State of the Housing Market

I’ll start with the subject we all care about the most: housing. First, some good news: Existing Home Sales (for February) came out yesterday and unexpectedly rose by 5.1%. This is the largest monthly rise since July 2003. As you all know, I thought home sales would bottom in November but I was wrong . . . January’s #s were lower than November’s. I expected Obama’s Stimulus package to more aggressively attack the housing problem.

Unfortunately, the housing problem was pretty much left out of Obama’s $800 billion stimulus package ($8,000 tax credit for 1st time homebuyers doesn’t really help much). As I explained previously, the deflationary spiral in housing is very well entrenched and really requires government intervention to stop it from continuing.

Fortunately, the quantitative easing (explained below) the Fed announced last week should hold mortgage rates low for awhile which should help the housing market. If the uptrend in sales continues, January will be the bottom in terms of Home Sales. However, due to the declining stock market and the extreme negativity of the media, consumer sentiment was very low in the first half of March, so, it is possible that March Home Sales will be lower than February’s. On the bright side, if the stock market keeps going up or at least, doesn’t decline much, I think consumer sentiment will improve dramatically in late March/April. This will definitely help home sales. A 500 point gain on the Dow yesterday will certainly help sentiment.

Home Sales can be thought of as the 1st derivative of Home Prices. In other words, Home Sales reflect the slope of the Home Price curve. As Home Sales start increasing, we will see the pace of Price declines start to moderate. Once home sales rise sufficiently and go above a certain threshold, Home Prices will finally bottom out and start to rise. I expect this to happen late this year on a National level, possibly sooner if we get a dramatic stock market rise or additional housing stimulus.

In the meantime, I would suggest that you use the dramatic and unexpected increase in existing home sales in February as an indication of a bottom in housing to generate some urgency with your prospects. Here’s a good article you may want to email to your prospects to create some urgency: www.cnbc.com/id/29553757

Home Prices & Affordability

It’s very frustrating for me when I hear “economists” in the media speaking about how they believe home prices still have to drop a bit to return to historical levels relative to incomes. Granted, I agree that home prices will indeed drop more but I vehemently disagree that home prices are still too high. I’m not sure what data these “Professionals” are looking at but the Nationals Data reported by the Census Bureau indicate that the housing bubble has sufficiently burst and prices are back to normal levels. In fact, if you factor in current mortgage rates, homes have never been more affordable. I’ll provide some graphs below to illustrate this.

One of the most common stats referred to regarding home prices is the ratio of the Median Home Price to the Median Household income. Historically, as you can see below, home prices are usually between 3 and 3.5 times Household Incomes. Right now, using today’s data, we are at 3.16. Going back prior to 1980 isn’t really that relevant since the 30 year fixed mortgage industry as we know it today didn’t really exist until the 1980s. In fact, pre-1940, if you wanted to buy a house, you had to take out a 5 year loan (imagine how high the payments were on a 5 year loan).

However, keep in mind, the graph above doesn’t take into account interest rates. As I’ve explained before, most people buy homes by getting a mortgage so you really can’t evaluate the affordability of home prices without incorporating current mortgage rates. The graph below shows the % of Monthly Household Income (Median) needed to pay the Mortgage Payment on a Median Priced Home.

This graph shows that for as far as the data goes back, homes have never been more affordable than they are now. HOWEVER, AND THIS IS REALLY IMPORTANT: Notice how the “bubble” in prices really doesn’t show up on this graph like it does in the first graph above. I found this extremely interesting. Why don’t we see the price bubble in this graph??? The reason is that while home prices boomed, mortgage rates dropped almost as fast as prices went up. So, one could make the argument that we really didn’t have as much of a price bubble as people thought . . . it was mostly a result of dropping mortgage rates as opposed to the common belief that people were buying homes that they couldn’t afford. Granted, many people did buy homes they couldn’t afford but the graph above shows that although median home prices went way up, mortgage rates came down so fast that there was only a slight increase in the % of Household Income used for the Mortgage Payment. So, the average home buyer between 2003-2005 wasn’t as overextended as is commonly believed. Clearly, in areas like California and Las Vegas, home prices were way too high relative to Incomes and people did overextend themselves, but this is not the case for most of the rest of the country. As you can see, homes have never been more affordable. Right now, it requires only 20% of the Median Household Income for the Mortgage Payments on the Median Prices Home (and this assumes 100% financing . . . just multiply all #s by .8 to assume a 20% down payment).

Mark-to-Market Accounting

One of the big issues discussed in the media regarding the banks’ health is Mark-to-Market (MTM) Accounting. First, let me explain what this means. Basically, prior to 2007 (FAS 157), when banks purchased securities such as Mortgage Backed Securities, banks would value the securities on their books at the purchase price (more or less). So, if ABC Bank paid $100 for Security X, ABC Bank would report the value of Security X as $100 until they sold the security, at which point, they would recognize a profit or loss on the sale. Mark-to-Market, or Fair Value, accounting states that banks must report the value of their assets at current market prices (whether they sell them or not). This means, that if a security similar to Security X was recently sold by another bank for $80, ABC Bank would be forced to “write down” the value of Security X to $80 and report at $20 loss.

Right now, most banks own a large amount of Mortgage Backed Securities (CDOs, CMOs, etc). A Mortgage Backed Security (MBS) is just a pool of mortgages where the owner of the MBS collects the payment made by all the people who took out these mortgages. Prior to late 2007, there was a fairly liquid market from MBS securities, meaning, banks could easily sell their MBS securities if they didn’t want to keep them on their books. Once home prices started to drop substantially and mortgage default rates increased, nobody wanted to buy MBSs anymore. Nobody knew how bad the housing market would get and how many people would default on their mortgages so it became very difficult to value MBS securities. So, basically, almost overnight, there were no buyers for MBSs. MBSs became “toxic assets”. Because a normal market from MBSs evaporated, the only transactions for MBSs that took place after late 2007 were “distressed sales”. This means that a bank or hedge fund who owned MBSs could only sell them at drastically discounted prices . . . usually less than 50% of par value. In the example above, ABC Bank could only sell Security X if it was willing to accept a price of $30 (30 cents on the dollar).

So, these “distressed sales” became the new market prices for MBSs. This creates a huge problem. These distressed MBS sales combined with the new Mark-to-Market accounting required banks to “write down” their MBS holdings by huge amounts. If a bank owned $10 billion of an MBS security and the latest sale of a similar MBS security occurred at 30% of par value, the bank would be forced to report a $7 billion loss and write their MBS holdings down to $3 Billion. The important thing to recognize is that this phenomenon is forcing banks to write down the value of their MBS Securities way more than is justified by the cash flows generated by these securities. In other words, many of these MBS securities are still comprised of mostly current loans and are still generating significant cash flow. So, from a Discounted Cash Flow valuation standpoint, these securities are still worth 80-90% of their purchase price. However, the MTM rule requires banks to treat these “good” MBS securities as if they are only worth about 30% of their purchase price.

Here’s why this is such a big problem: when a bank writes down the value of their MBS securities by let’s say $10 billion, there is an immediate decrease in the Bank’s retained earnings (and thus Equity) by $10 billion. For every $1 of Equity (Capital) a bank has, a bank typically loans out around $10 (10:1 leverage or a 10% leverage ratio). Banks like to maintain a constant leverage ratio and are required to maintain a minimum leverage ratio by the FDIC. So, when a bank loses $10 billion is Equity, in order to maintain the same Leverage Ratio, the bank would have to decrease the $ amount of their outstanding loans by $100 billion. This is the problem . . . as banks take more and more losses on their MBS portfolio, they need to reduce their lending by 10 times as much as their losses . . . this creates an enormous reduction in new lending and in some cases has caused banks to “call-in” some of their loans just to meet the minimum leverage ratio required by the FDIC. This is the reason banks have stopped lending. Also, another issue making the problem worse is that while the government is publicly telling banks to keep lending, behind the scenes, the bank regulators are scrutinizing everything a bank does and scaring the crap out of banks. Bank regulators (FDIC regulators) are literally threatening to take over or shut down a bank if the bank continues to issue “risky” loans.

Incidentally, you won’t hear this mentioned much by the media (mostly because they don’t know financial history that well) but Mark-to-Market accounting was also required during the Great Depression and is considered one of the reasons for the severity of the Great Depression and also one of the main reasons so many banks failed during the Great Depression. Recognizing the problems caused by Mark-to-Market accounting, FDR repealed the MTM rule in 1938. So, banks lived blissfully without MTM accounting between 1938 and 2007. Also interesting is the fact that Mark-to-Market accounting was required during the 1930s for much the same reason that it was re-instated in 2007: to create more transparency within the financial reporting of banks and other institutions. I can’t help but think of the cliché “Those who don’t know history are destined to repeat it.”

Here’s the real problem with Mark-to-Market accounting: although it seems like a good and reasonable idea, a side effect of MTM is that it greatly amplifies the economic cycle and creates both a positive feedback loop in good times (causing bubbles) and a negative feedback loop in bad times (causing depressions). In good times, banks are able to “write-up” their assets under MTM and thus significantly increase their lending which perpetuates the economic boom. In bad times, banks are forced to “write down” their assets and in order to maintain their capital ratios, they must significantly reduce lending, which perpetuates the economic decline. So, while it is honorable and it makes sense to require banks to use current market prices to value their assets, the negative side effects are devastating. One may even argue that without MTM, the Great Depression would not have occurred because much fewer banks would have failed. As a caveat, there was no FDIC prior to the Great Depression. The FDIC was implemented to prevent the types of “Bank Runs” that destroyed the banks during the Great Depression.

The Toxic Asset Plan

So, there are really two ways the government can help the banks right now: They can either repeal the MTM rule, allowing the banks to value the MBS securities at their purchase price or they can do something to help the banks sell these “toxic assets” and get them off their books. Here are the arguments for and against each method of helping the banks:

Repeal the MTM Rule

Pros: Repealing this rule would literally fix the banks balance sheets overnight and create windfall paper profits for the banks. The assets that these banks wrote down to 30 cents on the $, the banks could “write up” to 100 cents on the dollar, booking a huge profit, and creating a huge increase in equity (capital). Doing so, would allow banks to significantly increase their lending.

Cons: The opponents of repealing the MTM rule claim that all we would be doing is fooling ourselves by allowing the banks to value their MBS securities at values that are clearly not accurate given the state of these mortgages and the housing market. Doing this would simply delay the inevitable loss the banks would have to take when they either sell their MBS securities or let them mature. The argument is that repealing this rule would be financially irresponsible and would just be perpetuating the American way of sacrificing the future prosperity of our children for our own current economic benefit.

Buying the Toxic Assets from the Banks

Pros: this would allow the banks to raise cash and rid themselves of the assets that have been destroying their balance sheets. By selling these assets, the banks would have more cash “reserves” and would thus be able to make more loans. More importantly, once the assets are off the banks books, the uncertainty of how much damage these assets are going to do to the banks will be gone, allowing the banks some breathing room to rebuild and recapitalize.

Cons: The buyer of these toxic assets probably will not be willing to pay a price high enough to induce the banks to sell their toxic assets. Right now, the banks essentially have a “paper loss” on these assets. If the banks sell them for pennies on the dollar, the banks will be locking in a large cash loss on these assets. As I explained above, many of these assets are probably worth a lot more than the current market value assigned to them. So, unless the bank is desperate for cash, it is in the banks best interest to hold the toxic assets and hope that the housing market recovers to the point where these assets start trading at values closer to par.

As you know, the government has chosen the 2nd option above and yesterday announced a public/private toxic asset purchase plan. In my opinion, although this plan is better than nothing and may improve sentiment regarding the safety of the banks, I do not believe many banks will choose to sell their toxic assets under this plan. Banks know that the government will eventually have to fix our housing and economic crisis. Banks don’t want to “Buy High & Sell Low” so most banks will choose to hold these assets on their books until conditions improve and they can sell them at a better price. The Private Hedge Funds involved in the governments plan will only buy these MBS assets at a significantly discounted price (so they can turn a profit). However, I don’t think the banks are going to be willing to sell at this significantly discounted price. We’ll see.

There is some major opposition to repealing the MTM rule so I doubt this will happen either. However, I do think that the government will alter the MTM rule (they already have slightly) in a way that will allow banks to value their MBS assets at a higher value. This will help a lot.

AIG & Credit Default Swaps

If there is any one company involved in this whole mess who is really the villain and is worthy of the blame that has been placed on them, it is AIG. In order to justify why I believe that, I need to explain what Credit Default Swaps are. In one sentence, the Credit Default Swap market is an unregulated insurance market . . . “unregulated” is the key word. Because this market is unregulated (it never should have been), it is open for major abuse and fraud. Basically, a Credit Default Swap is simply a way to provide insurance against the default of a specific company or institution on its debt. So, for example:

Let’s say I own $100 of debt (bonds) of Company A. If I am worried that Company A might go bankrupt and not
pay me my $100 back, I can buy a Credit Default Swap to insure me against losing my $100 if Company A
defaults. So, let’s say AIG agrees to sell me a Credit Default Swap that pays me $100 if Company A defaults
anytime within the next two years (a 2 year term . . . swaps are sold with varying terms, usually 1 year, 2
years, and 5 years). In order to provide me with this insurance, AIG requires me to pay them $2 per year for
the next two years. After two years, the Swap expires. So, if the company does default sometime over the next
two years, AIG pays me $100. If Company A does not default, I will have paid AIG $4 and AIG will have paid me
nothing. I could also sell my swap sometime before it expires if I want.

Here’s the problem: As I mentioned, the Swap Market is an “over-the-counter” unregulated market. What this means is that there is no Exchange or Regulatory Agency (like SEC or CFTC) regulating the purchase and sale of these swaps. This creates a big problem because it allows anyone to Sell these Swaps, even if they person selling the swaps doesn’t have the money to pay in the event that a default event triggers a payment (in the above example, AIG could sell me the swap even if they didn’t have the $100 to pay me if Company A defaulted). When a derivative is regulated, the buyer and seller of the derivative are required to post “margin” in an account in order to ensure the ability of the buyer and seller to follow through on the terms of the derivative contract. If the price of the underlying market moves and jeopardizes the ability of the posted margin to cover the loss of the buyer or seller, the losing party will be required to post more margin $ (a margin call) in order to maintain their derivative contract. For this reason, in regulated derivative markets (currency future, stock index futures, stock options, etc), there really is no “counter-party risk”. In other words, you don’t really have to worry about the solvency of the person on the other side of a transaction because the rules governing the transaction will guarantee that the counterparty is always able to fulfill their obligation under the derivative contract. (Sorry if this is confusing or boring . . . this is an important part of understanding the problem created by CDSs).

So, because the CDS market is unregulated, anyone can sell CDSs to pocket the annual premium paid by the buyer of the CDS. Here’s the problem: What if the debt that the CDS covers actually defaults?? Then, the Seller of the CDS has to pay a large sum of money to the buyer of the CDS. What if the seller doesn’t have enough money to pay the Buyer? The problem is that unregulated swap markets creates somewhat of a legalized Ponzi scheme for immoral Sellers of CDSs. With these markets unregulated, someone (or some company) with little to no money could sell millions of dollars worth of these swaps in an effort to get rich, knowing full well that they have no ability to fulfill their side of the deal in the event that some of the debt covered by the CDSs they sold defaults. The Seller thinks: if this works out for me and the debt covered by my CDSs doesn’t default, I’ll be rich . . . if not, I’ll just declare bankruptcy because I know I can’t pay anyway.

This is basically what AIG did. AIG sold way more CDSs than they had the cash to support. In other words, AIG basically threw a Hale Marry pass and crossed their fingers. If the economy had continued to stay healthy, AIG would have collected millions, if not billions of dollars worth of “Premiums” from the Buyers of the CDSs, showing huge profits for the company. But, if the economy turned down and some of the debt covered by these CDSs defaulted, AIG would be obligated to payout Billions of dollars that they didn’t have. It was an extremely irresponsible and selfish thing for AIG to do. It’s kind of like watching a football game with your friend and betting your friend $50 on the game even though you know you only have $5 in your wallet. If your team wins, you smile and collect the $50 . . . if your team loses, you say, “Oh, whoops, sorry, I don’t have $50”.

The reason the government chose to bailout AIG is that the government thought that if they didn’t bailout AIG, that many other companies who bought CDSs from AIG (including many banks) might go bankrupt. The government felt it was easier to support AIG than deal with the fallout caused by not supporting AIG. I tend to believe the government made a mistake here and should not have bailed out AIG. Here’s why: something like 95% of the Credit Default Swaps issued were bought by speculators who did not actually own the underlying debt covered by the CDS. For this reason, these speculators were merely betting (hoping) that a certain company would default on its debt and they could collect a large payment from AIG. So, using my example above, these speculators were paying AIG $2 per year in hopes that the debt covered by the CDS would default and AIG would pay them $100. So, in almost all cases, the CDS buyer would not suffer a catastrophic loss if AIG failed to pay them the $100. On the contrary, if AIG did pay, the Buyers of the CDSs would experience a windfall profit ($2 investment for $100 payout). The buyers already paid the premium to AIG so there really is no additional loss of funds associated with the failure of AIG to pay them their $100. For this reason, I believe very few, if any, institutions that had purchased CDSs from AIG would have failed if we had let AIG fail. In reality, by funding AIG, all we are really doing as taxpayers is allowing some of these lucky CDS buyers to experience windfall profits. Of course, about 5% of the buyers of CDSs actually bought the CDSs to hedge the debt they own from Company A (using the example). These people or companies would have suffered a real loss but I would argue that because these people or companies had the cash to purchase the debt in the first place, they would have been able to sufficiently absorb the loss if AIG failed to pay.

Unlike many other programs the government has funded that have been termed “bailouts”, we are unlikely to get our taxpayer money back from AIG. We have given AIG $180 billion of taxpayer money . . . very little of which I expect to get back. To give some perspective, this # is equivalent to almost $1,600 per American Household. For all intensive purposes, it’s as if each household has written a check to AIG for $1,600. It really is incredible.

Government Intervention in Free Markets

There has been a ton of discussion over the last few months about the government’s role in business and “free markets”. Some argue that markets work the best with little or no government involvement or regulation and others argue that we need a lot more government regulation over our markets and economy. I used to be in the Free Market camp where I believed the government should stay out of the way and let the markets run themselves. I now realize that I was wrong. I believe now that it is the government’s responsibility to create and enforce rules in each market to ensure the fair, moral, and sound operations of markets. However, I also believe that the government should not get directly involved in the markets and also should not do anything that creates an unfair advantage for certain players in the market. Let me provide an analogy that may shed some light on this:

Let’s take the game of soccer. Free Market proponents would say, “Just give them the ball and tell them that the team that gets the ball in the other teams goal the most wins.” The Free Marketeers would not want a referee to supervise the game and would hope that the players general sense of fairness and morality would compel them to follow the basic rules of the game. What do you think would happen? The game would eventually turn into rugby and be dominated by the team with the biggest players who were willing to punch and push the ball into the goal using their hands and any other method they could think of to win the game. The teams that were trying to play fair and stick to the rules of the game, would always lose. Now, the flipside is the Pro Gov’t Regulation crowd. This crowd would not only want many rules and a referee to supervise the game, this crowd might take it too far and create gov’t owned teams that were allowed to play using slightly different rules. The Pro Regulation crowd may even alter the rules for certain teams in an attempt to keep the good teams from winning too much or force the good teams to give some of their players to the losing teams.

Hopefully the analogy makes sense and illustrates that we certainly need rules governing our markets and that the government or some entity needs to enforce those rules. What we don’t want is the government becoming an active participant in the markets or imposing rules that provide an unfair advantage to certain market participants. The Mortgage Industry is a perfect example of an industry that did not have enough regulation. As you know (especially if you watched “House of Cards” on CNBC), the mortgage brokerage business became a very immoral business between 2003 and 2007. Basically, the most successful mortgage brokers were the people who pushed loans upon people who shouldn’t have them and told these people to lie on their loan apps. They did this because there really was no legal or negative financial consequence to the brokers for doing this. Since the mortgage brokers sold off the loans to banks and investment banks who packaged them into CMOs, the mortgage broker didn’t care of the loans defaulted. Also, since there really isn’t any legal enforcement agency for mortgages (like the SEC for Stocks), there wasn’t really any legal risk involved with issuing loans to unqualified borrowers or encouraging borrowers to lie on their loan apps. Basically, the “good” mortgage brokers who tried to follow the rules and do what was right (morally) for the borrowers and the lenders were forced out of business by the brokers who were willing to bend the rules and game the system. One consequence of lax regulation is that in tends to encourage immoral behavior and put the “good” guys and girls out of business.

An example of the government taking regulation too far (in my opinion) is the compensation restrictions on companies that took the TARP money. By doing this, the government is inadvertently altering the game in a way that is not beneficial for the long term health of the economy. Regulating income has a couple negative effects: 1. It discourages people from working too hard since there is a cap on their income . . . in other words, if there is no benefit to being the best and working the hardest, why do it? 2. It creates an unfair advantage for the banks that didn’t take TARP money. If a bank didn’t take TARP money and can still pay whatever they want, they can “poach” all the best employees from the banks who did take TARP money, making the TARP banks even weaker and the other banks stronger. Government control over compensation in a free market economy is a very bad idea.

Ending on a high note, the light at the end of the tunnel is getting much stronger. 2 months of increasing retails sales, consumer confidence increasing, the stock market going up, existing home sales rising, mortgage rates dropping . . . there’s a lot of good stuff happening.