Posts filed under “Think Tank”
The 2 year note auction was very strong as the yield was about 3 bps below where the when issued was traded and the bid to cover at 3.63 is the highest since Aug ’07 and well above the one year average of 2.65. Indirect bidders totaled 44.5%, about in line with the previous few. With the October economic data out so far on the light side and persistent commentary from Fed members that rates will stay lower for longer, buying the two year note is a direct bet that monetary policy will not be reversed anytime soon and today’s auction is quite a vote on that belief.
Recent Developments in Mortgage Finance
By John Krainer
As the U.S. housing market has moved from boom in the middle of the decade to bust over the past two years, the sources of mortgage funding have changed dramatically. The government-sponsored enterprises—Fannie Mae, Freddie Mac, and Ginnie Mae—now own or guarantee an overwhelming share of originations. At the same time, non-agency mortgage securitization and loans retained in lender portfolios have largely dried up.
The period following the 2001 recession through 2006 is rightly called a housing boom. House prices and net borrowing by households surged in the early part of the decade, easily outpacing growth in household income. But, with the onset of the financial crisis and the failure of many mortgage market participants, access to mortgage finance declined dramatically. This Economic Letter summarizes some of the key ways that the mortgage market evolved during the boom years and during the ensuing housing market bust. It focuses on changes in the way loans were made and funded and how loan characteristics themselves changed.
Sources of mortgage finance
One of the distinguishing features of the U.S. housing finance system is the role played by the capital markets in funding residential mortgages (see Green and Wachter 2007). The direct link between housing finance and the capital markets is through securitization of home loans in various types of mortgage-backed securities (MBS). The pooling of mortgages into MBS permits the separation of loan origination and funding, as well as the transfer of risk. Also, depending on the type of MBS, securitization can facilitate the separation of credit risk—the possibility that borrowers default on their mortgages—and market risk, defined as changes in the value of a portfolio of mortgages as interest rates move and borrowers prepay. Securitization transforms relatively illiquid loans into highly liquid securities. In addition, pooling mortgages from different geographic regions serves as a way for investors to diversify away from shocks to local housing markets.
With the development of MBS and other types of structured financial products, banking institutions, including commercial banks, savings institutions, and credit unions, have slowly but steadily ceded market share to capital market investors in holding residential mortgage assets in portfolio. According to Federal Reserve flow of funds data, the banking institution share of total mortgage assets declined from a peak of about 75% in the mid-1970s to about 35% in 2008. Much of the decline in banking institution housing portfolios over this period was related to the expansion of the government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac, and Ginnie Mae. The GSEs purchase mortgages for securitization and guarantee MBS against credit risk.
Fannie Mae and Freddie Mac require that mortgages conform to certain standards to qualify for securitization. For example, mortgages must meet set size limits and underwriting guidelines. Ginnie Mae guarantees the repayment of principal and interest on MBS backed by federally insured loans, such as Federal Housing Administration (FHA) or Department of Veterans Affairs loans. Unlike Fannie Mae or Freddie Mac, Ginnie Mae is explicitly backed by the U.S. government.
Starting in the late 1990s, the GSEs’ near-exclusive hold on residential MBS issuance was challenged by so-called non-agency, or private-label, securities issued by brokerage firms, banks, and even homebuilders. Non-agency securitizations are conceptually very similar to agency securitizations. Lenders sell loans to an arranger, which then packages the loans, creates securities with claims to the cash flows of the loans, and sells the securities to investors (see Bruskin, Sanders, and Sykes 2000). However, in contrast to agency MBS, purchasers of non-agency securities are exposed to credit risk as well as market risk. Also, non-agency securitizations are more complex, involving many specialized parties. In recent years, securities were typically separated into tranches and structured to create different payoffs—more complicated arrangements than typical of agency securitizations. At its peak in late 2007, non-agency securitizations accounted for nearly 20% of outstanding mortgage credit.
An avalanche of research and commentary has examined why non-agency securitization grew so fast during the housing boom. One argument suggests that policymakers were worried that the GSEs were becoming too big and systemically important. These fears led to the imposition of caps on GSE portfolios, giving a boost to alternative sources of mortgage funding as the demand for housing finance boomed. Another story points to the decline in economic and financial market volatility that took place in the 1990s, especially in the first part of the decade. This phenomenon may have led to an increase in lending to previously marginal borrowers—a development that was probably not unique to mortgages but occurred in other asset markets as well.
The Oct Consumer Confidence # was a weaker than expected 47.7, almost 6 pts below forecasts and down from 53.4 in Sept. While the headline figure is still well above the bottom of 25.3 back in Feb, the Present Situation fell to the lowest level since Feb 1983. Expectations fell 8 pts to 65.7 but…Read More
David Rosenberg is a 20 year veteran of the Street, David most recently was Merrill Lynch’s chief North American Economist, where he correctly warned about the Housing and Credit Collapse and Recession in advance. He is the Chief Economist of Canada’s Gluskin Sheff
What made things so interesting is that in 2007, when I was at Merrill and calling for a recession, it was such an outlier view even though it seemed so obvious to me at the time. To think that it only became a widespread consensus view in the fall of 2008 when the downturn was already in full force for a good eight months. Back then, the bears still felt they had to be vindicated, and of course, the only barometer that seems to matter to anyone was the stock market, which gave absolutely no ‘heads up’ at all for what was to come down the pike. But now, it is universally viewed that the recession is over, that a recovery has begun, and a growing number of commentators are calling for 4%+ real GDP growth for 2010. We have never been a fan of group-think, but that is what we have on our hands today.
The question really is how robust is the economy and what is the root of optimism. It comes down to the massive doses of medication that have been applied by Uncle Sam. Unless we want to sustain state capitalism, which is what we had by the way, throughout the 1930s and 1940s, then this unprecedented public sector incursion into the capital market and the economy is going to have to end at some point.
But when you have a system that continuously extends unemployment insurance, provides subsidies for cars and homes (and the latter is still being considered as an extension at a cost of over $1 billion a month for the taxpaying public) not to mention the credit-boosting initiatives by the Fed and the FHA. The Obama team is now considering a capital infusion into small businesses as a means to bolster employment in this critical part of the economy. Friday’s WSJ also suggests that the Democrats are mulling over tax credits for “additional big ticket items.” Yes, that is true. Despite all the fraud involved in the homebuyer tax credit plan, its extension and indeed expansion is not being discussed in Congress. (100,000 improper claims for the tax credit? Who cares? It’s for a good cause.)
All of this (you have to see the Tim Geithner interview in BusinessWeek) is not being dubbed another fiscal plan — it is only an “extension” of the first. At the same time, we have a system where all the big banks have been safeguarded by the government and the liabilities of the entire system guaranteed by the taxpayer. Deficits continue to be racked up — $1.4 trillion in the past year and over $1 trillion as far as the eye can see and we are still being told that this all the fault of the prior Administration. The question that has to be asked is, while the coupon payments will be made, do the entities who are buying U.S. Treasuries today really ever expect to get their capital back? Without either deep spending cuts or tax increases (a dirty three-letter word in the U.S.A. — remember Bush Sr.’s “read my lips” back in the early 90s that cost him the election?) the only way out of this fiscal mess caused perhaps by the prior Administration and now accentuated by the current Administration will be by monetizing the debt.
Category: Think Tank
The Aug 20 city S&P/Case-Shiller home price index fell 11.32% y/o/y, a touch less than the expected drop of 11.9%. It’s the smallest y/o/y decline since Jan ’08. On a m/o/m basis it was up 1.18% where 17 of the 20 cities saw prices gains with Las Vegas, Charlotte and Cleveland down. Every city is…Read More
Add the Reserve Bank of India to the list of central banks that are moving to take away their extraordinary accommodation. They did not raise interest rates but increased the bank liquidity ratio, which is basically a reserve requirement, thus forcing banks to have a higher % of their capital in gov’t bonds which thus…Read More
The demand for inflation protection was evident in the Treasury 5 year TIPS auction as while the yield was about in line with expectations, the bid to cover of 3.10 is the highest since they were reintroduced in 2004 and is well above the average seen since ’04 of 2.12. The implied inflation rate in…Read More
Central banks around the world have released massive amounts of money in response to the current financial crisis. How to exit from the current super-loose monetary environment has become a popular discussion. The central bankers are talking down the prospect of raising interest rates, arguing that the weak economy keeps inflation in check. But the proposition that a weak economy means low inflation is false. The stagflation of the 1970s proves it.
This round of monetary growth has mainly fed speculation, not credit demand for consumption or investment. Speculation has reached a dangerous point with the oil price threatening to reach triple digits again. Its implications for inflation may spook the central banks to raise interest rates quickly and trigger another crash.The excess money supply has created a new liquidity bubble.
The resulting asset inflation (stocks and bonds in developed markets and everything in emerging markets) has stabilised the global economy. The current equilibrium is one on a pinhead. The hope for strong economic recovery led by emerging economies raises investor optimism – and asset prices. This eases pressure on corporate balance sheets, spurs property production and boosts consumption through the wealth effect, making the hope self-fulfilling in the short term.
A rising oil price threatens to derail this recovery. It can trigger a surge in inflation expectation and a major crash of bond markets. The resulting high bond yields may force the central banks to raise interest rates to cool inflation fears. Another major downturn in asset prices would reignite fears about the balance sheets of global financial institutions, leading to new chaos.
The last two times the oil price surged above US$100, it wreaked havoc on the financial markets and global economy. The runaway oil prices of 2006 were the final straw that tipped the US property market. The oil price fell sharply amid the subprime crisis as the market feared a demand collapse. Then, the Fed came to the rescue and began cutting interest rates aggressively in the summer of 2007 in the name of combating the recessionary impact of the subprime crisis.
The oil price rose sharply afterwards on the optimism that the Fed would rescue the economy, and with it, oil demand. It worked to offset the Fed’s stimulus, accelerated the economic decline, and pulled the rug out from under the derivatives bubble. The ensuing demand fear again caused the oil price to collapse.
Category: Think Tank
David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from…Read More
The Best of Times
October 23, 2009
By John Mauldin
It’s The Best of Times
The Elements of Deflation
It’s More Than Half Full
Argentina, Brazil, and Uruguay
What’s a Fed to do? We get talk about tightening and taking away the easy credit, but we got the fourth largest monetization on record last week. This week we examine the elements of deflation, look at some banking statistics that are not optimistic, and then I write a reply to my great friend Bill Bonner about why it’s the best of times to be young. I think you will get a few thought-provoking ideas here and there.
But before we get to the main letter, I want to recommend a book to you. I am on a 17-day, 12-city speaking tour. It is rather brutal, but I did it to myself. However, one of the upsides of traveling is that I get quiet time on airplanes to read books. I am working my way through a very large stack of books on my desk. One that caught my eye – and I’m glad it did – is a book by Tom Hayes called Jump Point: How Network Culture is Revolutionizing Business. Hayes writes about how we are getting ready to experience a cultural change every bit as profound as the Industrial Revolution. He argues that as the 3 billionth person gets online sometime in 2011, it will shift the dynamic of how we interact as businesses and consumers. We get to 5 billion by 2015. The mind boggles.
Clearly, it is already changing things, and I am not sure if I buy Hayes’ thesis that 3 billion is a magical number, though it is great marketing. That being said, I found something on almost every page that I underlined or highlighted. This book made me think about the future in ways that my kids already get but Dad doesn’t.
I like to read books about “important stuff” by people who have done a lot of thinking about their subjects, and who can write easily and fluidly and communicate their thoughts without weighing me down with unnecessary verbiage. Hayes has done that. (I am sure some of you, my patient readers, wish I could be better at that!)
No long review here. Go to Amazon and read the reviews. One writer wrote: “I gave the book 5 stars not because it was perfect — I think Hayes’s enthusiasm sometimes makes him jump to conclusions – but because there are so many ideas and observations here that it would take ages to put something like this together from other sources.”
I agree. If you are in business, any business, you need to read this. As an aside, I will insist that all my partners worldwide get this book and read it. You can go to Amazon.com and buy the book. And Tom, if you get this (and I bet one of your friends will forward it to you), call me.
The Elements of Deflation
One of the advantages of travel is that it gives you time away from the tyranny of the computer to think. (Am I the only one who feels like I am drinking information through a fire hose?) But getting the information is important too, as it gives you something to think about. And I have been thinking a lot lately about deflation.
I get asked at almost every venue where I stop, whether I think we will see inflation, or deflation. And I answer, “Yes.” And I am not trying to be funny. I think the primary forces in the developed world now are deflationary. When asked if I don’t think that the Fed monetizing debt of all kinds won’t eventually be inflationary, I answer, “We better hope so!”
Let’s quickly summarize some of the ideas from the last few months of this letter. Just as water is made up of two parts hydrogen to one part oxygen, so deflation has its own elemental structure.
The first element is Rising Unemployment. There has never been a sustained inflationary period without wage inflation. Wages are basically flat and falling. With 9.8% unemployment, 7% underemployed (temporary), and another 3-4% off the radar screen because they are so discouraged they are not even looking for jobs, and thus are not counted as unemployed (who made up these rules?), it is hard to see how wage inflation is in our near future.
Think about this. Only a few years ago, less than 1 in 16 Americans was unemployed or underemployed. Today it is 1 in 5. That is a staggering, overwhelming statistic. Mind-numbing.
Keynes said that you should stimulate the economy in recessions in order to bring back consumer spending. That is not going to happen this time. As my friends at GaveKal point out, this time we will have to have an Austrian (economic) recovery, or a business-spending recovery. My argument will be, when I am with them in Dallas in December at their conference, “Where are we going to get business-investment spending when banks aren’t lending and capacity utilization is at an all-time low?” This, of course, leads the Keynesians to jump in and say, “The government has to step up and jump-start consumption!” Which means more debt. Wash. Rinse. Repeat.
The next element of deflation is massive Wealth Destruction. Two bear markets and a housing market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas.
Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing each month. (See graph below.)
Next up in our elemental list we have Decreased Final Demand and its counterpart Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next 3-5 years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write.
Category: Think Tank