Sunday, January 13, 2008

A Long Housing Explanation and An Even Longer Hangover

If you read the media stories or listen as the talking heads tout the misery in the housing market, they almost always cite the Fed lowering interest rates as the number one way to fix the "credit crunch". This is bound to become a troublesome misunderstanding of the current problem as they associate lower interest rates with more lending which would jumpstart the flagging housing market and allow the economy to banks to recover, all the subprime borrowers to get into low fixed rates, and bamn, we can party like its 2006 all over again.

Unfortunately, this isn't anywhere near close to the solution as the media's attempt to condense their description of the problem and the solution into bite size nuggets that people can understand has again missed both the real problem and the solution.

In order to understand the solution, the genesis of the problem must first be discussed. Originally when interest rate were at historical record lows between 2001-2005, the mortgage market started to heat up as easy money spurred buying. The rising tide of housing prices fueled by easy money "lifted all boats" putting instant paper equity in people's home values through increased demand. This easy money effect should have been seen as fleeting (a couple years - like the tech bubble, remember) because a house is only worth what someone is willing to pay for it, OR what they themselves expect its worth to be - much like a stock.

The important part to remember is - as housing prices started rising more rapidly and clearly beyond the historical long term price appreciation trend, the second part of the estimated value of a home became the dominant factor - what its expected worth will become. Unfortunately 3-5 years of heady appreciation tempted greedy people to look at this trend instead of the 30 year trend of 2% per year or so.

So this short term focus along with still easy money caused paper value equity draws by homeowners to increase - either for home improvements to dress their home for a sale in the excellent market or to buy that new Escalade to replace their aging Ford Explorer. What wasn't seen in this phenomenon at the time was the lending standards were relaxing as banks were happy to lend money based on low rates and...HERE IT COMES...their own ability to package these mortgages etc together and resell them to investment companies, foreign sovereign funds, hedge funds, other banks, pension funds, mutual funds, bond funds, and generally anyone wishing supplement their investments with some sort of cash flow for re-investment or further leverage.

This market was so vast given the poor stock market opportunities, that many mortgage banks were making more money in the fees associated with creating and selling these mortgages, than they could have possibly made in the short term by holding the loans and just collecting the interest.

Now, with money coming in from fees, and the mortgage risk off their books (even this wasn't true is some cases, but in any event its not that important to the overall issue) the banks had more money to lend out back into the mortgage market to generate more of these mortgage packages to generate - yep MORE FEES and then more mortgages again!

So at this point its obvious of the loop going on here which is the classic feeder of any bubble. The consumer's willingness to buy stemmed from lower interest which made payments lower, the willingness to lend more by the banks stemmed from their ability to resell the loans and make fees to roll back over into more loans. The willingness to buy more mortgages by investment funds stemmed from the expected low risks associated with mortgages based on current credit lending standards.

As long as the consumer could still rationalize a house's present and expected future value with the payment and afford to pay the payment, everything would be fine - this is capitalism at its finest - everybody passing around money, creating jobs, buying stuff, seeing things they bought become sought after by their neighbor who, because his neighbor spent some money which has now trickled over, has some of his own money to buy that which his neighbor already has. Sounds great until the consumer overestimates the pace of this cycle and gets ahead of the long term trend.

Ok, so as this goes on and on, the mortgage brokers are assisting the consumer to leverage him/herself with exotic loans based on the premise that the current pace which is already deviating from long term sustainability - will continue to do so making the borrower able to either pay the higher amount or "get a fixed lower payment" using the house price appreciation when the higher payment comes due.

At this point everyone is acting "drunk" on money at the mortgage bar hoping the night will never end...well it always does as we now can see. So, how did it end? What happened?

Eventually, as people justified higher and higher payments based not on current variables of ability to pay - income, expenses, job security, etc.. but on overly rosy futures, some of these people's futures turned out to be not quite so rosy. With the lowest savings rate in history, few of these less rosy futures had much to fall back on and lost their homes.

Now, as these less than rosy futures start to surface and mount - as they will the longer we go on - because the further we project into the future the worse we are at projecting accurately - and because just as in a casino - the longer you play the more likely you are to lose - and unfortunately due to our bias - 90% of americans believe they will become millionaires yet less than 10% actually get there, we're bound to see more less than rosy futures as we wait and see.

The problem of these less than rosy futures becomes the damage it does to the loop described above whereby investment funds no longer want to buy more mortgages seeing more of these less than rosy futures rise to the surface. Because of the time lag through which we find out about these less than rosy futures, it acts like a virus - the investment funds wonder "how much of what I have already is infected". Like AIDS without a test for HIV - soon we're in a panic and keeping away from all known causes for possibly catching the virus, every fund worried that every other fund OR BANK has the disease.

So, now the banks have no way to continue to make money by reselling mortgages, because nobody will buy these things anymore, they're worried about their lending any of their existing money for fear of catching the disease themselves. Suddenly the days of "free financial love" in the mortgage markets are over and everyone is scared of financially deadly MTD (Mortgage Transmitted Disease).

This is the problem as it stands today in a nutshell (albeit a big one). To continue the analogy - we have no HIV test to determine what/who is safe and who has the MTD. Pile on the recession fears - a factor that will likely make the MTD spread more widely and become more quickly known, the financial community is bracing for the "equity-eating virus" to become an epidemic.

So without a test to determine risk of the disease, the only people who know they don't have the disease are those who haven't participated in the "financial free love" and the problem for them is - housing prices are at their most inflated point, and banks aren't willing to lend, but at rates high enough to justify possibly getting the disease.

Won't lowering interest rates by the Fed help? The answer is mainly "no" because with a lack of a test for the disease - the banks aren't willing to pass all this lowered rate on to most people due to the risk and therefore the Fed will need to lower by huge amounts in order to get banks to lower by anything approaching a level to bring buyers into the market. Couple that with the exepectation of falling prices, new buyers aren't willing to pay anything near the levels currently in the market.

The long and short - the Fed can't lower by enough without igniting inflation, the prices of houses need to have a major correction because anyone can look back and see a $600K 2BR condo in Arlington,VA was only worth $375K in 2004 and the only reason it went up is because of artificial forces not connected to any long term trend - so why should it stay at $600K if never would have gotten there given normal (now current) lending environments.

Until the prices of homes come down faster than the risk premium in mortgages rises or the other remaining variable in the affordability equation - income growth accelerates faster than the risk premium, the housing market is going into a freeze. With signs of a recession looming I'm not betting on broad based income growth acceleration.

My answer to this problem has to be in getting a decent test to determine likelihood of contracting the virus. Obviously the old methods were either flawed or not administered, but in any event it has tainted the usefulness of the test - that is your FICO credit score.

I don't want you to get to the end here and not at least get a few suggestions from me about other factors which might lead to better testing in a tough environment, so here are a few, but hopefully if you've stuck in for this long explanation, you now have a better idea of what happened and why its going to be a long time before this housing hangover is over.

Possible New Test Factors:

Data mining can produce profiles outside debt,# of year at residence, # at job, salary - the main current factors. How about these questions to investigate in a revised model:

--Average time at job by profession vs current time at job - this would give a pretty good future look at likelihood of job change (and thus income change).

--Income growth curves by zip code by profession.

--Current income vs. maximum income by profession by zip code.

--Financial stability rating and growth of employer - good predictor of job security?

--Retirement Plan Savings Rate & History (probably the best rating of borrower responsibility)

I think you get the drift - these things look at information outside of the current model and are less susceptible to short term doctoring. Getting confidence in a better model will help free up the mortgage reselling again as the buyers will have some better assurance of the risk of disease. Applying a new model to back test existing mortgage portfolios might help create better assessment of the value of them and also help free up the liquidity in trading these things as well.

In any event, its not happening overnight, but we might as well get started by learning from our mistakes - that the beginning of the solution to any problem.