Recent Housing Bubble reads

Just finished reading "The Big Short" by Michael Lewis - a nice explanation of CDOs and their contribution to the housing bubble. Lewis takes a head-shaking-you-won't-believe-this-happened viewpoint than Gregory Zuckerman's "The Greatest Trade Ever." (Zuckerman takes more of the holy-crap-you-won't-believe-that-this-Paulson-guy-figured-out-the-trade! approach.) Lewis only mentions John Paulson and his hedge fund once in the entire book that I can recall.

Both are worth the time. Makes me want to draw up an org chart of the key players just to see the direct and dotted lines to the whole thing.

Indulgences & Seigniorage

(Note: My thoughts on this aren't completely formed, but I felt it important to record as a start to the formalization process...)

Trolling through TED.com, I came across Jay Walker's presentation about his Library of Human Imagination. One of the artifacts he displayed during his talk was a Gutenberg Bible (about 90 seconds into the video) - the first substantial book to be mass produced using the printing press. Walker shared some insight about the reason behind the Catholic Church's reproduction of the bible - it wasn't so much for individuals to read the bible for themselves. Instead, the Gutenberg Bibles were reproduced so the Church could sell "indulgences" to the masses in order to raise money. The Church was struggling for cash, so in a sense, they financed their operations by issuing indulgences as currency, eventually printing millions of these and distributing them. In economic terms, this is known as "seignorage.")

It was this action by the Church that led to Martin Luther's 95 Theses, questioning the Catholic Church's operations and motivations beginning the eventual downfall of the Catholic Church in Europe during the Renaissance Period.

An oft-cited definition of seigniorage - "The amount of real purchasing power that [a] government can extract from the public by printing money" - presented by Alex Cukierman, Sebastian Edwards and Guido Tabellini in their 1992 paper published in the American Economic Review - "Seigniorage and Political Instability." The abstract of his paper explains more:

The importance of seigniorage relative to other sources of government revenue differs markedly across countries. This paper tries to explain this regularity by studying a political model of tax reform. The model implies that countries with a more unstable and polarized political system will have more inefficient tax structures and, thus, will rely more heavily on seigniorage. This prediction of the model is tested on cross-sectional data for seventy countries. The authors find that, after controlling for other variables, political instability is positively associated with seigniorage. (my emphasis added)

Christopher Adam, Benno Ndulu, and Nii Kwaku Sowa also study effects of government seignorage in their 1996 article - "Liberalisation and Seigniorage revenue in Kenya, Ghana and Tanzania" - published in the Journal of Development Studies.

The revenue consists of two parts, the first flowing from the willingness of the private sector to hold government financial liabilities (which we shall refer to as the real balance effect) and the second part from the taxation through inflation of the outstanding stock of real balances (the inflation tax effect.) Seigniorage is particularly attractive in economies where the traditional tax base is narrow and the costs of other forms of revenue collection are high. Moreover, in economies where the policy regime limits the portfolio of domestic financial assets available to the private sector, for example where there are limited possibilities for currency substitution, the potential for raising seigniorage revenue may be expected to be high. In addition, by exploiting the high adjustment costs faced by the private sector in such economies, revenue can be increased in the short-run as holders of money are temporarily forced off their equilibrium money demand functions and obliged to hold higher than desired money balances. The higher the costs of adjustment, the greater the short run value of the 'surprise' revenue.

Breaking this down in parts:

• "the willingness of the private sector to hold government financial liabilities" - This refers to the issuance of US Treasury bills and bonds, in the current case, to finance deficit spending and debt.
• "taxation through inflation of the outstanding stock of real balances" - This refers to the decreased value of current debt due to inflationary effects from issuing new currency via seigniorage.
• "Seigniorage is particularly attractive in economies where the traditional tax base is narrow" - The United States faces the primary problem of a shrinking tax base. As this CBS News article from April 15, 2009 notes that an "astonishing 43.4 percent of Americans now pay zero or negative federal income taxes. The number of single or jointly-filing 'taxpayers' - the word must be applied sparingly - who pay no taxes or receive government handouts has reached 65.6 million, out of a total of 151 million.
• "the costs of other forms of revenue collection are high" - Other forms of revenue refers to income taxes or VATS. Certainly the US qualifies here.
• "economies where the policy regime limits the portfolio of domestic financial assets available to the private sector" - Congress (and the administration) is placing restrictions on securitization and considering other financial regulations under consideration. Using the housing market as example, it's the GSE's and the Federal reserve buying mortgage securities and loan portfolios, not the private sector as would be more efficient and economically sound.
• "revenue can be increased in the short-run ... The higher the costs of adjustment, the greater the short run value of the 'surprise' revenue." - The net result is a short-term bump in GDP to the long term detriment of the economy. That's what we saw in Q3, 2009.

As described in the Abstract of the Adam, Ndulu, Sowo article, the "implication is that countries that have relied on seigniorage revenue need to undertake deeper-than-anticipated fiscal adjustment in order to maintain macroeconomic balance following liberalisation programmes."

This is often why prominent economists and thought leaders (including Steve Forbes) advocate the United States returning to the gold standard - so that the US Dollar is backed by an intrinsically valuable item. Additionally, Forbes backs the "flat tax" to make revenue collection by the government simpler versus the current income tax system or proposed VAT included in tax proposals of the 111th Congress.

I don't know what the answer to all of this is. I do know that rigorous academic work clearly shows that a government's use of seigniorage leads to long term pain for an economy and that current policies under pursuit work in strong opposition to these economic findings - financing government programs such as the American Recovery and Reinvestment Act, the proposed health care reform legislation, TARP, TALF, and others.

The questions that persists in my mind - is the government selling indulgences to get us out of economic purgatory only to cause a future collapse of our financial system? Watching Walker's presentation on TED.com sparked an immediate parallel in my mind that I can only hope is a result of my background as a history major and Catholic, and not founded on real economic principles. I sure hope I'm wrong on the one.

"Too Big to Fail" & Charlie Rose

A recent issue of Fortune Magazine included a nice piece about Charlie Rose - "Why business loves Charlie Rose." I'm thankful for the article because it reminded me how much I enjoy his program so I've now set my DVR to record these episodes. Heck, if Warren Buffet watches it, I probably should.

Mr. Rose interviewed Andrew Ross Sorkin this week, author of "Too Big to Fail" - a book about the events and people surrounding the financial market crash, and I found myself completely engrossed with the conversation between Rose & Sorkin on the program. Lots of intricate details about Hank Paulson, Richard Fuld, Tim Geithner, and others. I just ordered a copy of the book from Amazon...

The discussion quickly reminded me of "Barbarians at the Gate" by Bryan Burrough and John Hely on the leveraged buyout of RJR Nabisco in a previous decade. I finally got around to reading this book over the summer.

While it's hard to believe how Wall Street deals sometimes go down, it's really not when you read about the people behind the deals. In the interview with Rose, Sorkin described his book as a recounting of people and their personalities as much as it is a book about the events themselves.

John Hussman on the Banking & Housing Markets

From John Hussman, of Hussman Funds, this article provides one of the most lucid descriptions of why the poorly constructed (I hate using the word "toxic"...) mortgage assets on bank balance sheets pose such as problem, and a clear set of solutions that would probably work if implemented. Hussman explains why allowing the banks to charge the negative assets to existing bank bondholders instead of using government cash infusions is a more natural plan, and why we're not even close to getting out of the woods in the housing market:

http://hussmanfunds.com/wmc/wmc090330.htm

Geithner on George Stephanopoulos

Watching the George Stephanopoulos show this morning (I'm not sure why, but....), but here are some notes from the interview:

• "People with ideas still want to come to the United States."
• "We need banks to take risk again - take a chance again on providing credit to that business..."
• After Stephanopoulos introduced Paul Krugman's comments that the Geithner plan is financial hocus pocus - "This is a conservative structure to have the private investor with the government sharing the risk."
• Stephanopoulos asked how much is left in TARP? - "$135 billion in uncommitted, including money coming back from banks that are stronger than thought and are not in need to the money originally allocated to them."
• On inflation that could be caused by printing money to finance the federal actions - "We'll never have hyperinflation. Increased money supply will not cause hyperinflation."
• Government has historically taken too long to assist in recovery, and pulled out of recovery mode too soon as soon as a glimmer of light was seen - Japan and Sweden in the 1990s, the United States Savings & Loans crisis, and the Great Depression.
• "Right now, we're about where we thought we'd be."
• "Damage from this situation is brutal, indiscriminate."
• "The market will not solve this. The error is not doing enough."

Milton Ezrati at the IMN Distressed Investment Summit

Milton Ezrati, Lead Economist at Lord Abbott, opened Information Management Network “Distressed Investment Summit: Credit Crunch Investment Strategies for Institutional Investors” conference on Monday. From his viewpoint, the market is running on emotion, which is covering up current market fundamentals. And the market ran on emotion over the last couple of years, which previously covered up really bad fundamentals. But the markets have over-reacted and are pricing assets to fear instead of to value. And the markets are slowly recovering from the emotion-based marking. Got all that?

Ezrati illustrated his point of view with a few examples:

• The TED Spread: Has historically bubbled around 25-30 basis points. It rose to 460 basis points in November 2008 and has since dropped down to 100 basis points - still not back to normal, but recovering.
• Credit Spreads: Junk bonds, which normally trade around 500-600 basis points, reached 2100 basis points but have fallen to 1500-1700 basis points.
• Merrill Lynch: In their sale to Bank of America, mortgage assets were priced at $0.22/$1, indicating that 78% of assets are worthless; yet 60% of sub-prime borrowers are current (and this doesn’t even count the intrinsic value of the properties themselves…)
  

In discussing today’s market as compared to the Great Depression, Ezrati offered some salient points:

• There was no bank deposit insurance then.
• There was no unemployment insurance then.
• Unemployment rose to 30% during the Depression, versus 8.1% now
• 9000 banks went bust during the Depression, versus 40 banks now.
  

Other key points from his address:

• Worker Productivity rose in Q4-2008, even with the massive layoffs in the economy. (Those numbers have since been revised to show a -0.4% downturn in productivity, but given the sharp increase in unemployment in Q4, this value seems to indicate that productivity is still ahead of employment declines.)
• Personal Savings have risen to nearly $600 billion from nearly $0 in 2007. (You can verify this at the Bureau of Economic Analysis.)
• While the current government’s actions may create an inflationary environment, he is not forecasting any inflation at this time.
• When asked about China’s role in financing our debt, Ezrati likened the situation to a manufacturing company subsidizing a customer at a loss, only to gain when selling the end product. As long as China continues to run an export-oriented economy, then they have little choice but to finance US debt because of their reliance on the US for its economic base.
• When asked about drawing an analogy between Japan plight in the 1990s to the current U.S. situation, Ezrati cited that Japan’s government failed to acknowledge bad debt at the start (versus the mark-to-market requirements in the U.S.), that Japan’s sub-prime debt was non-paying (versus a 60% repayment rate in the U.S.), and there was not much of a corporate debt market in Japan (borrowers had to go to a bank for a loan). So overall, Ezrati indicated that the current situation in the U.S. does not compare to that of Japan’s a decade ago.
  

Overall, Ezrati saw reasons for abatement in the market’s negative direction, but as you might expect, hedged that with a little caution that future economic events such as inflation could hamper recovery in the intermediate.

Paul Volcker on Bank vs. Hedge Fund Risk-Taking

Paul Volcker, former Federal Reserve Chairman regarding risk profiles of banks vs. hedge funds:

"Maybe we ought to have a two-tiered financial system," Mr. Volcker said at conference at New York University's Stern School of Business. Banks "should not be taking extraordinary risks in the marketplace."

This is the basic premise of the financial system. Bank are inherently supposed to be risk-averse institutions, as discussed in this article about the US government's interference in the free market.

The rest of Mr. Volcker's comments are in the rest of the article on HedgeWorld.com.

The "Housing Rescue" by the numbers

The Obama administration released the details of the housing rescue today, and the WSJ put together a nice "Fact Sheet" that I just reviewed.

Here's the money reward if you purchased a home you could not afford, or were a lender that eschewed the standard practice of lending to credit-worth people:

Servicers that modify loans according to the guidelines will receive an up-front fee of $1,000 for each modification, plus “pay for success” fees on still-performing loans of $1,000 per year.

Homeowners who make their payments on time are eligible for up to $1,000 of principal reduction payments each year for up to five years.

Here's what it means:

• Borrowers will be given a $5000 as reward for paying their refinanced mortgages on time. The rest of us just get to continue living in the house we bought.
• Lenders will be given $6000 for modifying a loan that otherwise would have defaulted.
  

Gee... thanks...

Using the mortgage calculator on BankRate.com, suppose a $300,000 mortgage balance paid over 25 years at 8% interest, which assumes the new interest rate after the initial 5-year period adjustment of a 30-year, 5-year ARM mortgage contract. The monthly payment comes to $2315/month (not including taxes, insurance, and other monthly fees included in the monthly housing payment.)

Now, assume that a refinanced rate of 4.5% for the life of the loan. The new monthly payment drops to $1667/month - a difference of $648/month, or $7778/year. Keep in mind that both the borrower and the lender can each earn $1000/year, reducing the lender's "loss" to $6778 and subsidizing about 5% of the borrowers total annual payments for the initial five-year period. I say "loss" because this is a net gain for the lender versus the borrower defaulting completely on the loan.

Here's the good news that I can see from this program. Will this make a difference for most people that aren’t able to make their mortgage payments at the $2315/month? What's the elasticity of the borrower's willingness or ability to pay based on the 27% reduction? I'm guessing that these borrowers that will refinance are likely to miss at least one payment each year, even at the lower modified monthly payment amount. So the offer becomes void (until Congress inserts some exception to the rule... "You get points for trying...)

It probably will make a difference for some people who have had their hours cut at work or have lost a part-time job that was supplementing income. But for rest, I suspect that making mortgage payments was likely a binary condition - either you're paying or you're not. And if you're not, the 27% reduction isn't going to enable you to make the payments.

What about paying people $5000 and to go into foreclosure instead? Those that can't pay won't, so instead of delaying the inevitable, fast-track the foreclosures, and let the market clear faster so we can get on with the recovery.

The United States, Collectivism & Radar Guns

As the market continues to unravel and the socialist agenda of the current political administration moves farther along its path, my source of solace has been the late, great Milton Friedman. "Uncle Milty," as he's known throughout economic circles, had much to say regarding socialism, the government's constraint on markets, and American business.

Socialism in the United States

Back in a 1975 interview hosted by Richard Heffner on "The Open Mind," Friedman stated that the natural order of mankind is movement toward socialism. Human nature pulls us toward group behavior and collectivism, and while well-intended, we often establish laws and regulations in haste whose end result rarely (if ever) meets their initial objectives. It's natural for people to look to a central authority to establish rules and guidelines designed to protect their interests and propagate desirable behavior. If a condition or situation arises that negatively affects a minority group (that is numerically, not racially per se...), the initial response is to say - "That's terrible - there ought to be a law."

(The interview referenced here was conducted in 1975. Discussion topics focused on individual freedoms and the inefficiency of strong government intervention to solve social and economic issues. Here's a link to the 30 minute interview.)

In economic and financial circles, Milton maintained that free markets and permitting individuals to pursue their own self-interests is the most efficient way for societies to operate. This is clearly results in a duplicitous state of being - we know that the pursuit of individual self-interest is more efficient means to maximizing outcomes, yet our human tendencies move us to collectivism and socialism. Most importantly, the implementation of regulatory burdens by our socialist self results in exactly the opposite of its intended effect. As Friedman illustrated, consider any social program introduced by government - minimum wage laws, protective tariffs, or welfare. In every case, these enacted social programs resulted in ultimately hurting the very minority groups they are intended to protect, and can be proven to have done so using the most rudimentary technical economic models.

The long term effects of continued regulations and government intervention will lead us to the path of socialism, and eventually tyranny and serfdom under the weight of self-imposed governance. Friedman shared the view of Friedrick Hayek, who authored "Road to Serfdom" earlier in the 20th century. Given these natural human tendencies, Friedman estimated that there was only a 15-35% chance that we, as Americans, had the posterity to avoid complete socialism by taking the proactive measures necessary to enable individual freedom and resist our natural tendencies for collectivism, a state that which would evolve to the condition of serfdom and tyranny.

Fortunately, as Friedman explained, there are two situations that support the maintenance and protection of a free society. The first is government's inability to operate efficiently. As Friedman put it - "you almost never spend other people's money as carefully as you spend your own." Individually, we can examine nearly every social program at the most cursory level and quickly see the massive waste involved with its implementation. The second is the American commitment to finding loopholes and to circumventing laws.

The Housing Market: A Textbook Case of Government Inefficiency

The Community Reinvestment Act was enacted in 1977 and designed to encourage depository institutions (banks) to meet the credit needs of the communities in which they operate, with credit including home mortgages. In 1992, then-President Clinton signed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 which eventually authorized and capitalized Fannie Mae to purchase mortgage loans granted by banks to credit-risky individuals as a means to expand home ownership opportunities to low- and moderate-income individuals. Sounds noble - enabling the financial market to provide credit and mortgages to individuals that they would normally reject under financial guidelines. But what were the long-term net results?

The banking institution is inherently risk averse. They have liquidity guidelines that require cash to be readily available to the depositors. Traditionally, banks required a 20% down payment for home purchases and approved only those individuals with credit-worthy histories. There are sophisticated, mature industries along the risk spectrum – Hedge Funds, Private Equity Funds, Venture Capitalists, and industry-specific investment funds and private investors. Banks are not part of this cohort.

When banks were coerced into participating in higher risk activities, their response was to dispense of these risky loans in the form of mortgage-backed securities (MBS) to those in the marketplace better poised to take higher risks with the objective of higher returns. Seeing a demand for these assets, the banks accommodated by increasing the supply of risking loans. The mortgage broker industry, including firms such as DiTech, Ameriquest, and Countrywide, saw an opportunity to facilitate these loans on behalf of the banks, providing an avenue to banks to increase the supply of these MBS to meet the increased demand. Eventually, as is clear now, we see that many of the high-risk borrowers are unable to repay the mortgage payments due, are moving into default, or are going into foreclosure. This is causing a major increase in the available housing supply and reducing the housing market's equilibrium price.

As prices continue to fall and interest rates adjust upwards, more and more high-risk individuals are either deciding not to make their mortgage payments in protest of their poor decision-making process to purchase an over-priced asset, or are simply unable to continue making mortgage payments at today's adjusted interest rates. Shocking revelation - those with poor credit don't pay their bills or live beyond their means. This adds to the housing supply, further exerting downward price pressure on homes. "Wait a minute," you say, "when prices fall, shouldn't that mean that more people should be able to afford a home, especially those in the low and moderate income brackets?" Yes, the should... But now that banks are restricting access to credit to meet more traditional criteria, even restricting credit access to those that meet traditional credit ratings such as a +700 FICO score and 20% down payment available. Lending levels have fallen drastically, and thus those especially in the low to moderate income bracket are unable to receive approval for home purchases because the market for high-risk MBS dissipated.

This case illustrates exactly what Friedman stated - the same rules and regulations designed to promote home ownership has worked to the ultimate detriment of those they were intended to help. The "greed of banks and Wall Street" didn't create the housing market crisis. These market players acted exactly as they should under the rules of game placed upon them by government regulation.

And what makes greed so bad in the first place (Gordan Gecko notwithstanding)? Even Uncle Milty favored greed in its pure sense. Ask Phil Donahue what he thought after this interview with Friedman.

Baseball, Apple Pie & Avoiding the Law

The second salvation that we have as Americans to avoid complete socialism lies in our burning desire to take mulligans and interpret 55 to mean 64 on the highway.

With the monetary allocations to the bank bailout initiatives, it's been a popular mandate to require that CEOs of banks receiving bailout funding may not receive a salary about $500,000. Even with the newly-imposed executive compensation limits, there's evidence of loopholes. Check out this story in the LA Times.

And what about the new tax plan designed to pay for nationalized health care by taxing those earning more than $250,000 per year? Check out this article from the Associated Press. The tax plan is designed to increase government revenues by taxing the "rich." The net result - the "rich" decide to work less and pay fewer taxes. It's better to make $249,999 than it is to earn $250,000. Only the government could invent such as system that would actually encourage Americans to work less. Why would someone opt to earn less than more? Because it's in his individual self-interest to do so. The net result in weighing higher taxes on the wealthy? Lower revenues - the exact opposite result from the original objective.

These simple cases highlight that regardless of the laws and regulations instituted under a socialist agenda, Americans will find a way around the regulations. However, it's vital to understand the long-term effects of placing these institutional burdens on an economy. Finding a loophole comes with a cost as time, legal counsel, and accounting fees to name a few. These transactional costs eat into the ability for individuals and the marketplace to act efficiently. Slowly the regulations erode the foundation of a free marketplace, only to have it crumble beneath itself under the weight of collectivism.

Life, Liberty & The Pursuit of Happiness

Economic freedom is difficult to achieve and maintain. That's why individuals throughout the course of history have died to enjoy and preserve freedom. That's why Cubans try to swim 90 miles to Florida. That's why we all recognize the image of Tiananmen Square from 20 years ago.

It's difficult to take personally responsibility for your actions and outcomes, and easy to blame the rules of game for your failures. But it's those failures that spawn new efforts and eventual gains. I'd rather have the choice of failing 1000 times than abetting the singular failure of our free market system in America. How about you?

New Article posted in Seeking Alpha

In case you missed it, Seeking Alpha posted a recent article I authored:

http://seekingalpha.com/article/119580-can-we-expect-a-springtime-bounce-in-housing-prices

I usually re-post the articles here, but this one was a bit lengthy with lots of graphs, so in the interest of time, I'm simply linking to the article from here.

Enjoy!

Geithner on Lending Levels

And switching over Timothy Geithner's speech this afternoon... He stated that the program proposed is to (paraphrasing) "insure that lending would be greater than without government intervention."

Read: We're putting money in the market so that we can spur lending and open the credit markets.

That's what I thought they were trying to do.

Bernanke on Entrepreneurship

Watching Mr. Bernanke's testimony to the House of Representatives Budget Committee. He just said something very poignant (paraphrasing):

In1930s in US and more recently in Japan, the destabilization of the banking sector made it very difficult for entrepreneurs to get credit and very difficult to grow their business.

What I see in this statement is that business will lead us out of the current economic environment - not the government. Focus on financial market stabilization and business what it's good at - innovate and advance on new opportunities.

That is all.

Goodwill Accounting

Back in April, I outlined Yahoo's "goodwill" account to highlight how they were overpaying for acquisitions - other technology companies developing products that should have been developed in-house at Yahoo!.

Today, I say this link on Twitter which provides a list of companies whose "Goodwill" accounts exceed their current market capitalization. Most of the companies appears to by in the Consumer or Communications industry. Not sure what the implications are, but interesting nonetheless.

The Mortgage Market, Housing Market & Inflation

This week, the Mortgage Banker’s Association released the “good news” of mortgage rates falling and loan applications rising. But is it really?

The Mortgage Industry

From the mortgage industry, there’s applause when mortgage rates fall and loan applications rise. Considered healthy, innovative, and robust in 2003, the longer terms effects of this outlook are now evident.

At the annual American Economics Association conference in San Francisco this month, Karl Case presented his paper “How Housing Busts End: House Prices, User Cost and Rigidities During Down Cycles.” Two of the slides presented show some stark numbers from 2003 when interest rates and mortgage rates reached historical lows. First, look at the number of loan modifications (“Refinance Originations”) in 2003 compared to Purchase Originations:

Lest we forget that mortgage brokers are compensated by an origination fee and not on the number of mortgages successfully repaid by the borrowers. The top line number on loan applications and interest rates recently announced could be construed as a marketing effort by the mortgage industry to increase the pipeline of mortgage applications. Because of the tighter credit market and lower mortgage approval rates in today’s environment, the mortgage industry requires more applications to be submitted to meet their revenue targets based on approvals – it’s simply a numbers game.

This isn’t a criticism of the mortgage industry, just a simple observation based on their incentive programs. Measuring the health of the mortgage market based on loan applications and interest rates feels like gauging the health of an alcoholic who just bought his 14th round of drinks during 2 for 1 happy hour. Yes, he’s joyful at the time based on his criteria for happiness, but the long term effects are obvious. Fool me once shame on you. Fool me twice, shame on me.

With refinancing, a few more people may stay in their homes with the lower rates, but the risk profile of the American borrower has not changed in any structural way since 2003. America’s negative personal savings rate is well-documented. The objective to spur the housing market based on lowering interest rates is misguided. The evidence from 2003 shows that – lowering interest rates along with easing credit restrictions leads to housing price inflation.

The Housing Market

Historically, economic recessions are usually followed with a sharp decrease in housing starts. In 2002, the amount of available cheap money bolstered consumer demand for new homes, so builders naturally continued home starts where they normally would have pulled back.

What’s clear is that homebuilders habitually build during growth periods, eventually overbuild, allow for the existing supply to clear, and then begin the building cycle again over time. However, as Case presented in the figure above, this expected downturn in housing starts was essentially ignored by the homebuilders. Housing starts dropped briefly then continued their ascent through 2007. Referring back to the mortgage origination figures, this push of cheap money into the housing market led to the market we’re experiencing today.

For existing home sales, home price trends jumped dramatically starting in the early 2000s and appear to be returning to their historical rates more recently according to the Case-Shiller Home Price Index:

The California Association of REALTORS® reported the net effect of lower prices - transactions increased by 12% in 2008 over 2007. While year-on-year prices are down 40%, the laws of supply and demand are working, and doing so independent of mortgages rates which have been relatively unchanged over the past three years:

This provides some evidence that the housing crisis is not a mortgage or liquidity crisis, but home price problem. As prices continue to fall to historical growth rate levels, the market will clear because markets work.

Inflation

When interest rates fall to a lower rate by increasing the Nominal Money Supply, keeping Real Money Demand levels constant, the net result is an increase in the inflation rate.

By definition:

Rate of Inflation =
Growth Rate of Nominal Money Supply – Growth Rate of Real Money Demand

While the latest economic data is showing an ease in the inflation rate, this is presumably a function of slower economic activity and the reason for the proposed economic stimulus packages in Washington.

As economic activity grows, so shall the inflation rate. A look at the Quantity Theory of Money illustrates this point:

M x V = P x T

M = Money Supply
V = Money Velocity (the rate at which money changes hands)
P = Price of the typical Transaction
T = Total # of Transactions

Rearrange the equation to show the net effects of an increase in Money Supply:

M = PT/V

When Money Supply rises, holding Money Velocity and the Total Number of Transactions constant in the short term, the basic math shows that that Price of the Typical Transaction must rise (a.k.a. inflation). As the money supply increased from 2003-2008, the recent Federal Reserve’s cuts in the target interest definitely led to an increase in Money Supply. Inflation rates increased as money supply increased. With the recent economic downturn, the inflation rates dropped dramatically, matching with previous declines in the inflation rate that coincided with recessions (1981, 1991, & 2001):

The argument in many economic circles is that a little inflation would be good, just not too much. Greg Mankiw wrote about this back in December, suggesting that “moderate inflation would be desirable under the present circumstances. In particular, the overall level of prices a decade hence should be about 30 percent higher than the price level today.” (Be sure to read his comment to Paul Krugman…)

How does this relate to the Mortgage and Housing Market?

Some lending is good – economic activity will inevitably result with increased liquidity. Lending to everyone like we witnessed in 2003 is bad – it contributed to overly-inflated housing prices, credit defaults, and the current housing market situation. Every recession in economic history was followed by a boom of innovation, economic growth and prosperity. It’s understood that this longer view perspective doesn’t help the auto worker in Detroit or the single mom waitress in Miami. But let’s show some discipline and a little faith that the existence of business cycles indicates that it’s not necessary to solve the recessionary and housing market problems by Thursday with near-sighted patchwork.

(Author's note - This article was also published on Seeking Alpha on 1/19/09.)

A Case for Higher Interest Rates & Lower Home Prices

(Author's Note: This article was also published on Seeking Alpha on December 25.)

With the continual prodding by many to initiate 4.5% mortgage rates to pacify the current housing market glut, it's important to distinguish the effects based on two categories of buyers:

1. Existing mortgage refinancing
2. Home Purchase Mortgages

Fundamentally, the problem with this policy is that it is likely to have a minimal effect on latter category. Saskia Scholtes wrote about this in "Mortgage activity surges at US banks" -

With average rates for a 30-year, fixed-rate mortgage now at about 5.2 per cent, growing numbers of borrowers have an incentive to refinance to bring down their mortgage costs.

But tighter underwriting standards for prospective borrowers, combined with funding and staffing difficulties for mortgage originators, are likely to restrict the supply of new mortgages.

It's clear that rates falling to 4.5% would stimulate mortgage refinancing, but not new mortgage approvals. Everyone from my father-in-the-law to our data clients at Altos Research have consistently pointed out the merits of such action. If you're paying 6% or even 5.5%, if would naturally be in your personal financial interest in the long run to refinance to a lower rate.

However, Scholtes' article indicates exactly what I've been piny about - that lowering mortgage rates will not significantly stimulate housing demand. Here's an example of what I mean:

What if we kept mortgage rates at 5.5% to compensate lenders for lending risk, but awaited a continued aggregate home price decline?

Using Mortgagecalculator.org, I ran the numbers based on a $300,000 home price and a $240,000 loan (though I'm not sure someone buying a $300,000 house will have $60,000 to put down to cover the 20% down payment requirement, but this is an experiment...).

At a 5.5% rate, the monthly payments are $1,712.69. At a 4.5% rate, the monthly payments fall by $146.65 to $1,566.04. The move from 5.5% to 4.5% is a drop of 18%.

Now what if home prices fell 18% from $300,000 to $246,000 (a decrease of $54,000) but mortgage rates stayed at 5.5%? Assuming the same 20% down payment, the loan amount would be $196,800 for a home priced at $246,000 and the monthly mortgage payment would be $1,404.41 - a drop in the monthly payments of $308.28. Which would stimulate demand more - lowering the monthly payments by $146 or $308? Lower mortgage rates will lead to lower housing prices as viewed by the buyer (in terms of monthly payments), but not by as much as lower home prices.

Yes, I realize that this is blasphemy because I'm advocating unchanged mortgage rates and a continued fall in home prices. However, the net gain is that lenders can to more borrowers at the higher rate. Why? Because the extra 1.0% offers a risk premium to lenders that will enable lenders to account for the riskiness of the buyers (we don't pay our bills here in America), thus increasing the number of buyers that would quality for approval. Additionally, a decrease in home prices would lower the income requirements for approval for buyers of this same risk profile. At a lower interest rate (say 4.5%), lenders will be forced to maintain stringent mortgage approval guidelines and the lower rates would have less effect on a buyer's monthly mortgage payments.

Remember - it was cheap money to unqualified buyers that bears considerable responsibility for the housing price mess in the first place.

The counter to this argument is simple - if home prices continual to fall, the number of "walkaways" will increase because more current home owners will be under water in their existing mortgages. This brings us back to why advocates of the 4.5% mortgage rates feel this is a viable proposal to solve the housing problem - these homeowners will be more likely to refinance than walk away. I'm not so sure about that. Using same figures above, will a homeowner that's avoiding the $1712 payment above suddenly begin making payments if at $1566? Probably not. Check out the latest data on loan modification application-to-approval rates with the number of interest-only loans creating first and second-lien situations.

More on 4.5% Mortgage Rates

Came across this article on Portfolio.com - "Against Lower Mortgage Rates."  The author, Felix Salmon, presents some good analysis, digging into Hubbard & Mayer's oped piece in the Wall Street Journal this week and using some of their own research to build a case against the proposed 4.5% mortgage rate.

4.5% Mortgage Rates & Housing Demand

Earlier this week, I suggested lower price levels would spur housing demand far more than lower mortgage rates.  Using John Taylor's position that the Federal Funds Target rate was below the levels recommended by the Taylor Rule, it would appear that cheaper money led to the current housing glut but my conjecture is that cheaper mortgages in today's environment will have only a marginal effect on overall housing absorption.

In today's Wall Street Journal, Glenn Hubbard disagrees (not necessarily with me of course) -  but siding with the recommendation of the newly proposed 4.5% standard mortgage rate for homebuyers.   (What's even more interesting is that this proposed plan hasn't really been proposed and is purely rumor according to Treasury Secretary Hank Paulson.)

Hubbard argues:

Moreover, a 4.5% mortgage rate will raise housing demand significantly. A simple forecast can be obtained by applying the 2003-2004 homeownership rates to 2007 households. We use the 2003-2004 home ownership rates because those were the years of the lowest previous mortgage rates (the average mortgage rate was 5.8%).

Hubbard, Taylor, and Paulson know far more about economics, finance, and the housing market that I ever will.  However, applying some very basic financial and economic principles to this case:

1. Past performance is no guarantee of future results.

2. Mortgage rates (and all interest rates) should directly reflect the risk profile of the borrower.

3. If mortgage rates are set at 4.5%, this would implicate that all borrowers fall into a low-risk profile category, as rates at 4.5% are close to historical lows and represent less than a 1% real rate of return for lenders after accounting for inflation (estimated at 3.66% as of October).

There has not been a fundamental shift in the population of buyers in the market.  That is, in aggregate, today's buyer population is not constituted of a fundamentally lower risk profile set. We can probably assume that buyers today pretty much have the same characteristics of buyers in the period from 2003-2007.  As such, providing mortgages at a price lower than a large chunk of buyer risk profiles would dictate would seems to only elongate the current housing glut since offering mortgages at 4.5% would enable those not truly lendable to receive mortgage approvals.  

One might immediately argue that there are tougher lending requirements now, so the lower mortgage rates would not necessitate irresponsible lending practices as seen in the previous business cycle.  However, with the Federal Funds Rate near 0%, banks are in a position to take more risk and provide money supply to those seeking it, which is what the Federal Reserve wants to happen to prompt economic activity.  See the circular logic here?

One could argue that because price levels are lower (and perhaps exhibiting deflationary characteristics), houses are more affordable to today's population of buyers and thus is creating demand.   If that's the case, will dropping mortgage rates from 5.5% to 4.5% really have an impact, or is it the change in price levels that will spur housing activity?  As argued in my previous article, it seems that lower home price levels will have a bigger impact.

The Taylor Rule & The US Housing Market

(Author's note: This article was published on Seeking Alpha on December 26.)

I received a link to this article on Twitter from Paul Kedrosky, author of Infectious Greed, on John Taylor’s criticism of the Federal Reserve’s recent monetary policy. I was drawn to the post because of the chatter that I hear from residential mortgage brokers applauding cheaper money (a.k.a. lower interest rates) -- their belief that sub-5% mortgage rates will spur housing demand. (Much more on this shortly...)

The article described Taylor’s criticism as published in his most recent paper. This is particularly poignant because this criticism comes from John Taylor of the Taylor Rule.

The Taylor Rule is a simple rule for determining the federal funds rate:

Nominal Rate = Inflation + 2.0 + 0.5(Inflation – 2.0) – 0.5(GDP gap)

Using the Taylor Rule, the current federal funds rate would be calculated at approximately 4.5% (assuming that a natural rate of GDP growth is 3.5%, with inflation calculated in October 2008 at 3.66% and current GDP growth at -0.5%).

With current rates well under 2% and looking at a historical graph of the Federal Funds Rate since 2000, we are still well below the level estimated by the Taylor Rule and have been for several years, thus the reason for Taylor's scorn.

Going back even further to the 1990's, we see that that Federal Funds Rate more closely followed the Taylor Rule recommendation:

(Source: Gregory Mankiw's "Macroeconomics" 4th edition)

It was the Federal Reserve's policy starting in 2001 that irked Taylor, to put it lightly. More so, The Federal Reserve has been dropping it's target Federal Funds rate lately in an effort to combat recessionary pressures. This has perceived implications in the real estate industry by many mortgage brokers out there, as mentioned above.

Here's the catch - the demand for money in the housing market is probably not the problem right now, because the aggregated buyer demand will not change unless lending requirements change at the current price levels. There are a fixed number of buyers in the market to which lenders will approve and make loans. Lenders are offering few indications that they will be loosening lending requirements in the near future, and so we can't expect new buyers to enter the market simply with cheaper money available.

However, there are buyers at lower home price levels that would qualify for a loan if the overall price of homes were lower. For example, assume that there is a fixed supply of homes on the market (say 1,000,000 homes) and assume that all of these homes were all priced at $250,000. There are a certain number of buyers that are willing and able to buy a home at this price (meaning that they are actually receiving loan approvals), but given the surplus of inventory on the market, it appears that the number of buyers is below our assumed supply of 1,000,000 homes.

Now, if the price of these 1,000,000 homes for sale dropped to $200,000, then basic economics tell us that more buyers become willing and able to buy homes. That is, some buyers that would not be approved to purchase a $250,000 home would be approved to buy a $200,000 home, simply because income requirements are lower for the buyer at the lower home price. The profile of the buyer doesn't change for the lender under their stricter lending requirements - strong credit scores and meeting income level requirements - there's just more buyers when home prices drop overall.

The cheaper money will decrease the final price of homes to the eventual buyers, even if the actual sold price of homes does not change. This is because the lower interest rates will result in a lower long term mortgage payment. As many Realtors have told their buyer clients - the final price of the home matters far less to you monthly than does the monthly payments that you will be making for the next 30 years. That said, lowering interest rates to make money less expensive won’t spur housing demand in a drastic way.

This would indicate that the fundamental issue in the housing market is total quantity of homes demanded from qualified buyers as determined by the money suppliers – banks and lenders. Only buyers that will be approved are part of the buyer pool, the rest are just lookers. With more stringent (and responsible) lending requirements, the question is whether the true number of buyers in the market is numerous enough to purchase the existing supply. Given that suppliers (home sellers) are continuing to drop their prices, it would appear that the real number of qualified buyers are less that required for the housing market to find equilibrium.

Here's an illustration of this example, courtesy of my AltosXplorer application from Altos Research (shameless plug):

This graph illustrates the point of fixed supply and declining prices. Using a 90-day rolling average value for both Median Price and Inventory, we can see that Inventory has mostly leveled off since the end of 2007, but prices are still falling at a constant rate. There's just no buyers for the homes on the market at the price levels. As such, the suppliers (home sellers) are adjusting their price until they will reach a clearing price where willing, able, and funding-approved buyers will enter the market and begin purchasing homes.

To bring this back to John Taylor and his target for the Federal Funds rate - the problem with the housing market will likely not be improved with a decrease of interest rates, and cheap money bears considerable responsible for the housing price mess. Instead, long-term relief has better prospects with lower price levels that will clear the market.

Just one man's perspective.

Michael Lewis - "The End"

Just in case you missed it, here's an interesting piece from Michael Lewis, author of Liar's Poker (a book about Wall Street back in the 1980's that you should read if you haven't). His new article - "The End of Wall Street's Boom"- is a new perspective on the current financial market situation. It's about 18 pages printed, so grab a cup of coffee first.

(Chris M. - thanks for sending to me...)

Recent Commentary on Venture Capital Trends

From PWC's report "Exit slowdown and the new venture capital landscape":

"In the second quarter of 2008 there were zero VC-backed exits - on the heels of five in the previous quarter which raised a thin $283 million. In the first half of 2007, by comparison, 43 VC-backed IPOs collected $6.3 billion."

From the Q3, 2008 report of University of San Francisco Silicon Valley Venture Capitalist Confidence Index™:

The Silicon Valley Venture Capitalist Confidence Index reading "fell from the previous quarter’s reading of 3.07 to a fourth consecutive new low since the Index was originated in Q1 2004 and indicates a continuing downtrend in venture capitalists’ confidence."

From Lawrence Aragon's article on PEWeek.com this week:

"The preliminary numbers indicate that VCs are hunkering down more quickly than they did after the dot-com crash. The data show that U.S.-based venture firms invested in just 250 companies last month, down from 565 companies in September and 518 companies in October 2007. You have to go all the way back to January 2004 (when they invested in 232 companies) to find a lower number. The only other October with fewer deals was in 1993."

Some positive does exist out there. The Q3 2008 MoneyTree Report published by PriceWaterhouseCooper indicates that overall venture capital activity is stable if measured in terms of dollars.

"Despite the turmoil in the global financial markets, US venture capital investing remained within historical norms in the third quarter of 2008. Venture capitalists invested $7.1 billion in 907 deals..."