months here in Manhattan are a bit mixed. What I mean is, while inventory is dropping from a combination of a pickup in activity in JUNE & JULY and stale listings being removed from the marketplace, buyers are still bidding cautiously and only those sellers willing to entertain a price lower than they would like are getting deals done. Lets discuss.
As I said many times, out of all the charts I offer here on UrbanDigs, total inventory & new listings to me is the most accurate thus far. When I look at price reductions & contracts signed, I just don't see a good correlation to what I see out in the field.
Right now, inventory is tighter today than it was just a few months ago. But Noah, the NY Times had a whole report on the glut of 1BR apartments? True, they did. But I think something interesting is going on there, reflecting the macro environment. Lets think about it for a moment. One-bedroom buyers are mostly first time buyers and new couples, and the like, who may be more exposed to difficulties in financing and affected psychologically by the media reports of the credit crisis. Its easier for a first time buyer to hold off buying, than it is say for a growing family that needs more space to accommodate two kids. There is certainly a larger stock of one-bedroom apartments in Manhattan, compared to two or three bedroom properties, and I wonder how many alcove studios were converted to JR1's and marketed as one-bedrooms that are skewing the numbers a bit.
Taking a step back and looking at the real time inventory data, I see a 7-8% drop in actively marketed listings over the past few months. Here is the 3-MONTH chart of Manhattan inventory so that you can see this trend:
This is real-time data folks and the only purpose for me working to get these charts for you was to solve the lagging nature of Manhattan real estate statistics. I did not want to look at quarterly reports, and instead, I want to see what is going on NOW.
In normal markets, Manhattan is generally very active during JAN-APRIL and slows down as we enter the summer months and active buyers seem to be cut in half. Today, this market is anything but normal considering the macro environment. In my opinion, the months of JAN-APRIL or the so called wall street bonus season, was very sluggish which led to a steep rise of inventory as sales volume dropped significantly. Data shows inventory rising about 42% from mid-DEC to mid-MAY; from 4,500 listings to a top of about 7,800 listings. Thats quite a rise for the most active months of the calendar year!
For me, I saw a big pickup in activity in JUNE & JULY (two months that usually are slow for me after an active wall street bonus season; this year was reversed) and reported that to you in my July 16th post, "Manhattan Inventory Holding Steady":
"However, I must say that JUNE & JULY have been active months for me and when I talk to colleagues, these two months have been more active for them as well. So, I would expect this activity to contribute to slightly declining inventory for the next few months."Doug Heddings over at TrueGotham.com also reported on a pickup in activity in mid July:
"It's summer and although vacation took me away for a week, I have actually been quite busy selling real estate (4 closings this week and 5 contracts signed in past few weeks)."Those are two front line reports of the pickup in activity that we wrote about in mid-July, but is more reflective of the increased activity in late MAY & JUNE! First we see it, then we report it. When you go back and look at the total inventory reports, you can see the end result of the action that we reported to you last month in declining inventory. If anything, it validates the real-time reports Doug & I are providing to you, as we see it.
Moving forward, I think inventory will continue to stagnate if not, decline a bit more for the next few months. Right now, I have completed deals for most of my buyers who are now awaiting their closing dates. For anyone seeking to take advantage of headline shock, your biggest advantage is the generally slow traffic levels for this time of year; at the expense of fewer options! You really need a rising inventory environment and more seller competition that comes with more supply, to really get that ultra low-ball bid accepted. In my opinion, inventory will start to rise again next January and enter a weak 2009 wall street bonus season. Anyone seeking a deal right now will have to do so at the expense of fewer options. Certainly there will be pockets of distress where you can get a great deal from a seller that just needs to unload their property, but they will be fewer than what it was in May. If things change, I'll report it to you here on UrbanDigs.
A: Hmm, an expected decision yet confusing statement. As I read over this statement, I have to lean on the dovish (rate easing) side, as opposed to the hawkish (rate hike) side. It's hard to imagine the fed cutting rates when inflation threats remain and commodity prices have risen as far as they have, but if you look at the past few weeks commodity prices have come down fairly significantly. Lots of differing views on this latest fed decision and issued statement.
Let me break it down by downside risks statements and inflation statements, to make it easier for us to review. Afterwards, I want to get into Ron Insana's interesting take after the decision, warning the fed that they are missing the boat on the bursting commodities bubble and the deeper slowdown that we are facing.
DOWNSIDE RISKS STATEMENTS
* Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. (hmmmmmmmm)
* Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters.
* However, labor markets have softened further and financial markets remain under considerable stress.
* Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated.
* The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.
Fisher dissented and wanted to hike rates. Tough statement to break down. As CNBC had the economists and analysts break down this report, there were vastly differing views on whether this was a hawkish or dovish statement. It was very interesting to hear Ron Insana, whom I consider one of the voices of reason on the program, discuss:
a) the current bursting commodities bubble
b) the deeper recession
c) that the fed needs to cut rates and not worry about inflation that will ease as commodities tumble
Interesting. Certainly, the inflation that is out there is resulting from commodity inflation and is passing through to consumers in the form of higher food & energy prices. The inflation that most economists fear most is that of rising wage inflation and the money supply. There are so many definitions of inflation, that for this argument, we need to focus on the right ones.
Putting aside commodity inflation, I just do not see wage inflation or an expansion in money or credit. Do you? In fact, I see massive credit deflation out there and massive destruction of wealth in the shadow banking system; which ironically saw a massive build of wealth in the past decade to the tune of approximately $10 trillion dollars by early 2007. Boy how times have changed. Write-downs thus far in the banking system are around the $450 Billion mark and estimates range from total credit losses of between $1-$2 Trillion before all is set and done.
Should commodities continue to fall as Insana predicts, we could see a significant fall in inflation expectations as a result. My only problem with this is that if the fed has to cut rates aggressively to combat the deep slowdown, the US dollar will likely fall again and that could lead to a rise in commodities priced in dollars. But hey, he is Ron Insana and I am Noah Rosenblatt of Halstead Property! Time will tell.
In meantime, I think the fed is talking tough about inflation and may have to cut rates before raising them should the credit markets / housing markets continue to deteriorate OR if an event occurs to stabilize markets before trading re-opens; so I'm more on the dovish side while I see Barry Ritholtz on the hawkish side. Until then, I see continued pressure in the pipeline for housing, a rising threat to commercial real estate and the mortgages that back them as seen in widening CMBX spreads, rising lending rates, continued wide corporate spreads, and a tapped out consumer.
A: Peak credit, sounds like I hit my limit on my credit cards! I guess its kind of true. For owners of home equity lines of credit, you may have noticed a decrease in your available credit line recently. Why is that? Because credit has peaked, and is now contracting! As banks work to repair their toxic balance sheets, capital must be raised and cash hoarded; that means less lending for us consumers. Peak credit, the idea that our system of borrow now & pay later has reached its pinnacle, is a scary notion. So lets figure out just how out of whack we actually went, before discussing what credit deflation may bring in our future.
Yves Smith, of NakedCapitalism, was one of the panelists with me on the Inman Bull vs Bear debate a few weeks ago. I recall her mention of total credit debt as a percentage of GDP, but didn't really think much about it until I got back from San Francisco. Looking back at the video of the debate, Yves stated on the panel:
(5:56 into the video) - "...right now we got a level of debt to GDP which is OUT of proportion, way out of proportion, right now debt to GDP is 350%...never been that high, the highest it was at the depth of the depression was 260%, and its only went above that level since basically 2000, we had a parabolic increase in debt to GDP, but this is at a level that is just not sustainable in the long term, so the question is...what's going to make this break?"Interesting stuff. Below is a chart (courtesy of Austrianenginomics.com) that visually shows you what our total credit market debt is as a percentage of our GDP. Look closely and you will realize something very interesting when comparing the two spikes (the first starting after the Great Depression & the second from the past few decades as our economy was driven by debt & credit):
The use of debt in the 1930s was a direct response to the Great Depression! We used debt to get us out of the depression. Recently, we used debt for an entirely different reason: TO SUSTAIN ECONOMIC GROWTH! My two questions are, who are we going to borrow from this time to get out of this mess + how are we going to service our current levels of debt?
Yea, thats right. That huge runup that you are looking at above is the amount of debt that we have taken on to fund our growth for the past few decades. This is giving the term 'peak credit' a whole new meaning isn't it!
When you hear Mish discuss peak credit and credit deflation, now you know what he is talking about:
Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.So where does this leave us? Unfortunately, we are far from finding out as we are only in the beginning phases of credit deflation and credit destruction. The system that has drained every ounce of umph from available credit, is in fact, broken. That is why you are not seeing lending rates fall with the 325 basis points of fed easing seen thus far, and instead, seeing tightening lending standards implemented. It's a new world of tighter credit and higher costs of credit. For now, we still need to let the process unwind, delever, re-price risk, or whatever you want to call it.
Some choose to call what is happening "credit deflation". In this regard "credit" is an unnecessary label. Deflation is about the contraction in money supply and credit. The conditions now are very similar to what happened in 1929. The primary difference is that prices of many goods and services (notably energy and food) have been rising.
That is what worries me. How bright is our economic future when the credit system is deflating, the cost of credit is rising, and we already took on huge loads of debt? Lets face it, we have been a society built on credit, and now:
a) credit is contracting
b) the cost of debt is rising
Unfortunately, I wonder how much more debt we can afford to take on for future stimulus and to bail out troubled institutions that are too intertwined to our financial system to allow to fail. On the consumer side, credit is not being dispersed the way you would hope; those that need credit, can't get it, while those that don't need it continue to get new offers via snail mail. Looking ahead, I see three endings to this story:
1) we continue to service the debt as rates rise
2) we pay off the debt
3) we default on the debt
Its hard to imagine the US defaulting on our debts, but its also hard to imagine that Fannie Mae and Freddie Mac may be nationalized by this time next year! The key element here are the foreigners holding massive amounts of dollar based assets; our debt. I would expect the bond market to be hit at some point, as treasury prices fall and yields surge; especially if foreigners slow down purchases of our debt or decide to dump some of their holdings in. The next big bubble to burst could very well be the bond market resulting in double digit treasury yields. This is not a new argument, but to me, is probably closer than some people would like to admit.
Back to peak credit, I think we have seen it. How we adapt is anyone's guess. One thing is for sure, is that the credit platform that we have gotten used to for the past few decades, has vastly changed, and psychology with it. There comes a time when we will have to pay off our debts, and like with our pesky credit card bills, paying off debt is no where near as fun as spending it!
Bond guys have always been frowned on for being lovers of bad economic news....doom and gloom actually makes these guys bullish on their market - they're like Dr. Evil. The more people who lose their jobs the happier bond buyers are, unless it's bond market participants being laid off, oops, now there's a touchy subject. But seriously, bond owners receive a fixed payment for extending credit to others, who presumably use that credit to juice up their equity returns, which can increase with the success of their ventures. But the poor bond guy can only earn the coupon he has been promised and get back his principal. He has no upside. Not only that, if the value of money declines through inflation (or exchange rates) the poor bond owner actually sees the purchasing power of his money decline while he clips his coupons and waits for his capital to be returned. But if there is deflation, then he's in the catbird seat so long as it doesn't bankrupt his borrower. The bond owner clips his coupons, which keep going up in value versus everything else, and eventually he gets back his original investment, which has effectively increased by the amount that everything else has deflated over the same period. No wonder bond guys hate inflation and love unemployment. It's hard to have inflation with people being thrown out of work. With lots of workers around, who has the gumption to ask for a higher salary? For those thrown out of work, their consumption goes way down, freeing up goods for others to buy. This causes price increases to stay more contained than they otherwise would be or it might even make them decline. Makes sense to me.
This concept is embodied in an economic theory called NAIRU, which stand for Non-Accelerating Inflation Rate of Unemployment. You can read more about it here. The theory holds that there is a natural rate of unemployment that offers enough of a buffer of labor supply that the economy can grow at its full potential, without igniting an acceleration in inflation. Now the idea that increases in un-employment always have an immediate and direct impact on inflation (as calculated using the "Philips Curve") fell into dispute after the stagflation of the 1970s. But in a way this period actually caused people to rethink the NAIRU theory. It is now more often framed in terms of a relationship between employment and inflation where there is no absolute number below which one will see accelerating inflation, but rather a NAIRU that moves around over time. In an economy that has invested scads of money in labor saving industrial or computing equipment the NAIRU level declines, because productivity helps the economy produce more with more people employed, before wage growth needs to accelerate. In an economy that has strong unions, little investment in labor saving technology or capital equipment and cost of living adjustments (COLA) baked into the wage structure etc (as the US did in the 70s) the NAIRU level of unemployment is much higher. You have to throw lots of people out of work before expectations of future wage gains get squashed. This time NAIRU may have climbed for a different reason: growth in demand for commodities, outside the U.S.
So where are we now?
As you can see from the chart below, CPI is up significantly from the low of 1.069% year to year growth in June 2002, to the June figure of 4.901%. However, CPI is not really all that much higher than at the last economic peak of July 2000, when it was running 3.599%. Now we all know these numbers are junky and that the impact of price increases on our daily lives are much greater right now....but we will touch on this factor later.
Courtesy of Guild Partners
Note that unemployment bottomed at about 3.9% during the dot com boom, but never got quite that low during the housing boom. It troughed this time at 4.4% in March of 2007. In both cases the Fed got nervous about how low unemployment could go without sparking inflation (NAIRU). As is usually the case, the end of the recent boom was brought on by Fed rate hikes, which usually precipitate the upturn in unemployment, as the Fed engineers a slowdown or recession.
Courtesy of Guild Partners
The impact of rising unemployment on consumer price inflation during the dot com boom/bust cycle is quite vivid from the chart below. Now this is only one cycle, but I think you get the logic here and you can see the correlation. We don't have the July CPI number yet, so we can't see how it compares with the 5.7% unemployment just registered, which is the highest since December 2003. Please note that as Noah has described on Urban Digs before, the screwy seasonal adjustments the government makes means that recent inflation has thus far been under-reported in the headline numbers and will start to surge this summer as the funny stuff reverses. I believe that this time things will be slightly different in terms of unemployment's impact on inflation as much of the inflation we are seeing is beyond our control. For one, much of the inflation has been based on commodity price inflation, specifically energy-related commodity inflation - which now includes agricultural product inflation courtesy of the geniuses who brought you ethanol (food as fuel) subsidization. Also, the inflation pick up has been accompanied by and/or caused by a weak dollar. For this reason many feel that the inflation we are now seeing is completely out of the control of the Fed in that the higher interest rates needed to stabilize the dollar and quell inflation would send the economy into a depression.
Courtesy of Guild Partners
So let's talk about these two issues. On the commodity inflation side let's not forget the surge in metals like copper and steel as well as some construction materials like lumber that has occurred in addition to the energy spike. These commodities give us a bit of a laboratory to look at commodities that have been impacted by domestic demand and those that haven't. Check out this chart of copper (they call it Dr. Copper because it has an honorary economics degree). It is supposed to be a strong predictor of economic growth.
As you can see, copper, which is consumed all over the world and particularly in China, as they build out housing and their electrical grid, hit a peak in 2006. The big move that year was actually driven by a rogue trader in China who was caught massively short. (Note to traders: always get out/get short on the blow-off rally that results when someone else gets squeezed to death). It took copper a couple more years to make a nominal new high. It's still a bullish chart and commodity, but it really has not contributed to "inflation" for a couple of years. But it didn't fall out of bed, despite the fact that a lot of copper is used in construction of single family homes and the housing bust has trimmed US demand from this source. In contrast, take a look at lumber prices.
Lumber prices should be called US & Canadian lumber prices, as it is a largely domestic market, because it doesn't really pay to ship lumber around the world. See how lumber peaked, even before the housing market, probably just as the largest number of new homes were being framed out for sale in 2005. Now these commodities have their own supply demand stories, but they give you a feel for the fact that some can really be influenced by the US economy, while others are more global. Let's face it, the world has never been more global, so lack of US consumer demand for stuff, despite it being 30% of the total demand, doesn't automatically or immediately relieve price pressure on a global basis. However, when things get too expensive, it does kill demand. We have seen demand killing by gasoline prices for the last few months and oil prices have gotten hit pretty quickly. So while I think there will be a lag between unemployment rising in the US and a drop off in inflation, this time, I don't think the rules have been rewritten. Couple the increasing unemployment with a slowdown in foreign economies, which is causing the dollar to firm, and you can see where commodity inflation could start to fade. In order for this somewhat rosy scenario to play out, foreign economies must continue to slow, without US employment falling off a cliff by itself. This will be helped by US demand for overseas goods declining, while our exports continue to grow.
Bob Barbera is an economist whose work I used to read religiously. He has an amazing ability to point out the obvious, importantly it is usually only obvious to him because he actually does the work to scrub down economic numbers and see what they are really saying. In a recent piece that a friend forwarded me he opines "if it were not for improving net exports, U.S. output would have declined over the past three quarters. Deconstruct that contribution and you find that the big story is not booming exports - they rose at a 9% pace last quarter, equaling their growth rate over the previous two and a half years. The news is embedded in the import line. Real imports fell at an astounding 7% annualized rate. He goes on to mention that "Quite amazingly, average hourly earnings in July climbed only 3.4%, year-over-year, compared to a 4% year-on-year rise over the year ending in July of 2007. That is amazing because headline inflation rose by nearly 5% over the period. To what does the Fed owe this good fortune? Over the same period the jobless rate leapt, climbing to 5.7% from 4.7% one year back. Relax President Plosser, the leap for joblessness is keeping wages in check." Bob avers that the lack of wage inflation coupled with energy inflation is squeezing the purchasing power of U.S. households as never before.
So I find myself at least somewhat on the side of those bond market baddies playing Dr. Evil. Bring the unemployment.....just not too far or too fast and I'll be looking on happily....wearing my Nairu jacket of course.