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Archive for the ‘Interest Rates’ Category

There is a combination of worry and hope about the coming wave of mortgage resets.  First came the subprime.  Next will be the Alt-As and Option ARMs.  And then, in 2013 or so, it appears that we may be out of the woods.  Housing will stabilize.  Rates will be set. Foreclosures will level off and decline.

Will they?  ARM resets lock in a particular rate and then float.  They’re a good mortgage product for people that expect rising income, or expect to sell their house in a few years, or have good credit and equity to allow conversion to a 30 year fixed at the reset point.  And low rates–caused in part by the 2008-2009 flight to treasuries and deflation–have made resets a boon to homeowners that led (for now) lower rates.  But times are changing.  Banks are stingier with their credit, and even those with ARMs (especially Alt-A ARMs) are being buffeted by unemployment, reduced assets, the inability to refinance their homes based on their nonexistent equity, and all the other tales of woe unleashed by the recession.

The reset is not a one-time event.  It’s periodic.  It means that the ARMs will now be floating based on the LIBOR (i.e., an overnight rate that is pretty much the lowest market rate) plus some marginal rate.  LIBOR plus 2-3%, let’s say.  But the LIBOR floats, as will the new floating rates.  As government spending goes up, defaults of various loans continue apace, and inflation risk gets priced into borrowing, interest rates across the board will rise.  This rising cost of borrowing will be reflected in both the floating rates and the available 30 year fixed rates in the years ahead.  And these rates by design adjust periodically, either every six months, once a year, or monthly (according to The Handbook of Mortgage Backed Securities).

Far from being relieved of danger after the “Alt-A reset bomb,” the reset bomb will be a continuous threat to housing, made more permanent by the inability of upside down ARM holders to refinance.  Every year, as interest rates rise, their monthly payments will go up.  Borrowers will get the double whammy from inflation that the old-fashioned fixed rate provided protection against.  The ARM, which made a great deal of sense in the go go years of the mid 2000s, may become a permanent albatross on homeowners, and, in turn, a continued source of new insolvency, reduced consumer demand, and declining wealth nationwide.

The rough ride is only beginning, I fear, and the loose money policies of the Federal Reserve and the Federal Government are only going to make things worse by pushing up interest rates and inflation.  Those who did the historically responsible thing by buying a home in the last ten years will get whacked by the combination of inflation, rising interest rates, and wages that lag behind this wealth-destroying pincer movement.

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Market-oriented Republicans see the housing crisis and say, “The market is working, and will, if only we let it.”  Democrats see the temporary pain of the slowdown and say that we need a stimulus.  Missing from both accounts is any talk of monteary policy; today, monetary policy is out of the hands of the domestic market and in the hands of the Federal Reserve.  It is a government agency with a twist:  with worldwide currency markets, the Fed must act like other market players at least in regard to international markets or our currency will be rejected or devalued (as it has been in recent months).  More important, like players in any other competitive market, the Fed can make mistakes, particularly as it balances its contradictory mandates of stopping inflation and keeping full employment. 

Republicans should take notice that markets have always been vulnerable to force and fraud and do not work well when those threats are undetected and unpunished.  This is why we have laws.  This is why in the “internal market” of a corporation people are fired or rewarded for making money for the company.  Mortgage markets are vulnerable to fraud where obligations travel up a chain from buyer, to broker, to bank, and finally to some mortgage backed security holder.  The broker gets paid up front even though the real risk holder bears the cost of default down the line.  This is cause for external regulatory reform and also internal business structure reform.  For example, wouldn’t banks and brokers be more careful if they had to return some of their commission (or otherwise be penalized) if whatever they sold had to be refunded if it defaulted within, say, five years?  Alternately, they could be paid partially by a stake in the mortgage backed securities holding their notes.  Bundles of mortgages could be valued based on a particular bank, broker, zip code, or some other combination of common, information-bearing factors.  Brokers, banks, and anyone who gathers information from lendees ideally should have “skin in the game.”  

These mortgage backed security holders should not be bailed out, of course, as this conflict of interest between lender and note holder should have been apparent to anyone purchasing these instruments.  Spreading risk may still be valuable, however, and would be more so in a proper environment of incnetives, including targeted regulation.  (We should also consider how much of this craziness was a function of the rates themselves, which drove a “flip this house” culture and shook up banks’ otherwise conservative culture.  Higher rates might do much of the work of bringing banks down to earth as any specific regulation or structural reform.)

The problem today is not a lack of stimulus or demand in the economy.  Rather, we are in a classic “supply shock” correction featuring simultaneous inflation and a reduction in output.  It’s sad that the NY Times editorial on the recent slowdown is largely silent about the causes and, in particular, ignores the fact that we are reaping the rewards of an early “stimulus” policy in the form of extraordinarily cheap money from 2001-2004.  They write, in Pavlovian fashion:

The best place to start is by rethinking economic stimulus. When Congress passed the existing stimulus package, gasoline was around $3 a gallon. By the time the rebate checks start going out in May, gasoline is likely to be well on its way to $4 a gallon. At that price, much of the $100 billion or so in rebates will go to fill Americans’ tanks, a bigger boost to nations that sell oil to the United States than to the United States itself.

The next round of stimulus, which Congress should be considering now, must accomplish what the first round neglected. It must focus on bolstered unemployment compensation and bolstered food stamps, ensuring that taxpayer dollars are spent on the neediest and on programs that are proven to spur the most economic activity for every dollar provided. The nation cannot afford more misguided giveaways.

The Carter administration faced the same problem in the late 1970s.  Bound by Keynesian analysis, they simply couldn’t make sense of the simultaneous reduction in demand and inflation that signalled the supply shocks rolling in from OPEC and elsewhere.  Stimulus packages may win a vote or two, but this kind of response is simply the fiscal equivalent of the loose money policy that Treasury Secretary Paulson and Fed Chairman Bernake continue to embrace in response to the current financial crisis.  Neither the NY Times, nor Bernake and Paulson, care to acknowledge that the earlier Fed-driven inflation and the fiscal stimulus of Bush’s deficit spending are largely the reason we are where we are now. 

As the old saying goes, when you’re in a hole, the first thing you’ve got to do is stop digging.

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One thing that struck me during the height of the housing boom was how out of wack housing prices were with income.  At the time, I owned a modest condo in Dallas with a nominal value equal to a little more than 1.25 of one year’s income for me.  I remember thinking:  who can afford $300K or $600K notes, particularly for a first home, as folks were doing in places like California and Northern Virginia?  In response I’d hear dazzling tales of “interest only” loans, the value of leverage, a “new paradigm,” “free money,” blah blah blah.  As much as it was mystifying, it all sounded more than a little fishy and unsustainabe.  If for years and years the vast majority of housing values were in the $75-200K range (in real dollars), which was roughly in the 2-4X annual income range for most homeowners, how could it now make sense that homes were valued at 10X or 20X the annual income for the average homeowner?

 Well, they didn’t. And, in fact, income/housing price disparity is one of the great predictors of high foreclosure rates:

If you are looking at the worst zip codes in the country for foreclosures, they all tend to share some of the same characteristics. The homes values are slightly below the state averages in terms of value while the income level of the residents are significantly below the state average income levels.

This price/income gap is in my view a very sensible indicator of a potential “bear” local real estate market going forward, including where I now live in Florida.  Orlando has an average local income maybe .75 of what was normal in Dallas, but where housing values are probably 1.25X to 2X the Dallas values.  Things will bottom out, I believe, at somewhere close to historical levels, which have gotten very out of kilter:

  

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