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Thursday, July 24, 2008


bill gross and housing price support

some time ago i wrote of comments made by PIMCO's bill gross:

gross ... either does not understand the mechanics of house prices (very doubtful) or is being disingenuous when he claims that the government can "support housing prices" by buying packaged loans even in a massive public intervention (whereas is might do so in a large inflation, by debasing the currency and allowing a big fall in real prices to occur as nominal prices are essentially static). what the government can do by such an act is help deleverage the money center banks, investment banks and hedge funds that are holding these illiquid, loss-making securities, recapitalizing them by buying their troubled assets as artificially inflated prices. importantly, the same holds for fannie mae and freddie mac, which increasingly appear fit for nationalization in total.

for gross to be correct, not only the banks but the whole shadow banking system would then have to use their newfound capital strength to... dive right back into the huge leverage and widespread fraud that characterized the mortgage market in recent years! that is exceedingly unlikely to happen, in my view.

recapitalized banks are very likely instead to follow the mode of past bubble-burstings (a precedent set very clear to japanese technocrats if not americans) and find ways to allocate capital to economic sectors that have been the best and safest -- not the worst and most troubled -- recent performers.

and yet i read again today via yves smith that gross is still trying to find ways for government to halt house price declines.

PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.”

A trillion dollars is a lot of money, but in this age of photoshop wizardry it seems that experts can make just about anyone or anything look good. Lose a trillion? Well, just write it off a little more slowly, or suggest that mark-to-market accounting is not applicable to banks and investment banks. ... But the reluctance to remark rancid mortgage loans rests on the heretofore inevitable conclusion that home prices will bottom and then reflate within a reasonable period of time. If they go down even more, and stay down, well then Washington – Wall Street – and ultimately, Main Street – we have a problem. That is why Hank Paulson and in turn Christopher Cox are waving their independent but coordinated wands in an effort to 1) prevent a market run on the price of bank and investment bank stocks until there is enough time to reflate the U.S. housing market, and 2) ultimately recapitalize our primary mortgage lenders – FNMA and Freddie Mac. An interesting press release by the CBO on July 22nd, by the way, points out that the GSEs are barely solvent (9 billion dollars) when their assets are valued at current market prices. Housing’s cow needs to turn into a bull real quick.

Make no mistake, the current conundrum that must be solved is: how to make the price of 120 million U.S. barns stop going down in price and then to make them go up again. That, however, is easier said than done. One of the wisest men I know has this serious but admittedly impractical solution: have the government buy one million new/unoccupied homes, blow them up, and then start all over again. Absent that, he’s not quite sure what to do, nor am I, with the exception of the next paragraph’s proposal.

Up until this point, the joint efforts of the Fed and the Treasury have been directed towards maintaining the stability of our major financial institutions, recapitalizing their balance sheets in “current form,” and lowering the cost of mortgage credit. All are crucial to any solution, but it is this third and last point where markets have failed to cooperate. With Fed Funds having been lowered from 5¼% to 2%, it would have been logical to assume that the price of mortgage credit would go down as well and that the price of homes would at least slow their current descent. Not so. As Chart 2 points out, the yield on a 30-year agency mortgage-backed loan has actually risen since the Fed somewhat unexpectedly began to lower Fed Funds in early September of 2007. Add to that of course, the increased fees, points, and total spread that an actual homebuyer pays to finance his purchase now as opposed to then, and it is obvious that homes are not the bargains that starving realtors claim they might be. Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

says yves:

Readers will no doubt note the curious failure to acknowledge the delevering as the result of mounting insolvencies, which makes the idea of stopping the fall in loan (sic) prices an exercise in fantasy.

private mortgagemaking is all but dead for the time being, i agree. but even if the banks are recapitalized from outside and the deleveraging of high finance slowed or stopped, which bank is going to immediately start hosing the mortgage market with ultracheap loans and neither underwriting standards nor care if the loan could actually be repaid? that's what it took for american household incomes -- which in real terms actually declined over the whole timeframe of the boom -- to support such a massive runup in prices. and that is something like what would have to happen again to halt price declines at current levels, much less reflate them to 2005 levels.

the whole principle of price-to-income valuation in the housing market is to assess affordability by time-honored measures of normal and sustainable lending that endangers neither the mortgagor nor the mortgagee.

gross proposes to shift risk to the government by forcing lower mortgage rates -- effectively nationalizing the mortgage market and turning the GSEs into explicit policy instruments. but he doesn't seem the quail at his own words:

... the cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability. In addition to home prices, $130 a barrel oil and their resultant distortion of global wealth and financial flows head that list.

those investors include foreign central banks, who would recognize the effort of the united states to turn treasury bonds into a conduit for subsizied housing in perpetuity and reprice them accordingly.

backstopping what the GSEs have already wrought is one thing, and that itself may prove prohibitively expensive and enough to drive treasury rates higher on inflationary/sovereign default concerns. then turning the GSEs into liquidity firehoses for the housing market, enabling all interested americans to get mortgages prices so far below market interest rates that the "free money" aspect becomes comparable to what we saw a few years back is quite another -- and sounds like an excellent plan to create a run on the american treasury.

a still imprudent but far less dangerous plan is to accept house price valuation mean reversion as banks liquidate mortgage exposures and the GSEs are nationalized and wound down to a more manageable size -- and use the government balance sheet as a means of recapitalizing the core of a downsized banking sector in the aftermath.

UPDATE: paul jackson at housing wire takes away less concern about gross' proposals.

In other words, HW readers, we’re facing a housing cycle that in the short run isn’t likely to solve itself. Which means it’s time to strap in. Gross suggests that the housing legislation now making its way through Congress may be of some help, at least in the form of making sure that the primary sources of mortgage liquidity don’t blow up in the near-term.

“[L]owering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy,” he suggests, although it’s clear from his remarks that even Gross doesn’t believe it’s a great way to get there. But our options are somewhat limited by a cost of credit that seems stubbornly set on rising further amid growing fears over inflation.

“The cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability,” Gross said.

Which means that homes are in for a rough ride, something that the investment side of the mortgage business is now coming to grasp. Fitch Ratings, for example, suggested Thursday afternoon that home prices nationwide may fall 25 percent of more in real terms over the next 5 years.

strap in, indeed. you can expect government to throw the kitchen sink at this problem over the next couple of years -- but there seems to be less than a ghost of a chance of halting the slide in home prices.

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