Interest Rates Only High If Compared With Six Months Ago

Call me a skeptic when it comes to getting really nervous about rising interest rates. "All of this debt we are selling is really having a severe impact on interest rates," they say. It is true that interest rates on 10-year government bonds have doubled from 2% to 4% in recent months. However, not looking more than six or twelve months back does not give a very clear picture. Below is a decade-long chart of the yield on the benchmark 10-year treasury bond:

See why I am not buying the whole "higher interest rates will kill the economic recovery" argument? Yields between 4% and 6% were pretty common before the recession began and they existed with solid economic growth and less government debt. Even if yields rise further, to the 5%-6% range, it won't be the end of the world. In fact, it might actually be nice for consumers. We finally have a positive savings rate in the U.S. and it would be good to get bank certificates of deposit to yield 5% again so those dollars being saved could earn solid interest.

Of course, many will argue that if mortgage rates reach 6%-7% the housing market will never recover because people will no longer be able to afford to buy a house. Consider these numbers, though. The monthly payment on a $200,000 mortgage at 5.5% (today's rate) is $1,136, compared with $1,331 at a 7% mortgage rate. If you are earning ~$5,000 per month (about what you should make to buy a $200,000 house) another $200 per month (before the interest tax deduction, mind you) really should not be the difference between renting and buying for most people. Mortgage rates would have to go up a lot more to cripple the housing market, in my view.

NYT Economics Reporter Details Personal Credit Crisis

An interesting story of how even those who follow the financial system intimately on a daily basis can get pulled into the mess.

From the 5/14 edition of the New York Times: My Personal Credit Crisis by Edmund Andrews

CNBC Documentary by David Faber, "House of Cards," Is Worth Your Time

One of CNBC's finest, David Faber, recently completed a two hour documentary about the housing bubble and the credit crisis. I had the chance to watch it on Sunday and it is very well done. For those of you who are interested in how the combination of mortgage brokers, Wall Street, and consumers led to the dire financial predicament we find ourselves in right now. Faber really hits on all of the major culprits and explains them well along with his superb guests.

CNBC replays House of Cards in prime time during the week and over the weekends. According to my Comcast program guide, the next airing is Wednesday from 8-10pm ET but check your local listings and set your VCR or Tivo.

Obama Housing Plan Details

Lots of people are already complaining about Obama's housing plan unveiled yesterday based on the presumption that it is bailing out lenders and homeowners who made poor decisions at the expense of those who are paying their mortgages on time each month. Here are the details of the actual plan, which don't seem as bad as some are claiming with respect to moral hazard.

1) Allow Responsible Homeowners to Refinance their Existing Mortgage (4 to 5 million households)

You may not think the government would need to intervene in order for this to happen, but Fannie Mae and Freddie Mac do not guarantee loans if the loan amount is more than 80% of the home's value. This is a problem in the current housing environment because with housing prices dropping so rapidly, home owners who are paying their mortgage on time still may not qualify for a refinance, even if they are current and simply want to lower their payments since interest rates have fallen.

The Obama plan lifts the loan-to-value cap for refinances to 105% from 80%. As a result, responsible home owners who want to refinance their mortgage to a lower rate can do so, as long as their loan balance is no more than 105% of their home's value. This change will reduce monthly payments for many responsible borrowers and therefore help prevent future foreclosures.

2) Offer Incentives to Lenders and Borrowers to Modify At-Risk Mortgages (3 to 4 million households)

Since not all mortgages are guaranteed by Fannie and Freddie, Obama's plan provides incentives for lenders to work with borrowers who are at-risk of default before they become delinquent. Currently most lenders require you to be a few months behind on your mortgage before they work with you on a loan modification.

This plan offers lenders cash payments for every modification they complete. To prevent lenders from dropping the monthly payment by a very small amount simply to collect the upfront fee, they are offering another incentive payment if the loan remains current for a year after the modification.

As for what amount the monthly payments should be adjusted to, the government is offering incentives for loans that total no more than 38% of the borrowers income. The government will subsidize the mortgage interest by 7% of income, so that the monthly payment will equal 31% of monthly income.

The lender will still decide if it wants to modify a loan or not, so the government is not forcing them to do anything, but merely providing incentives to try and reduce future foreclosures for at-risk mortgages. If you lose your job and are facing foreclosure, adjusting your payment to 31% of income may allow you to keep your home in some cases, but clearly not all of them. Investment properties owned by speculators do not qualify under this program.

Home Inventories Drop Meaningfully in December, Trend Needs to Continue

Updating our long-running chart of existing home inventories, we see a sharp drop in December. The chart below shows 2007 and 2008. You can see that monthly inventory drops in the past have been temporary, and not the beginning of a new trend. Hopefully this can change going forward.

In order for the economy, our financial system, and the markets to produce real, sustainable stability we need the housing market to halt the price declines. Stable home prices require a reasonable supply-demand balance. The median existing home price in December fell to $175,000 from $207,000 the year before. That price decline brought out some buyers, which reduced inventory to the lowest levels since mid 2007.

Price declines will continue for some time, but if we can get inventories down to 6-7 months supply, those price declines should begin to moderate. A stable housing market would do a lot to support stable prices for mortgage-backed securities, which in turn would ease the pressure on bank balance sheets and boost confidence in our financial system. As a result, we should cross our fingers that the December inventory decline continues in coming months.

Housing Recovery: Long Way Off

It is going to be very difficult for the U.S. economy to turn a significant corner without a housing market that is at least stable. Amazingly, the housing situation has not improved much at all during 2008, even as builders halt new construction and slash prices on newly built inventory. Increases in foreclosures have completely negated any of those builder actions. As you can see, home inventories remain elevated and have just been treading water all year, well above historical averages.

The Treasury Department is thinking about trying to get mortgage rates down to 4.5% from the recent 5.5%-6.5% range. Will that help the housing market recover? I doubt it (interest rates aren't the problem). How many people can't afford to borrow money at 5.5% to buy a home, but could do so with a 4.5% rate? Not many, I suspect.

Readers Were Right, Paulson Nixes Asset Auctions

Has anyone else noticed that whenever Treasury Secretary Henry Paulson speaks the market goes down? Today is no exception, as we learned that Paulson has abandoned the idea of using the TARP funds to buy bad assets from banks using a reverse auction process. When the idea of auctions first came to light I was very keen on the idea, but others preferred direct capital injections into the banks, in return for preferred shares as well as common stock warrants. Readers pointed out that there was no assurance that an auction would actually happen. They were right.

Instead, TARP money was used to buy stakes in banks and now Paulson says the auctions are no longer a priority. I still believe that auctions address the core problem far better than direct capital injections. As we have seen, the financial institutions can do whatever they want with money if you just hand it to them. Heck, they might even use it to buy other banks or invite their top salespeople on expensive resort getaways. That wouldn't go over too well, would it?

The root cause of the problem, huge losses resulting from bad loans (and the need to raise more capital after losing much of what they had), could be addressed by buying the assets from the banks for pennies on the dollar. Future bank losses would be reduced because the assets causing the largest losses would be jettisoned, and the banks would have cash to make new, hopefully better, loans. The direct capital injections have done nothing to reduce bank losses or help the housing market.

At this point, the remaining TARP money would be best-served by tackling the problem directly. If the Treasury prefers not to go the auction route, then you have to do something to address the home foreclosure problem. On that front, why don't we just use the money to pay mortgage servicers a fixed amount for each loan they modify for borrowers who are struggling to make their monthly payment? Such a move would incentivize the lenders to work with their customers and stem the housing downturn, which is a major impediment to financial stability in the system.

It is in the best interest of everyone involved if the banks agree to take a little less money back on their loans rather than become a real estate developer by foreclosing on properties. If home supply and demand imbalances are corrected, and home prices stabilize, the economy would benefit tremendously.

Home Supply Nationwide Still Sky High, but CA Market Improving

Updating our running chart, existing home supplies were above 11 months worth of inventory in June, so no progress is being made generally speaking:

That said, some markets are showing signs of improvement. Fortunately, California is among them.

According to Bloomberg:

California led the U.S. in default notices and bank seizures for the 18th straight month in June and had seven of the 10 metro areas with the highest foreclosure rates, according to Irvine, California-based RealtyTrac Inc., which sells default data. That drove down prices and led to "discounted distressed sales,'' with two-thirds of transactions under $500,000, compared with 40 percent a year earlier, the California Association of Realtors said. The amount of time it would take to deplete the supply of homes decreased to 7.7 months from 10.2 months a year earlier, and the median price fell 38 percent to$368,250 last month, according to the Realtors.

If this trend continues, banks with large California exposure might just start to see metrics stabilize, which would be a relief for the market. If you are in the market for a home out in CA but have been wary, it might pay to start browsing for a bargain.

Housing Market Not Showing Any Life

Inventory levels of existing homes had been steady for several months but preliminary April figures show another spike to more than 11 months of supply. The housing market cannot improve until the supply and demand picture does and these numbers are pretty ugly. When supply is growing faster than demand, prices will continue to fall, so investors should keep this in mind when allocating investment dollars to anything that is dependent on home prices.

Housing Price Stabilization Nowhere In Sight

March 2008 existing home inventory data was released this week and for about nine months now we have seen inventories hover around a ten month supply, as shown by my updated chart below.

Without declining inventories (prompted by sellers reducing their prices to more reasonable levels) we will not see stabilization in housing prices or improved loan performance in the banking sector. So for anyone looking for housing market improvement anytime soon, it looks pretty bleak on a national level. After all, basic economics tells us that when supply far exceeds demand, prices fall.