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.
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.
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.
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.
From the LA Times:
Signs of distress are piling up in the California housing market, where prices are falling at three times the national rate of decline. Statewide, median sales prices fell by a stunning 26% from year-ago levels in February, with home prices dropping at a rate of nearly $3,000 a week, the California Association of Realtors reports. Further, the CAR says the Fed’s interest rate-cutting campaign “will have little near-term direct effect on the housing market.”
That’s right. If you live in California chances are your 401(k) has outperformed your home over the last year. Normally that would be expected, but we’re in a bear market for equities!
I am amazed that it has become conventional wisdom that a house is the best way to accumulate wealth in this country. Hopefully a year-over-year decline of 26% in the California housing market will diminish some people’s desire to accumulate as much property as possible. Remember everybody, homes appreciate by 3% per year over the long term, so they don’t even outpace inflation.
That reminds me. Has anyone seen the television ad currently being run by the National Association of Realtors? It states that homes “nearly double in value every 10 years.” I’m shocked they are claiming such a ridiculous statistic.
If we go back to high school math class, we recall the Rule of 72, which lets us divide an annual appreciation rate into 72 to determine how many years it takes for something to double in value. A double in 10 years implies a 7% annual return. That is twice the actual long-term appreciation of U.S. housing. Does anyone really think that homes return 7% per year?
How can the NAR get away with this ad? Because they simply chose a time period where the average return was 7% (yes, it includes the recent housing boom) and implies that was a “typical” period. Gotta love the fine print…
I know they cut 75 basis points at today’s meeting, but the 400+ point gain in the Dow probably isn’t in reaction to more rate cuts. Many people have made the argument, myself included, that rate cuts are not the magic anecdote for our economic problems. Sure they’re nice, but the structural issues we are dealing with cannot be solved by simply lowering the Fed Funds rate.
Recent steps by the Fed show that they realize they can and need to do more to help. Things like opening the discount window to investment banks, not just commercial banks, and backing the first $30 billion of liabilities to help avert a Bear Stearns (BSC) bankruptcy are doing a great job in restoring confidence to the market. I would not be surprised to see them take another step and start buying mortgage backed securities from the likes of Fannie Mae (FNM) to ensure orderly markets for bonds backed by the U.S. government. Fannie bonds are trading well below par despite the fact that they have no default risk.
Do the Fed’s recent actions mean we are completely out of the woods? Of course not. We have gained some footing over the last week or so by holding the closing lows of 1270 on the S&P 500. Even more positive, we are seeing the market react well to bad news, a good indicator that a lot of terrible news has already been priced into stock prices.
Even though JPMorgan (JPM) accounted for the gains (making the feat less impressive), the Dow finished up on Monday, the day the fifth largest investment bank narrowly avoided going belly up. Good news has been hard to come by, but today marks the second 400 point daily Dow gain since last week. Remember, since markets are forward-looking, news itself is far less important than the market’s reaction to it. On that front things are looking up, at least for now, although we all know the trend can change on a dime.
Full Disclosure: No positions in BSC, FNM, or JPM at the time of writing
Given that the housing market malaise is the prime culprit for our economic and market adversity, I decided to post some charts showing key indicators such as delinquencies, foreclosures, and inventories. Sources for this data are Countrywide Financial (CFC), which has the nation’s largest mortgage servicing portfolio ($1.48 trillion), and the National Association of Realtors, which tracks home sales.
First up, Countrywide’s mortgage delinquency rates and pending foreclosure rates for the last twelve months:
As you can see, delinquency rates have stabilized the last few months, with foreclosures still headed higher, but not severely. While certainly a good sign, we can not call it a trend just yet. After all, last summer we saw a leveling off, only to see another spike shortly thereafter.The next chart is home inventories, I believe a key proxy for the future direction of home prices. We will not see stabilizing home values (and eventual gains again) until we work through very high inventory levels. Typical inventories levels are about 50% below current levels.
Again we see a curtailment of rising inventories in recent months, but I still do not think we can call it a long lasting trend of stabilization as of yet, given that we will not pass the peak in ARM rate resets for the next quarter or two.
But let’s assume for a moment that these indicators do stop getting worse in coming months. Does that mean the housing market will stabilize also? Probably not. Inventories need to come down. The only way we get that is to increase demand. With home buyers now needing the “trifecta” to get a mortgage loan application approved (good credit, proof of steady income, and money for a down payment), demand won’t outstrip supply unless prices come down further to get qualified buyers to pull the trigger in greater numbers.
This is what I’m worried about. The market got severely oversold and has had a nice bounce as a result. We are not out of the woods by any means. Most market participants will want to see a nice rebound out of the oversold condition, and another leg down (preferably with signs of capitulation). How long will this current rally last? It’s hard to know, but I think it could face some issues as early as next week.
After the Fed’s emergency 75 basis point rate cut on Tuesday, a full week before their scheduled meeting, the futures market immediately priced in another cut for their upcoming meeting. At first the market was expecting another 75 bps, but now it is down to 50 bps. Do you really think Bernanke is going to cut rates again next week? I’m not so sure.
The point of an emergency cut is to act early because they don’t think they can wait. In this case, they didn’t want a market crash on Tuesday (overseas markets were indicating a 5% drop of 600 Dow points). By moving a week early the Fed averted such a meltdown, but I would think there is a good chance they simply pushed up their move to accommodate the markets (we can argue whether this was warranted or not, but that is why they did it).
If so why would they cut again next week? Will they have gotten any new data in a week’s time that shows things have deteriorated since the last cut? If not, how can they justify cutting rates more than 1% in such a short amount of time?
Call me skeptical of the market’s thinking on this one. Next week should be another interesting week, albeit less exciting if you are long equities.
The wires are reporting that the White House is working on a plan that would freeze rates on adjustable rate mortgages for certain borrowers, in an attempt to help curb the rapid increase in home foreclosures expected in coming months. While it certainly will help the situation, consider a slide from Countrywide’s Keynote Presentation at the 37th Annual Bank of America Investment Conference in September which showed the following:
Causes of Foreclosure (July 2007)
58.3% Curtailment of income
6.1% Investment property/Unable to sell
5.5% Low regard for property ownership
1.4% Payment adjustment
I find it very interesting that Wall Street has soared the last two days on hopes of more Fed rate cuts. On one hand, this makes sense, but on another, it baffles me.
First of all, stocks do better historically when rates are falling. It’s a mathematical relationship; lower interest rates increase the present value of future cash flows and vice versa. Lower rates also make stocks more attractive relative to other income-related asset classes. That’s the general concept propelling stocks higher this week, but what about the specific situation we face today?
The current dislocation in the credit markets has really hurt the market lately. We all know the state of the housing, mortgage, and mortgage-backed securities markets, but a general lack of liquidity in many other areas of credit are really having a negative impact on the ability of many companies to conduct normal business lines that require liquidity to fund operations.
Will more Fed rate cuts help this part of the problem? The market’s move in the last two days signals that it will, but I am skeptical. My thought process isn’t very complex. The liquidity crisis has gotten meaningfully worse since the Fed started cutting rates (there have been 75 basis points of cuts so far). To me, that indicates that another rate cut on December 11th (even 50 more basis points) won’t have as much of a positive impact on the credit markets as recent stock market action would have you believe.
What do you think?