Now It Really Is Time for Federal Agencies to Act on Housing

Friday morning was shaping out to be the much awaited follow-though day for the 400 point Dow rally on Tuesday. The equity markets had retraced a bulk of the gain and then bounced back on Thursday. The CPI number on Friday morning was benign and we seemed to be set for the races.

A few minutes before the market opened, the news about the Fed led bail-out of Bear Stearns (BSC) came out. Bear was under pressure throughout last week with rumors of a liquidity crunch. Bear's CEO Alan Schwartz had tried to dispel these rumors earlier during the week; however his public statements seemed to have worsened the situation. Bear's prime brokerage customers started pulling their cash; traders cut back on trades with Bear as a counterparty. There was a run on Bear and on Thursday night Bear's executive decided to seek help. A firm using a large amount of leverage needs time to unwind them. With the credit markets in a spin, it was not possible for Bear to raise the cash.

Bear's downfall was being predicted in the options market. There were tens of thousands of March put contracts bought at strikes of $20 to $30 below where Bear Stearns was trading. The put-buyers were confident that something big was going to happen very soon. It is not known who bought the puts, but I will not be surprised if it were entities related to those who were pulling their cash out from Bear.

There was also some chatter that Fed's decision on Tuesday to start exchanging AAA rated MBS for Treasuries was in part driven by fear of a major bank failure. UBS seems to have liquidated off large Alt-A mortgage portfolio at a 30% discount to par (PIMCO was the presumed buyer) and subsequent margin calls had decimated Thornburg Mortgage. Major companies have trouble raising cash using their MBS portfolio as collateral; the liquidation of Carlyle Capital's mortgage fund which invested in GSE-backed MBS was a prime example.

The Wash-Out Event

Disruptions in markets can simmer on for a long time till a major unthinkable event happens. If the catastrophic event washes out a major player or two, then that serves as a wake-up call to higher-powers who typically come out swinging.

We saw that wash-out this week. As I had written in my earlier post, it seems that the beginning of the end of the credit crisis is here. This being an election year, Washington will act, and act soon.

A Perspective on the Size of the Problem

Before going into details, it will help to get a sense of the magnitude of the problem and put it in proper perspective.

According to Arthur Frank, a mortgage-bond analyst at Deutsche Bank (DB), there are $950 billion of outstanding Alt-A securities, $650 billion in sub-prime securities and $500 billion of prime-Jumbo securities. The rest of the mortgage debt is GSE-backed paper.

All the mortgages are backed by homes where people live. Typically homes do not sell for less than replacement value for too long. And thanks to an increase in prices of raw-materials, replacement costs are likely to increase in the future.

Federal Spending and Resources:

• The United States has spent more than $500 billion on the Iraq war.
• The Fed has a balance sheet of $800 billion of high-quality collateral.
• The 2008 Federal Budget has a total outlay of $2,900 billion.

Restoring Equilibrium in the Capital and Housing Markets

Until recently, there was hope that the market would sort things through itself. However the disruption in GSE-backed paper has meant that the government is going to jump in.

The root cause of the problem is the decline in house prices, after the easy availability of credit boosted demand and pushed prices out of the realm of affordability. In order to restore equilibrium, the price of homes has to come in sync with the buying power of home buyers.

The equilibrium will be restored by:

• Increase in wages.
• Lower mortgage interest rates.
• Lower home prices.

It may take years for the housing market to find the equilibrium. What Federal Agencies should focus on is to make the re-pricing process orderly, and reduce economic disruptions resulting from it.

The best way to prevent disruption is to reduce the rate of decline of home prices while allowing wages to catch up. At the same time, increasing availability of credit to creditworthy borrowers at low interest rates will help increase affordability.

It is imperative to reduce and manage the amount of foreclosed homes which are coming to the market. A large number of foreclosed homes has a significant negative impact on home values and overall consumer and market psychology.

Managing Foreclosed Inventory: Long Term Rentals

Until now there has not been too much focus on how to handle properties which have been foreclosed. A silver lining, if at all, is that many of the foreclosed homes are concentrated in specific geographical pockets, especially in California, Florida, and Nevada. Regardless of the housing bubble, these areas are very desirable places to live in and have bullish demographics. This concentration allows the creation of property management entities who can rent out the homes till the markets stabilize.

As home-ownership rates decrease, the number of renters is going to increase. The rental market is quite healthy and showing signs of good rental income growth in the next few years.

In cases where the banks/servicers have already foreclosed, they should sponsor the creation of quasi-independent property management entities, which can then purchase the homes at a price which will make them cash-flow positive. These rental properties will then be off the market and will not contribute to the existing foreclosed inventory. The bank will be able to take the loans off their books. Further, the property will become an income-producing property and will be properly maintained.

This approach is different from the traditional approach of banks sitting on the property till they find a buyer. Banks have not traditionally been in the property management business. However, new challenges require new creative solutions. The property management companies can start selling the homes after a few years, once the housing market stabilizes.

There is legislative action being considered to provide up to $10 billion for states to buy and fix distressed properties. This is a step in the right direction. The scope of the program should be enlarged to encourage the creation of the property-management entities to reduce foreclosed inventory.

Fed Action: Reduce Mortgage Interest Rates

The Fed's focus is going to be to stabilize the market for MBS which will narrow the spread between treasuries and MBS. Lower spreads will translate to lower interest rates at the retail level and will increase the affordability of homes. It will also allow the Fed's interest rate cuts to make an impact on the housing market.

The Term Security Lending Facility is the start, since it allows a group of broker dealers to exchange MBS for Treasuries.

If the situation demands, the Fed can also go out and buy the MBS paper, especially the GSE-backed paper, in the open market. This will provide a bid to the MBS market and lower mortgage interests further. A number of commentators including Jim Cramer on CNBC have been urging the Fed to backstop the GSE-backed debt and restore market confidence.

FHA: Preventing Foreclosures

There are legislative efforts under way to empower the FHA to offer $300 billion more in new guarantees to help refinance distressed mortgages that banks and mortgage holders have agreed to write down. This will allow home-owners who are upside-down to refinance into mortgages, which will give them some equity and skin in the game. It will also result in lower mortgage payments. Sub-prime borrowers with good payment records would now qualify for better rates, as a couple of years of regular payments would fix their credit scores.

This is similar to the idea first circulated by Chairman Bernanke asking bank to write down under-water mortgages. Write-downs will bring clarity and more visibility into the liabilities of banks and help restore confidence in the markets.

Note that in terms of the losses realized, in most cases it will be profitable for the note-holders to allow the short-refinancing. The foreclosure process can take a lot of time and cost quite a bit of money. Further, there is no certainty of finding a buyer at a fair price, especially in auctions.

Allowing short-sales will enable the banks to recognize the loss, get the bad loan off the book and then redeploy the capital. It will help clarify the magnitude of the loss, and restore visibility and confidence in the markets.

Credit: Life Blood of the Modern Economy

There is a lot of pessimism in the air-waves about the state of the U.S. economy, and especially the credit markets. After sub-prime mortgages, investors expect Alt-A and even Prime mortgages to start underperforming. If the economic slowdown worsens, investors also expect credit-card and auto loan delinquencies to soar.

The root cause of this fear is the decline in the housing market. Restoring confidence in the housing market is the key to breaking the vicious, self-feeding spiral. A quantitative analysis of the scope of the problem indicates that the Federal Agencies have enough resources to stabilize the market. There is now increasing recognition that the Federal Agencies have to intervene to unfreeze the credit markets; even die-hard opponents of Federal intervention are reluctantly agreeing. This intervention will be for the greater good of most Americans; unlike a lot of other ways the government spends our taxes.

Comments

[romorris]

Should there be a disclosure that Vikram is long on housing ?

[Vikram]

rmorris:

1. I sold my home in September 2007 so I do not have any direct exposure to housing apart from any holdings in diversified mutual funds.

2. I do have some long calendar spreads on home-builders and financials; I am expecting short term volatility/downward pressure but long term growth.

3. I do live in the United States, and would like our country and its citizen to prosper. Free markets are fine as long as they are working properly. Right now the credit markets are completely broken and need government intervention. If past is any indication, government intervention at the peak of doom and gloom, has benefited tax payers (e.g. resolution trust corporation) directly and indirectly by generating stability.

[Erworth]

So far, the reaction of the mortgage markets is to increase rather than reduce rates on conforming first mortgages. Why is this not mentioned?

[e-mail]

[Vikram]

Erworth: Mortgage prices have gone up because the secondary market for mortgage backed securities is frozen. What was once considered (almost) as good as Treasuries is now being treated much worse.

Once the Fed's actions of allowing banks to exchange MBS with treasuries percolates into the system, the mortgage rates will come down. The spread between treasuries and MBS tightened right after the Fed announcement last Tuesday even though there were many entities who were deleveraging and liquidating their portfolios of MBS securities worth billions of dollars.

["Magazine-Cover-Indicator"Indicator....]

Once house price declines have finished (a longs ways down yet to get back to the long term trend lines), *then* a recovery can begin.

Slowing this correction down, as suggested here, means continued losses for builders, furniture makers, etc., as the correction is prolong.

That would mean more of these busniess go out of business than would in a faster correction.

The aid for speed and beneficial disruption in a fast correction are defaults and bankruptcies helping to re-set prices more quickly.

Likely we will get instead a bailout that prolongs the downturn and causes far, far more long term damage to the American economy.

The bailouts are yet another version of central planning instead of free markets.

Thinking your own interference and intelligence is wiser than the collective intelligence of everyone else (the market).