Wednesday, September 26, 2012

The housing market deal of a lifetime


This chart of the yield on current coupon FNMA collateral and 10-yr Treasury yields, and the spread between the two, is good evidence that the Fed has finally managed to distort market pricing. MBS spreads are now almost zero—implying that FNMA MBS are as rock-solid and as attractive as Treasuries. Which of course they aren't. Mortgage-backed securities have nasty characteristics that Treasuries don't: when yields fall, their duration shortens (because homeowners can prepay their mortgages), and when yields rise, their duration extends (nobody will ever want to prepay a 30-yr mortgage with a 3% rate). That's called negative convexity, and that's one big reason why MBS yields are almost always higher than Treasury yields. Investors require an extra yield on MBS to compensate for their erratic cash flow risk. Not to mention, of course, that they don't have an explicit U.S. government guarantee.



If MBS spreads remain near zero, then 30-yr fixed rate conforming mortgages (orange line in the first chart above) could fall to 2.25%. (Over the past 15 years, the average spread between FNMA collateral and 30-yr conforming mortgages has been about 60 bps, which when added to today's 10-yr yield of 1.62%, gives you an idea of just how low conforming mortgage rates could go.) At that outstanding, almost unimaginable level, everyone who doesn't own a home should be willing to stand in line outside a bank for however long it takes to qualify for a mortgage, and then turn around and buy just about any home on the market. The Fed has succeeded in creating the housing market's biggest "blue plate special" of all time. Come and get it! A once in a lifetime opportunity to lock up unbelievably low fixed-rate financing and buy a home at a price that's not going to last much longer.

The one thing standing in the way of what should be a stampede of new home buyers is that it's not so easy to qualify for a loan. Banks have been loaded to the gills with reserves, and thus able to make an almost unlimited number of new loans, but they haven't—because they are still very risk-averse. You need 20% down to qualify, and your credit scores need to be good, and your employment solid. Not everyone can qualify, and many can't.

Regardless, this is a situation that can't last for very long. When market prices are distorted artificially, powerful arbitrage forces are set in motion. Large institutional investors are going to want to sell their MBS holdings at what could be record-setting high prices. Yields going forward are paltry, downside risk is enormous, and upside potential is extremely limited. The Fed's promise to buy $40 billion per month of MBS could be swamped by the decision of money managers to lighten up on their MBS holdings, which are measured in the many trillions of dollars. In other words, the big decline in MBS yields could quickly reverse, because the Fed can't permanently distort the yield on a market that is many trillions of dollars in size by buying a paltry $40 billion per month.

Meanwhile, those who can get loans are going to be putting that money to work in the housing market, and that's one reason why prices are firming in many parts of the country. The new mentality: buy now, before prices go higher. (Banks with tons of REO on their books will be thinking: no rush to sell now, maybe prices will go higher. Homeowners who are currently underwater will be thinking: maybe I can hold out a little bit longer and things will get better. It all adds up to less selling pressure and more buying pressure and the outcome can only be higher prices.)

And of course, banks are at some point going to be relaxing their lending standards. If they don't do it on their own initiative, then you can bet some politician is going to figure out a way to force them to. There is a precedent for this sort of thing in the U.S., after all, and that's one reason we got the housing market bubble.

13 comments:

Dr William J McKibbin said...

I concur with Scott -- anyone who fancies themselves as a real estate investor should be crowding to the front of the line to buy equities while the bargains are still out there.

In particular, families who have been paying their bills and have good credit will want to scratch up a down payment any way that they can, and then purchase a family home -- I purchased my first home back in the 1980's with 20% down, but my interest rate was over 10% (and I thought that was good at the time) -- families today can purchase a home at record low prices AND record low interest rates -- the deals cannot get any better -- if you are in the market for a home, now is the time to scratch up your down payment anyway you can -- get another job, sell a car, have a massive garage sale, whatever -- we are in a window of opportunity that will not last forever.

PS: For the record, I advise that families buy homes only if they plan to live in those homes for a minimum of 10 years. I am not a fan of "flipping" houses. Buy the home you can afford and want to own and maintain.

PPS: Accredited investors will want to confirm occupancy, management fees, and deferred maintenance before investing...

PPPS: I am still concerned about the long-term implications of QE3 in the meantime -- also, the spread between the DOW industrials and transportation does not bode well...

Gloeschi said...

Yes, a home is an asset, and I can live in it, for free! Oh wait, town taxes are going up exponentially. Oh no, my house is actually a liability once I account for the net present value of school and other taxes over the next decade! I wish I had never listened to those siren songs...

Benjamin said...

interesting post by Scott Grannis. I concur; buying housing any way you can.

But, one always has to ask the question: What makes any level of interest rate that the Fed chooses "artificial" or "natural"?

By some estimates of the Taylor Rule, right now the Fed should be pursuing negative interest rates---which of course, it cannot.

While Scott Grannis keeps thinking interest rates must go up, they keep going down. In Japan the same thing happened. There is capital everywhere, gluts of it, in the banks, the mutual funds, the private equity shops, the sovereign wealth funds, pension funds and more and more and more.

The Fed has been far to coy and timid in fomenting economic growth. It's peek-a-boo, hide-and-seek monetary policy belongs in another era.

steve said...

Glooeshi has it right. ONLY buy a home if you need one and can afford it. taxes/maintanance/slippage (cost of buying and selling) eat up much prospective gain. I've been in my house in albany, ny for 23 yrs and am way underwater relative to purchase pr.
moreover you guys ignore another obama term and the pernicious results that will surely follow.

Public Library said...

Haven't we seen this record play before? Although the coming crash will not be a securitized/counter party problem, you will need to get in and out before you are left holding the Japanese real estate bag. We already know what decades of artificially low rates do to asset prices. The answer is not that they go up...

On a side note; I am happy to see in this post Scott admit for the first time the Fed is manipulating prices!

Gloeschi said...

Radio silence

(Beach Pundit desperately trying to put positive spin on durable goods orders)

Tom Armstrong said...

You're not carrying your thought experiment to it's logical conclusion. If/when rates drop even further and institutional holders of MBS decide to sell, rates rise, right? Ok, if rates rise then mortgage payments rise for the next buyer. In other words, you bought a home for $500k with 20% down because at 2.5%, the P&I is only $1581/mo. On your modest income of $5300/ mo, that's 30% of income; not bad. Lots of people make $5300/ mo and can afford that payment. But rates start to rise, to say, 6%; still modest historically. Assuming the price doesn't change when you sell your house, the next buyer is looking at a P&I mortgage payment of $2400; meaning the next buyer has to have a household income of $8000/ mo to have the same 30% primary DTI. A considerably smaller pool of buyers make $8000/ month. In most cities, $5300/ mo is below the median, but in almost all cities, $8000/ is well above the median household income.

So, what has to give if you are to find a buyer?

The price.

To get to the same $1581/ mo P&I payment at 6% interest, the loan amount has to come down to $263,700, which is 80% of a $330k purchase price.

So congratulations. You're 20% underwater. Again. But at least your interest rate is low.

Unknown said...

what ever happend to "Better to buy cheap assets with expensive money rather than expensive assets with cheap money"?

Dr William J McKibbin said...

@Tom, the goal is not to buy and resell real estate in this market -- rather, the goal is to own real estate and then rent to others -- housing costs will rise sharply as prices and interest rates go up -- rents will also rise, which will advantage owners in 20-30 years from now -- the key is to make acquire quality real estate in excellent condition that you can rent for the rest of the property's usable life -- looking for a short-term or mid-term flip will not work, you are correct.

Tom Armstrong said...

@Dr. McKibbon. I understand the competing goals, but given that the average time of ownership on any given home is something under 7 years; especially for owner occupied homes, and that the overarching goal is the increase of net worth, does it make sense to make $200/ month on rent while you lose $1000/ month in value, and have no flexibility to sell if you need to for whatever reason, since you're underwater?

It makes more sense to me to keep the powder dry and wait for the next leg down, then buy at a higher interest rate but lower price.

Anna Tycner said...

I agree with Gloeschi “Yes, a home is an asset, and I can live in it, for free! Oh wait, town taxes are going up exponentially. Oh no, my house is actually a liability once I account for the net present value of school and other taxes over the next decade! ” Good to have a home. When times are uncertain and high the price of gold “ceny zlota”.

allenrobles1 said...

The secret about buying houses at an optimal time is... there is no optimal time. It's always good. Having clear guidelines and goals about what it is that you want as an investor is the key to going out and purchasing good rentals.roofing materials cost

Mark John Acantilado said...

A home could be both become an asset and liability at the same time. It becomes an asset as it you may use in in several purposes for paying something or investing in something but also becomes a liability as paying taxes becomes a burden, etc. how to get your real estate license in Michigan?