The Housing Problem
Everyone is now focused on housing, mortgage resets, losses at financial companies, and potential effects on the consumer. There seems to be some competition to claim who was first in pointing out these problems. Before the days of this blog, we warned our clients about over-investment in real estate. The difference between us and others is that we did not suggest some imminent market collapse. There was opportunity in equities, on a comparative valuation basis, and there still is.
The Market Perspective
Most market pundits see this as a black-and-white, light switch kind of problem. There is an economic problem. It is up to the Fed to act. They should cut rates aggressively. The Fed does not see what we do, therefore they are slow in acting. (We should offer a prize for any article that makes this point without using the phrase "behind the curve.") It is all about the Fed and how fast rates are cut.
Then we see last Friday's trading, after Bernanke does signal aggressive action is in prospect, the markets start to worry about what that means. There is a reason for this: It is not a simple problem of interest rates.
A Multi-Faceted Problem
One of the things that distinguishes our approach is a public policy perspective. We look at all aspects of problems and consider the possible role of various government institutions in reacting. This is important for our readers and investors, because it represents how the Fed sees issues. An investor can pretend to instruct the Fed or can understand the Fed. To us, the choice is obvious.
A public policy analyst would see the housing problem as having various dimensions, including the following:
The Housing Market. Prices are falling. Mortgage resets are forcing refinancing decisions. Falling prices make refinancing difficult or impossible.
The "old" Mortgage Market. Structured investment vehicles including both performing and non-performing assets were improperly rated by agencies. Trading in these securities is now illiquid. Financial institutions are scrambling to deal with this. They are holding distressed securities rather than selling because current market conditions do not reflect the likely payout prospects. Meanwhile, the market for securitized mortgages has seized up.
The Existing Mortage Market. The absence of securitization has disqualified many potential buyers. The limitations on Fannie Mae (FNM) and Freddie Mac (FRE) exacerbate the problem. Those seeking loans of over $417,000 pay a penalty rate of a point or more, if a loan is available at all. Other willing buyers who qualify for loans, albeit at a lower level than before, arevhave difficulty in getting loans.
Interaction Effects. Falling home prices exacerbate the problems of refinancing, shifting supply curves to lower price levels. Mortgage unavailability shifts demand curves lower. Falling prices cause potential buyers to hesitate, also shifting demand curves lower. There is an interaction effect making each problem worse.
The "new" Mortgage Market. There is and will continue to be a demand for securitized mortgages. The market will emerge again with cleaner products and better ratings. It will probably not happen until the "old" market has stabilized. It is a good idea, which was poorly implemented.
How Long to a Solution?
Our view is that the "static" analysis of the number of homes in inventory and the number of possible foreclosures overstates the problem. This approach looks at the problem without any view toward possible solutions. It is a worst case. We take a critical and analytical eye to anyone who asserts that a bottom will not be found until "late 2009" or similar forecasts. Without thinking about possible policy reaction, how can one possibly answer such a question?
The Solution We Will Not See
In a different time, without a lame-duck President, and with stronger leadership, one could imagine a comprehensive solution.
We wrote about such a "fantasy solution" in a recent article for TheStreet.com. It is a dream version of a State of the Union Address to be delivered later this month by President Bush. If it were a Reagan or a Kennedy or even Bill Clinton, early in the Administration, we might actually see something like this. Even now, we suspect that the "dream speech" predicts a few things the President will actually say.
Please take a moment to read the article. It shows one view of a comprehensive solution.
What Will Happen
In the absence of this approach we will see a collection of incremental efforts. How close will these come to a solution? We do not yet know, but it provides a scorecard for those following this problem. Watch the candidates, watch the Congress, and watch the President.
Meanwhile, this is not just a problem for the Fed. The market attention to the Fed, with limited policy levers available, is a reflection of the vacuum in leadership. The Fed can only do so much. The exact pace of interest rate reduction is not terribly important. Some Fed initiatives, like the TAF, have succeeded in reducing LIBOR and helping institutions take distressed securities on the balance sheet.
Investors who do a little work to understand the complexity of the problem will be well-placed to appreciate steps that signal real improvement.