SunLakes of AZ Blog

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March 2017

Future of American Housing Finance

by Karl Schroeder for Finance

 In recent weeks, government discussions have (again) picked up concerning how to prevent a repeat of the recent mortgage crisis.  The problem is multi-faceted, but all begins in the loan origination process, which eventually turns to the heart of how and to whom business is incented during that process.  Intertwined in that discussion is what to do with Fannie Mae and Freddie Mac—the government-sponsored mortgage securitization entities now in conservatorship and effectively owned by the American public.  According to recent statistics, approximately 90% of the U.S. residential mortgage market is currently backed by the government in some fashion. 

A few weeks ago, the FDIC board offered a proposal to formally define a “safe” home loan as one that is originated with a 20% down payment (the familiar standard for many years).  If enacted, banks would be restricted in their ability to repackage or “securitize” loans sold to other entities that don’t meet this criteria… with the caveat that loans that meet other/different strict underwriting standards, or that are sold to Fannie Mae or Freddie Mac directly, could be exempt, so this may not solve as many problems as we hoped it might.  (By contrast, the Dodd-Frank bill had defined a “safe” loan as a 5% down payment.) 

We may end up somewhere in between.  The hoped-for impact is to encourage banks to underwrite loans of a much higher quality—at least for those that are sold away and securitized to global fixed income investors.  Banks would then be essentially “punished” for producing lower-quality loans by being forced to keep them on the books, as they tended to do prior to the creation and explosion of mortgage-backed securities markets in the 1980’s and 1990’s.  The proposal is now open for public comment, but is likely to receive push-back for a lower-quality standard, from both banks (where tightened loan requirements may mean a smaller pool of “quality” borrowers and,  hence, more competition) and realtors (whose livelihoods depend on a high volume of real estate transactions; tighter financing availability thwarts this). 

Historically, a “traditional” lending model tended to work due to the common alignment of risks between borrower and lender.  In loan underwriting, determining which borrowers were deemed stable enough for loan approval, the well-known “C’s” (capacity, capital, character/credit and collateral) provided a fundamental theme for the due diligence process and overall loan portfolio risk reduction—critical to bank solvency long-term.  Simply put, the better the ability and willingness to pay back a loan (or ability for the bank to recover assets in default), the better the risk-reward tradeoff for the lender.  While this has translated into a more complicated political issue when we talk about housing, it seems fairly simple when we apply the same standard to “risky” assets like high yield or emerging market bonds.  We use this same terminology of the “C’s” and such analysis is assumed to be a standard part of the process.  In fact, it would be considered highly imprudent for an investor to disregard any of them when reviewing these criteria from the standpoint of a potential investment.

In regard to Fannie Mae and Freddie Mac, a recent government report co-authored by the Treasury Dept. and HUD summarized their complicated histories in providing homebuyer stability as well as cataloged their respective breakdowns in the years prior to and during the 2007-08 financial crisis.  As these quasi-public institutions now reside in public conservatorship requiring billions of dollars of ongoing support, their ultimate wind-down seems likely.  Yet-to-be-determined are the how and when, as well as what type of entity might take their place.  Or, if any entity at all needs to fill this role (many Democrats believe government should remain involved in housing finance, while Republicans tend to be not so convinced). 

Putting this into longer-term context, some have referred to this as a classic case of government’s good intentions gone awry.  Under decades of economic prosperity and rising home prices across the U.S., financing mortgages with down payments and interest rates that were almost certainly lower than what would have been required by the “unsubsidized” private market, was not as risky as it could have been if a lower-growth/more volatile housing price environment had been the norm.  During this time, the psychology that home prices “only go up” started to become ingrained.  (Data crunched by Dr. Robert Shiller showed that, on an inflation-adjusted basis since 1900, residential home prices moved upward at an annualized real rate of only 0.7%—which appears to be lower than estimates assumed by homeowners in some markets.) 

Political goals also seemed to muddy the waters here.  Owning a home has become synonymous with “The American Dream,” and elected officials have largely promoted widespread home ownership.  However, after a certain ownership point was reached (roughly 65% or so) and banks and federal agencies were prodded to expand loan availability to larger cross-sections of borrowers, higher home purchase levels have come at the cost of deteriorating credit standards.  Interestingly, in other areas of the world (in Europe, for instance), ownership does not appear to carry the same sense of urgency.

In fact, as American workers need greater flexibility (both economic and geographic) in the modern economy to effectively compete—as corporate “restructurings” and flexible work make a single employer in a single location for long periods of time less and less common—one might argue that owning a home over shorter stretches might make less sense than it once did.  These are important changes to consider when looking at current and future housing market pricing dynamics.

What does this mean for investment portfolios?  There is probably less of a direct impact than may first appear—aside from clients who own rentals in certain geographic areas and are concerned with occupancy rates.  Commercial real estate properties, such as REITs, respond to different fundamentals such as overall economic growth, vacancy rates, level of supply and other business conditions.  From a homebuilding industry perspective, we are still building fewer homes than we will eventually need—in reaction to the overbuilding of the last cycle. 

One positive aspect for GDP growth that separates us from other developed areas like Japan and Western Europe is that our demographic situation is not as dire.  On average, our population is not aging as quickly and our immigration is net positive—which creates additional demand for housing through higher household formation rates.  All requires patience; these are long-term trends and real estate cycles are notoriously slow to unfold due to the low liquidity of a home relative to other assets.  We will continue to build new homes.  The question of how we will finance them, however, remains unanswered.

Economic News

The ISM Non-manufacturing Index slowed to a still healthy level of 57.3% in March from 59.7% in February.  Although this index retreated somewhat from the levels last month, any number above 50% indicates growth in services.  This is important since almost 80% of Americans work in various service industries:  finance, healthcare, utilities, retail and wholesale trade, education, media, etc.  The employment sub-index within services was reported at 53.7%, below the 55.6% from February.  The good news is that the overall level is still in line with above-trend GDP growth, according to several economists.

The European Central Bank has raised their benchmark interest rate by 0.25% to 1.25% in the first change in over two years.  The bank argues that increasing inflation pressures compelled them to act now despite all the weakness in the peripheral European nations, the so-called PIIGS.  The move coincidentally follows Portugal applying for aid from the ECB to avert a liquidity crisis in government funding.

The Bank of England left their key policy rate unchanged at 0.50% after their monthly review of monetary policy.  They argued that rising unemployment and a general malaise in the economy is a bigger threat than inflation.

The FOMC Minutes came out, which essentially told us what we already know.  Officials raised concerns last month about potential higher energy prices weakening the economy and sparking inflation—this led to talk of when/how much to raise rates.  On the other hand, enough slack exists in resource utilization to pre-empt many core inflation fears at this time.  Currently, the December 2011 futures have implied a 66% probability of the Fed Funds rate remaining at its current 0.00-0.25% level, and only an 18% probability of a 0.50% level.

Initial jobless claims continue to decline down to 382,000—the decline was expected, but the number was even better than forecast.  Continuing claims and extended benefits also fell in line with the improvement trend.

Market Highlights

U.S. stocks lost ground a bit last week, as the S&P 500 fell roughly half of one-percent.  Foreign stocks were up roughly a percent and the U.S. dollar weakened by about the same amount, which explained some of the difference.  Investors may looking ahead to corporate earnings results this week and beyond.

The 10-Year Treasury yield rose from 3.45% to 3.55%, which caused a poor week in the domestic bond market.  Accordingly, the Barcap Aggregate lost about 0.5%, led by a very difficult for long government debt.  Floating rate and foreign bonds, including emerging markets issues, were generally positive for the week. 

The Asian group led the REIT market, followed by continued strength from improving conditions in 2011 for European REITs, while U.S. REIT were down across the board about -2.5%.  Apartments outperformed industrial. 

The big winners of the week were commodities, as the GSCI gained 4%—led by sizable gains in oil and industrial metals.  After a strong month, natural gas was the biggest loser of the week.

Have A Great Week!

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.

4801-895-0611

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