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Wednesday, February 09, 2011

Thunder Blizzards Of Housing

In general, mortgage rates respond to demand. If apps go up, prices do. If apps fall hard, prices (rates) also begin falling. But mortgages are longer term obligations, and so expectations, especially inflation expectations, play a big role in pricing.

MBA's weekly release generally has been recording low app volume since the full expiration of the housing tax credit, and now mortgage rates are rising very fast. This week's report has an increase from 4.81 to 5.13. In one week.

Treasury yields just soared yesterday. What's interesting is that when QE2 began, long rates started an inexorable rise. Short rates haven't moved much. In February, the action has been in the mid term - 2 to 10 year yields. I was kind of buffaloed to see the 3 year yield move from 1.04 on 2/1 to 1.40 yesterday. The implications are that the US will be facing much higher interest payments on our debt even if we keep rolling short.

Given those moves, I was awed and charmed by this Bloomberg article covering the Delphic musings of several Fed presidents. For example, what can one make of Fisher's comment?
“I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream,” he said.
It's hard to see how that could happen; rising food and fuel prices mean that the average person has less disposable income. More income, i.e. a significant growth in jobs, would produce an increase in money circulating, but QE2 is due to end in June anyway. That's not time enough. So I interpret this as Fed presidents trying to talk inflation expectations down.

Risks to the economy include a “depressed” housing market along with foreclosures and a high inventory of vacant homes, Lacker said. At the same time, the industry represents about 2 1/4 percent of U.S. output, “so the damage this sector is capable of inflicting is in some sense limited,” he said.
I think we need to send him over to CR's place. It's a highly variable piece of the economy that accounts for a disproportionate amount of economic change. Also mortgages account for far more of the economy than implied here. FHA has a loan program for home improvements/repairs. People get the money and pay to have their heating/cooling units fixed, their rooves fixed, their plumbing fixed. In other words, to keep their homes habitable. And mortgage refis account for a lot of financial income.

Home values in the US have resumed their inexorable drop. They aren't going to be helped by higher mortgage rates or the inevitable resumption of foreclosures. Or tax increases. Case-Shiller has prices down 31% from their peak. That is probably underestimated in total; homes that are selling now are generally the best of the lot.

Anyway, it is hard to see how the Fed is accomplishing much aside from raising prices, which have certainly already crossed out of commodities. Here's a NY Times article on the program. The Fed is buying in the mid term securities:

It's hard to see how much this is doing, if you look at a YoY comparison. The differences appear at the short end of the spectrum and the long end.

The political pressure on the Fed to keep those rates down is going to be fierce, but it does not appear that they can, using this strategy. One theory is that the Fed's buying program is holding rates lower than they otherwise would be. However Washington's habit of constantly increasing deficit spending might have more to do with the trajectory than anything else. Surely it raises inflation expectations (or risk). However risk and inflation factors in sovereign bonds are conceptually the same thing, and therefore impossible to distinguish.

Finally, just to close out this virus-addled post, take a look at Zandi's idea of how to fix the housing GSE problem. I think it is transparently idiotic. It does accomplish the main purpose of sheltering the large banks from their putbacks on more recent loans, thus sticking the taxpayer with the tab.

I do not think the taxpayer will be thrilled to find that instead of one Fannie, the proposal is for 5 or 10 (more, so they don't have the power to put back bad loans and can be dominated by the big banks) all of which will be taxpayer guaranteed. The incidence of sadists among the management of large banks appears to be rising, but the percentage of masochists among the taxpaying population is not. Oh, and you can kiss your small bank goodbye.

A white paper on the Treasury proposal of how to "fix" the GSE problem is due out Friday. That's because they do not want this discussed in the press. It is going to be a big-bank proposed deal. That's guaranteed. Our democracy is failing.

The other big banking news is about QRMs. This has to do with the financial reform, which as I have commented before, is lethal to small banks. A QRM is a "qualified residential mortgage", and it is deemed to be low risk and thus not subject to the 5% risk retention mandate in the financial reform bill. Wells is proposing that such mortgages should have 30% down. In theory, this is realistic. After all, housing values have fallen more than that in the recent debacle. But in practice:
"All other things being equal, a narrow definition will result in further consolidation in the mortgage marketplace to the benefit of large players and to the detriment of smaller lenders and consumers," said Karen Thomas, the senior executive vice president of government relations and public policy at the Independent Community Bankers of America.
Most banks were thinking more along the lines of a ten percent downpayment. The FDIC was thinking twenty percent. It seems logical to presume that higher costs will be charged to non-QRMs, so there is an impending collision with reality. The rule is supposed to be final in April.

Technically portfolio lenders do not need to worry about this, but in fact small portfolio lenders do. Getting caught in a liquidity squeeze or a rate squeeze is a much more serious problem for smaller institutions. They can either write variable rate loans or write five years with the idea that they can recover their capital at the end of the period by rolling the loan to a GSE once it has improved enough to qualify for good rates. Other than that, they are restricted to personal/business type deals. The final conformation of these rules and whatever mortgage umbrella packaging institutions exist in the future will control the types of loans that smaller institutions can write.

QRM rules are being written jointly by the SEC, FDIC and other banking agencies.

PS: People have a very incorrect idea about mortgage costs and financing. They really aren't that loose. For example, the current FHA mortgage insurance premium is 1% up front and about 0.85 percent annually. This takes your annual effective mortgage rate, using last weeks average, to 6%. For poorer credit risks, FHA is the way to go, but your front ratio (housing payment to income, including property tax and insurance) has to be at 29%. Fannie's LLPAs make their loans more expensive.

Believe me, home values are going to keep falling in most of the country.

First, thank you for the awesome material you post on your blog.

I have not had as much time as I'd like to pour through current real estate trends but was wondering where/when you think prices will bottom out? The government interference and artificial stimulation of the market has me wondering where the bottom is. I do see real estate prices approaching pre-bubble prices (I'm in Northern Connecticut) but sellers are still resisting the reality. We are looking to make our first home purchase, I am patient and truly see a home as an investment not a monthly payment, so want to make sure we don't lose money right away. Is the forecast drop of 5-10% more realistic in your view? My impression is those prices will sink even lower as food/gas prices continue to rise.

I also forgot to ask, there doesn't seem to be any clear indication of where/when interest rates are headed...any clue?

"Finally, just to close out this virus-addled post, take a look at Zandi's idea of how to fix the housing GSE problem. I think it is transparently idiotic."

You aren't a believer in the wisdom of Mark Zandi?

Every week is Snark Week! ;)
Mark - I have always thought reasonably well of Zandi, but now I'm wondering.
Mitch - interest rates are headed up. Probably not hugely over the next year, because I expect there to be some blowback from this little game we are playing.

As to RE prices bottoming out, it depends.

Locally, the first thing to think about is property taxes and demographics. If property taxes are going to keep rising, and if the demographics (new buyers and their incomes) aren't sufficient to move housing stock, then you can bet your downpayment that prices will keep falling locally.

In some places in NJ, I expect home prices to continue to drift down for 5 years or more, based on those factors.

Before you buy, figure out where you are in the new buyer spectrum. Are you low, medium or high?

The new census data will be released this spring. Once it is, you can pull all sorts of information about the county or counties in which you are looking. You can get population by age, population by household income, etc. Use "American FactFinder" at www.census.gov to do this.

Then look at property taxes and ask around. A lot of delusional people seem to feel that property taxes must fall when property values fall. That is very rarely true; it only happens in states in which they have a limit on property tax percentages as a percent of property value.

Usually, property tax RATES are jacked up when property values fall, because the cost of local government keeps rising.

So ask a realtor or someone in local government what their forecasts are when you have decided on a home or an area.

Find an older realtor who has been working the area for some years. They can be very useful.

People in which property taxes are hugely discrepant to what looks like the steady value of homes should not buy at all. I know this is hard to accept, but it means that the local government is out of control.

The housing situation in places like Trenton, Camden, Detroit and Buffalo did not happen accidentally. Once property taxes exceed certain value ratios, buying a home in that place is not a way to build capital for the future. Figure what you would be paying over 10 years for property taxes as a percent of the value of the home. If it is over 25%, it's probably a bad idea unless you can confirm to yourself that the situation will correct.

If it is over a third, don't even dream of touching it. Just walk.

You also need to know the percentage of bad mortgages in your area. Fortunately, you can access a county map of this data at FRBNY. Select all the loan types and go through for current, then the other statuses. You can use the county search option to see what the local stats are.
Mitch - It may seem that I am overcomplicating things, but what I am seeing in high-tax areas would knock your socks right off. I have areas in which some properties are selling for 50% more than others. Eventually it will stabilize down at about 60% off current if they can get their taxes under control. If not - implosion a la Detroit.

You can easily lose your shirt buying right now if you are not careful. Your losses will be limited if you are rolling plenty of equity over from one house to another. Your total housing payment might be much lower than rent, so that would pay you back over the years for equity you might lose, and with a lower mortgage, far more of your payment will go toward principal anyway.

But for first time buyers, buying in some areas right now can be a fatal mistake. You could wipe out 10-15 years of savings with one mistake.

"Mark - I have always thought reasonably well of Zandi, but now I'm wondering."

I don't think he's evil. He did put his money where his mouth was by buying real estate in Florida at the wrong time.

That said, good (optimistic) intentions can pave interesting roads.

My word verification is "reckstio".


"Mitch - interest rates are headed up."

How do you reconcile this with something you said last week?

"My belief is that ZIRP is a deflationary policy because it must and will constrict lending, thus shrinking the money supply and decreasing the velocity of money."

In my opinion, most believe that ZIRP is an inflationary policy. If they are wrong then the rise in interest rates we've seen over the last 6 months may be undone. We might see quite the shocker.

I'm not willing to bet on this either way. My bet is on inflation adjusted interest rates. I think a guaranteed 2% real yield on 30-year TIPS is a gift in this environment and the environment I project forward. I could be wrong of course.

I can say that it would have been a fine rate in the inflationary 1970s and it would have been a fine rate in deflationary Japan. (Japan's rates have been very low and their inflation has been mostly flat, hence their real yields are mostly flat).
Mark - in the short term, I think (and most seem to be speculating) that when the Fed exits its buying program most prices will quietly correct on their own. If you look at rates, there is a pronounced step after 1 year.

But in the longer term, more relevant to mortgage rates, the market is forecasting inflation. And I think they're right.

Certainly if we continue our drunken spending surge there will be.

You are buying TIPS to shelter from inflation. I am not sure I want to be in 20 or 30 years - there risks are too big. But you do expect a high chance of inflation over the decade.

"But in the longer term, more relevant to mortgage rates, the market is forecasting inflation."

Treasuries with inflation protection are being sold off too though.

I don't see what you see here. I see a market assuming that we are returning to business as usual.

I see a market trying to realign these two funds.


TIP holds inflation protected treasuries. IEF holds treasuries without inflation protection. Other than that, they are pretty much the same.

Note that they tracked each other extremely well until 2008. Now they are simply trying to get back in sync.

"You are buying TIPS to shelter from inflation. I am not sure I want to be in 20 or 30 years - there risks are too big. But you do expect a high chance of inflation over the decade."

You don't understand my motivations. I want the insurance. That's all. I buy fire insurance on my home not because I think there is a high chance that my home will burn, but because there is a risk it will burn.

If I truly feared high inflation then I would own fewer TIPS and more hard assets (like when I owned silver and gold from 2004 to 2006).

I'm just as fearful that these high hard asset prices (as seen in silver, gold, and copper) are no more sustainable than high housing prices were.
I also want to point out that I've been buying inflation protected TIPS and I-Bonds since 2000.

I certainly wasn't buying them out of fears of high inflation back then. I simply wanted the same thing I want now, long-term purchasing power protection. That's all.

I assumed then that inflation would be tame but I wanted the insurance just the same.

It is my hope that those without inflation protection do better than me. As I have said before, inflation won't help me as a holder of inflation protected treasury bonds.

All inflation would do is give me some bragging rights as the taxes on the inflationary gains make me worse off. I'll pass on that!

Here's my TIPS philosophy as stated back in 2008.

Broken Inflation Expectations?

"If you KNEW severe deflation was coming then there is no better bet than normal treasuries. You lock in 3% say and then watch the value of your investment rise during the deflation. Things get cheaper and yet your money still grows. It is a perfect situation for you. You will get richer. No doubt about it.

If you KNEW severe inflation was coming there are many better bets than TIPS though. When investors get scared of inflation they often run to gold, silver, food, and energy. That's exactly what we are seeing right now. Further, TIPS cannot protect you against hyperinflation. There's simply too much lag and taxes inherent in them for that.

TIPS are therefore a wimpy bet. They are for people such as myself who KNOW that we don't know (and there doesn't seem to be that many of us). I'm scared of inflation but I'm also scared of yet another bubble (commodities?). I KNOW how sure I would have been in the late 1970s stocking up on gold and silver. I also KNOW, using hindsight, that I would have been dead wrong."

In hindsight, commodities crashed shortly after I said that.
MoM, Excellent discussion of property taxes effect on property values. You should make that answer a post all its own.

Being a native NW Hoosier (ie. Gary, IN next couple towns over growing up), I know well how one can get a city full of houses that are absolutely worthless. It's actually not hard. If the deferred maintenance plus property back-taxes are greater than the cost of a home in the burbs, people aren't going to buy in the city.

It's not all neighborhood demographics. Taxes + purchase price < comparable good neighborhood is a necessary, albeit insufficient, condition for gentrification.
Here's an idea of where prices are headed. This is for the 884sq ft house on a third of an acre that I used to own.

In 1997, the house sold for $32k. It sold the following month for $60k. In 2000, it sold for $104k (which is when I bought it. I sold it for $125k in 2006. It sat empty for a year and sold for $195k.

I think prices for it will likely drop down below $100k at some point. To be in line with those $12 an hour jobs, it should drop down around that $60k price.
My younger daughter and her MIT grad hubby purchased in 2007, a 710K townhouse! They put down 100K but it has lost so much value that to sell now they need to bring money to the closing and with two small children they need a real house. I will bail them out, put up the necessary dollars so then can move along with their life and find a good place to raise the kids.
Disgusting is all I can say about the RE bubble in Calif. Nothing good comes from creating massive debts that young families in need of housing are forced to pay. My son in law makes very good money for someone so young but this experience will forever change his ideas about housing as an investment and make him much more cautious consumer. We are creating millions like him.
I wonder how much damage the housing bubble has done by limiting mobility? The economy relies on workers being able to go where the jobs are. If they can't sell their current home, they won't be able to move and purchase one in a new location.

I'm from The Region, too. Illinois side. The land of dead shopping malls.

We got the worthless houses in part because of jacking up property taxes on industry - it slowly whittled away and those businesses that could move to lower tax areas did and took their jobs with them. Some of those moves were only 30 or 40 miles so the residents stayed put and just drove longer, but their kids are the ones who escaped as soon as they could.
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