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Dana Point | Since the lows of late-June, financials have rebounded more than 10% even as issues such as trade and the flattening Treasury yield curve have dominated the Wall Street narrative. Meanwhile, the bloom is clearly off of the rose in the world of real estate as prices for high-end residential and commercial assets have started to swoon. Lower prices mean higher loan-to-value (LTV) ratios, rising loss given default (LGD) and eventually increased loan default rates.
While backward looking measures such as the Case-Shiller 20-City Composite Home Price Index do not yet show the turn, more granular measures such as the Weiss Residential Research index show the number of homes rising in price is decelerating rapidly. At the moment this trend seems to be mostly confined to high end properties, but past experience shows that market turns in home prices typically start at the top where there are relatively fewer buyers vs the available supply.
In beautiful Orange County, for example, luxury home sales in expensive venues such as Newport and Laguna Beach have basically slowed to a trickle. As is the case in New York and Connecticut, luxury homes prices in Southern California have experiencing growing price compression, especially since the first quarter of this year. The chart below shows the S&P/Case-Shiller 20-City index and sub indices for New York, San Francisco and San Diego. Notice the extreme volatility of the San Francisco and San Diego indices.
Anecdotal reports from the world of real estate brokerage suggest that the asset price bubble created by the Federal Open Market Committee is generally starting to deflate. In particular, the “aspirational pricing,” to paraphrase Jonathan Miller of Miller Samuel, is basically done. Prices for high-end homes are now being marked down rather than up as sellers are forced to capitulate in order to close the deal. It is worth reviewing the factors that led to this latest bubble in residential real estate prices.
First and foremost we have the actions of the FOMC, which not only forced down short-term interest rates but also explicitly manipulated the shape of the yield curve via “Operation Twist.” In our previous comment in The IRA, we featured the comments of Senator Pat Toomey (R-PA) on same to Fed Chairman Jerome Powel. As several pundits have noted in recent days, Operation Twist is still affecting the markets, holding down long-term interest rates and causing the Treasury yield curve to flatten.
The compression in credit spreads caused by the FOMC’s reckless and ill-advised market manipulation has also reduced profits for lenders and curtailed residential lending volumes. Literally hundreds of banks and non-banks focused on mortgage lending, confronted by mounting operating losses, are laying off employees and shutting down operations around the country. The 4% GDP print last week was definitely not a reflection of business realities in the mortgage sector.
Q: Wasn’t Operation Twist supposed to help the housing market? Perhaps Senator Toomey ought to ask Chairman Powell to comment on the current dire situation facing many mortgage lenders and how the FOMC has contributed to this disaster.
One industry veteran commented to The IRA last week that the poor financial performance of many mortgage lenders has caused them to blow through credit covenants with bank warehouse lenders. So far, the banks have not pulled the plug on these important commercial customers, but at some point prudential regulators will force the banks to act.
As we have noted in past comments, in the current regulatory environment, when non-bank lenders eventually fail, the lender banks won’t buy the non-bank and take over the servicing portfolio as in days gone by. The non-bank will instead file bankruptcy and the secured creditor bank will simply take the loans pledged as collateral on warehouse lines and walk away.
In 2018, new loan originations will be about $1.6 trillion – maybe – the lowest level since 2015. With new loan profitability negative in Q1’18, making up for operating losses with more volume is not an option. Of note, the Mortgage Bankers Association has been steadily revising down their estimates for future residential loan origination volumes, but remain optimistic about the out years as shown in the chart below.
Source: MBA
The other factor that has caused home prices to surge is increases subsidies from the government sponsored housing agencies, Fannie Mae, Freddie Mac and Ginnie Mae. Ed Pinto at the American Enterprise Institute lists several actions by the GSEs that have exacerbated the home price bubble and created greater risk for the US taxpayer, including:
* Greater availability of income leverage, which is allowing borrowers to compensate for faster home price appreciation. This trend has been aided by the QM exemption for government agencies and Fannie Mae’s decision in August 2017 to raise its debt-to-income (DTI) limit.
* A shift towards lower down payment loans. For FHA loans, often times such low down payment loans are combined with down payment assistance.
* A greater presence of cash out (CO) refis; as homeowners’ equity has increased, the share of COs has increased in tandem. COs by nature are riskier than other loan products and they are rapidly getting riskier.
“The multiyear surge in home prices, particularly for entry-level homebuyers continues unabated and is fueled by high-risk mortgages guaranteed by taxpayers,” notes Pinto, codirector of the AEI’s Center on Housing Markets and Finance. “We see no halt to this trend so long as FHA, the GSEs, and the VA continue offering easy mortgage credit terms which keep demand for homes well in excess of supply,” Pinto adds.
Other factors that have driven the sharp upward move in home prices since 2012 include the increase in the number of people who can qualify for a mortgage under various government programs. Writing in The Scotsman Guide on the 10th anniversary of the failure of Lehman Brothers, industry veteran Dick Lepre of RPM reminds us that government programs to encourage home ownership begun in the 1990s caused the 2008 mortgage bust. Similar efforts in Washington are again setting the stage for a crisis in housing finance. He writes:
“One cause of the 2008 financial fiasco was the vast expansion of the number of people who could borrow money to buy property. There are at least two things already happening that are allowing people to obtain loans who would not previously qualify.
“One was instituted by the Consumer Financial Protection Bureau last year, which persuaded credit bureaus to remove most civil debt liens and tax liens from credit reports. The Wall Street Journal estimated this would improve credit scores for 12 million individuals, some by as much as 40 points.
“Another is the expansion of Fannie Mae’s Home-Ready program, which is aimed at low- to moderate- income borrowers. One of the features of the program is its liberal interpretation of income, which allows lenders to consider the income of nonborrowers living with a borrower — such as adult children, friends or extended family. That nonborrower income can be viewed as a compensating factor in the loan-approval process for the program.
“HomeReady is similar to the National Homeownership Strategy of 1995 in that it has a social goal. Under the Federal Housing Finance Agency’s housing goals for Fannie Mae for 2015 to 2017, at least 24 percent of the single-family, owner-occupied mortgage loans acquired by the government-sponsored enterprise (GSE) must involve low-income families. At least 6 percent must be to very low-income families.
“Borrowers need at least a 620 credit score to qualify for the HomeReady program. Freddie Mac has a similar program called Home Possible. If the Feds increase the percentage of such loans the GSEs must purchase, be concerned. Mortgages to folks with bad credit or high debt should stay inside the Federal Housing Administration (FHA) program. As long as the FHA mortgage insurance premiums cover the inevitable losses, the taxpayer is not picking up the bill.”
These programs to expand home ownership by the GSEs have added to the buying pressure on moderately priced homes, but that may not continue for much longer. Indeed, a change in the behavior of the GSEs may come sooner than many investors realize. As and when Federal Housing Finance Administration (FHFA) Mel Watt leaves the agency, the Trump Administration intends to significantly cut back the loan guarantee activities of the GSEs.
Loan size limits are likely to be reduced for Fannie Mae and Freddie Mac, financing for investment properties is likely to end and the pricing of GSE loan guarantees may also change. The mission creep into new areas, such as Freddie Mac’s initiative to provide financing for non-banks to acquire mortgage servicing rights (MSRs), is also targeted by Republican policy operatives.
A final factors driving the next, downward leg in US home prices is the 2017 tax legislation, which has significantly increased the cost of home ownership in high tax states such as CA and NY. While the greatest pressure is felt on the luxury end of the market, the cost of living in the high-tax, blue states will over time tend to drive broader emigration to other states.
With all of the different government programs put into place since the 2008 financial crisis to manipulate the credit markets and artificially boost home ownership, the fact of a bubble in home prices is no great surprise. Add to that the limitations on bank lending for new residential home construction and you have the perfect formula for killing the American dream of home ownership of American families.
We believe that the year 2018 may be remembered as marking the peak in both bank equity valuations and residential home prices. Residential loan default rates are unlikely to rise very quickly given the shortagge of moderately priced homes, but as we note in The IRA Bank Book, bank net interest margins are likely to be as flat as the yield curve by year-end. And the embeded credit risk in the financial system will continue to build with each passing day and largely due to the conflicting policy decisions emanating from Washington.
Further Reading
The American Conservative
Barron's