Rolfe Winkler

This article isn’t long on details. Treasury feels “enhanced regulatory powers” would be a “better tool than interest rates” to “contain asset price bubbles.”

Hmmm. The Fed isn’t currently charged with the task of containing asset bubbles to begin with. Its job is to maintain low inflation consistent with full employment. The prevailing view of the Fed’s role vis-a-vis asset bubbles during the Greenspan years was summed up by the man himself in 2004:

“It is far from obvious that bubbles, even if identified early, can be pre-empted at a lower cost than a substantial economic contraction and possible financial destabilization,” Greenspan told the American Economic Association in 2004.

The Fed has been rethinking this view of late.

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Tell you something you don’t already know, right? Though the conclusion has been stated often enough, it’s nice to see data to back up the story. For that, check out Hale Stewart’s latest article over at Huffington Post (via Patrick).

It includes the Case Shiller chart showing the run-up in house prices over the last few years. The chart is similar to the NAR chart I reproduced in a post last week, though it doesn’t juxtapose prices with median income.

Like I said last week, the path of house prices will definitely have plenty to do with interest rates. Homes remain overvalued relative to income, but with mortgage rates still near historic lows, folks that CAN get financing are still able to pay up for houses.

[Recall the math from last week: With a fixed rate 30-year mortgage of 18%, a $2000 monthly payment will buy $132,000 worth of home. Cut the interest rate to 6% and the same $2000 payment will buy $334,000 worth of home. Low interest rates support higher house prices.]

And since the threat facing the economy may be Japan-style deflation rather than U.S.-style stagflation, interest rates are likely to stay low for some time….

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With much thanks to Calculated Risk a compilation of early nominees for word/phrase of the year, 2008. This is NOT shameless plagiarism: I take NONE of the credit for these….I’m just not that witty. The best I’ve saved for last…

• Liquidity Cushion
• Hyperstagflation, or hyperstagdeflation
• “we’re all level 3 now”… with apologies to Tanta who coined “we’re all subprime now.”
• Ben Dover (as in Ben Bernake, I think)
• Bear-Stearned
• Systemic Risk
• Counterparty Risk
• Perfect Storm …. as in the problems facing the American economy
• walkaway
• wheelbarrow….as in the thing you use to carry bus fare after hyperinflation.
• Viagrate: “to artificially pump up.”
• lagflation
• subflation
• “underwater” and “upside down” as in the condition more homeowners find themselves in
• homeower
  
• Banana Republicans … for their subpar economic/fiscal mgmt.
• Hoocoodanode … as in the excuse you hear on earnings conference calls
• subprime food riots
• Mark to Myth
• jinglemail … what you send to you bank when you walkaway from your home.
• Mozilloed
• Bailout
• Paradise Foreclosed
• homedebtor
• short sale
• Alt triple A
• deleverage
• sustainabubble
• Debtrimental
• Housing Pustule … as opposed to housing bubble. Bubbles are cute. The implosion of the housing market isn’t.
• Depression-Lite
• Uncle Ben’s Rice … kind of like Jeopardy’s before/after category: popular foodstuff whose price is soaring after this central banker fans inflation fears with too many rate cuts….
• bank run
• “Japan 2.0″ or “Weimar Republic: American edition”
• meltdown
• residential copper mining
• Granite Countertop Quarries
• Decleverage … when they repo your boob job
• “Don’t Haircut me bro!“
• “I see debt people”

Late entrants (please, offer your own):

• agflation
• ZIRP or ZIRPification … as in “zero interest rate policy.” Closely related to “Japan 2.0″
• Dollar Carry Trade
• equity cushion

And my favorite:

The bad news on housing keeps coming:

WASHINGTON — U.S. new-home sales slid further in March to their lowest level since 1991 while the supply of homes for sale soared to nearly a three-decade high, suggesting little prospect of any near-term turnaround.

Sales of single-family homes slumped 8.5% last month to a seasonally adjusted annual rate of 526,000, the Commerce Department said Thursday. That’s the lowest level since October 1991. Economists had expected a much smaller drop of 1.9%, according to a Dow Jones Newswires survey.

February new-home sales fell 5.3% to an annual rate to 575,000. Originally, the government said February sales dropped by only 1.8% to 590,000. Year over year, new-home sales were down 36.6%.

Other recent data confirm the headwinds the housing sector faces. Earlier this week, the National Association of Realtors said sales of pre-owned homes fell 2% in March. Prospects for a recovery in the broader economy are closely tied to housing, given its effect on construction, employment and consumer spending. With housing still under pressure, Federal Reserve officials are likely to lower official interest rates again when they meet next week.

The median price of a new home decreased by 13.3% to $227,600 in March from the previous year, according to Thursday’s report. The average price tumbled by 11.3% to $292,200 from a year earlier.

Regionally last month, new-home sales decreased 12.5% in the Midwest and 19.4% in the Northeast. Sales fell 4.6% in the South and 12.9% in the West.

The month’s supply of homes for sale rose last month to 11 months, the highest since September 1981.

Inventories of various housing assets (single-family homes, condos, etc.) are the key to determining the path or prices. High inventories mean supply is outstripping demand, putting the onus on sellers to cut prices in order to bring buyers back to the market.

The Sunday Times Magazine will be publishing a fascinating article regarding the credit rating agencies and the role they have played in the housing bubble. (The introductory paragraphs of the article are below; the full article is available at the link above.)

In the course of describing the rating agencies’ failures, Roger Lowenstein also offers the clearest explanation of mortgage backed securities (MBS) and collateralized debt obligations (CDOs) that I’ve seen to date.

In 1996, Thomas Friedman, the New York Times columnist, remarked on “The NewsHour With Jim Lehrer” that there were two superpowers in the world — the United States and Moody’s bond-rating service — and it was sometimes unclear which was more powerful. Moody’s was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.

Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody’s, then the investor could forget about the underlying mortgages. He wouldn’t need to know what properties were in the pool, only that the pool was triple-A — it was just as safe, in theory, as other triple-A securities…..

I should note that I finally got around to reading his book on the failure of hedge fund Long Term Capital Management last August. It was about that time I was getting antsy about my Citigroup stock. Read that book, which awakened me to the dangers of leverage on Wall Street, and decided to punt Citigroup the next day. Got out at $47. That book, “When Genius Failed,” is a lightning fast read that I recommend VERY highly, especially in this market environment.

(He also wrote the definitive biography of Warren Buffett, another great read.)

Using a phrase like “too expensive” would seem to be subjective. But compare median house prices with median income (via Patrick). If people’s incomes aren’t climbing, how can they afford so much more house? (Click on the image to see a larger version of the chart….and the back button to return to the post)

This is a very common argument peddled by housing bears. Home prices have to fall to re-establish their historical relationship with median income. (I’ve made the argument myself on this blog). Then I went back and looked at interest rates:

Maybe I’m missing something here, but it strikes me as obvious that house prices relative to income were lowest in 1982…interest rates were 18%!

With a fixed rate 30-year mortgage of 18%, a $2000 monthly payment will buy $132,000 worth of home. Cut the interest rate to 6% and the same $2000 payment will buy $334,000 worth of home.

In this example, home prices may be higher, but the total cost of the home purchase–using only price and mortgage interest as inputs–is the same.

While I agree overall that house prices have to fall, I’ve become skeptical about conclusions drawn from the first chart above. The fundamental flaw–you probably know where I’m going with this–is that it is based on a home’s price, not the total cost of home ownership.

So an important consideration has to be, where are interest rates headed? If mortgage rates stay around 6%, then objectively-speaking, house prices should remain well above the “historical” relationship with median income since below “average” interest rates would support above “average” prices.

And yet I certainly wouldn’t argue that low interest rates will keep prices from falling farther nationally. In those markets with exploding inventories (the Inland Empires and McHenry Counties and Sarasota) prices are sure to keep falling until inventories have returned to normal.

The Fed’s aggressive interest rate policy is fanning inflation fears, causing some intrepid observers to argue for a return to the gold standard. I thought it very interesting last February when the WSJ published an op-ed by Judy Shelton that concluded as follows:

It’s time to confront currency disorder. Our goal should be to put forward a new proposal for international monetary relations on the scale of the 1944 Bretton Woods agreement, invoking the same sentiments that inspired architects John Maynard Keynes and Harry Dexter White to provide a foundation of hope for a world all too prone to violence. A global system based on a universally-accepted monetary asset — the U.S. has the world’s highest level of official gold reserves, followed by Germany and France — would not only counter Russia’s offensive. It would convert a national security threat into a golden opportunity.

When was the last time you actually read or heard serious people talk about returning to the gold standard? I say “serious” people not because I think the idea kooky, but because the only people who have heretofore raised the possibility are typically thought of as such. Say Ron Paul.

Who doesn’t think the guy sounds a little kooky when he talks about abolishing the Federal Reserve? And yet on that subject, he makes a pretty compelling argument, an argument that ends with a policy prescription to “allow competing currencies.” Huh? You mean we’d have multiple forms of payment legalized in our economy? The idea has merit and perhaps the biggest reason it isn’t catching on is the sheer complexity of what would be involved. There’s a lot of inertia behind the dollar.

But most observers I’ve seen calling for a new monetary regime have thrown their support, not behind a system of competing currencies, but behind gold….

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A few interesting items to pass along today.

The first is an interesting interview with an anonymous hedge fund manager (via JL). It’s a longish interview, but a good insider’s view on everything from the credit crunch to the downfall of Bear Stearns to the hedge fund business itself. A highlight:

Bear is not a commercial bank, it’s an investment bank: it doesn’t have these capital adequacy rules, it’s not regulated by the Fed, and Bear, if your average bank had a capital adequacy rate supporting 10:1 leverage, Bear is more like 30:1. And that is one of the reasons confidence evaporated so quickly: people looked at the balance sheet and realized that if assets have to be written down even a small amount, Bear can be insolvent. And that creates a panic.In reality I don’t think they had a solvency issue, but when the capital cushion is so small it creates instability.

The other investment banks are also levered in the 30:1 range, including Lehman/Merrill/Goldman. Bear was, in many ways, more vulnerable to a run on the bank, so to speak. But we’re not through the woods yet and bigger banks may fail.

That’s a good segue into two good articles on the cover of today’s WSJ. The first tells the story of Merrill’s misadventures in the CDO world. The second discusses LIBOR, the London Interbank Offered Rate, which is a benchmark rate banks charge each other for loans. The spread of LIBOR over U.S. Treasuries has been a remarkable barometer of market panic. That indicator, well, indicates that the worldwide financial system is still in trouble.

And as the WSJ article notes, there are those that think this rate (which is based on data self-reported by banks themselves) may be understated….

Didn’t think I’d see an op-ed like this in the Journal. The editors themselves hate Fed easing, and for good reason. Inflation hurts everyone in the economy except for those in debt; those who, financially-speaking, have behaved most irresponsibly. But this opinion piece says the Fed shouldn’t feel ashamed about printing money in order to get us through the housing crisis.

The author’s fundamental argument is that if the Fed just prints money, and lots of it, that the ensuing inflation will rescue the housing market and, thus, the economy. He says this would be preferable to nationalizing the housing market, which seems to be the only alternative in his mind.

Nationalizing the housing market may be a fait accompli…..but done correctly it probably doesn’t have to be a huge burden for taxpayers. Lenders who want to be bailed-out should be forced to take massive writedowns on the bad loans they want to pawn off on taxpayers. If the Treasury buys bad home loans at a really good price, taxpayers don’t have to lose that much in the long-run….

If the Fed “prints money”, the ensuing inflation would only serve the interests of those in debt by reducing the value of their debts in real terms.

Inflation happens when the supply of money increases relative to the supply of goods and services in the economy. More paper currency chasing the same amount of goods and services means each individual unit of currency has less purchasing power; it has less value. Savers lose because the dollars they’ve saved buy less after a period of inflation. Debtors win b/c the debts they owe are smaller in real terms after that same period of inflation.

Say I take out a $100,000 loan due next year. To make the math easy, let’s assume my lender isn’t going to charge interest….a rich uncle perhaps. If the value of the dollar declines 6% over the year, then $94,000 of today’s dollars will be sufficient to pay back the $100,000 loan next year.

Of course, most lenders do charge interest and if they EXPECT inflation will decrease the value of the dollars with which they’re paid back, they’ll simply charge HIGHER interest rates to offset the loss in value of those dollars.

Folks who have already taken out loans at fixed interest rates would benefit from higher inflation. New borrowers and those with adjustable rates would be forced to pay higher interest rates.

More inflation could also spark a run on dollar assets.

But perhaps the main reason this is foolish is that if the Fed lets inflation run wild now, it will just take more draconian monetary measures to get it back under control in the future. Take a look at the steps Paul Volcker was forced to resort to in order to tame inflation back in the early 80s. To beat inflation he had to increase the Fed Funds rate to 20%(!) by late 1980. It’s at 2.25% now. How many of my readers who bought a house in the early 80s recall what mortgage rates were back then? Would you believe they got as high as 18% for a 30 year fixed rate mortgage?

According to Wikipedia, raising rates that high to tame inflation “contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression.”

So far Bernanke has laid off the inflation lever. All of us who avoided overpaying for a house should pray that he continues to.

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From Bloomberg this morning:

April 11 — Confidence among U.S. consumers sank to a 26-year low in April as the labor market continued to deteriorate and gasoline prices rose.

The Reuters/University of Michigan preliminary index of consumer sentiment decreased to 63.2 from 69.5 in March. The reading was below the lowest forecast in a Bloomberg News survey and the weakest since March 1982.

Not a good day today, what with GE’s earnings miss. I wonder why the market was so surprised by GE’s numbers. After all, most of GE’s profits now come from various financing businesses. Finance of any kind is not a good business to be in right about now.

Interesting, by the way, that the previous low for consumer confidence was hit in 1982, toward the END of the last great inflation in the U.S. Could this be a good contrary indicator that the market is headed back up? Plenty of “experts” argue that the bad news is “priced in.” Just watch CNBC any morning.

Personally, I don’t think so. There are plenty more shoes to drop as the credit crunch/consumer pullback is only in its early stages here. Also house prices have farther to fall and corporate earnings estimates are still too high for the second half of this year.

Still too early to buy this market. Though I love reading the new low lists every day in the Journal. There are plenty of decent stocks that are washed out. Here’s hoping Moody’s gets back to $20…

Arthur Kimball-Stanley published a fascinating op-ed on Credit Default Swaps in the Providence Journal on Monday. I spoke with the author and he gave me permission to republish his piece in its entirety. A 30-page version of this argument was accepted for publication in a law journal to be published this fall. The author gave me a recent draft, though the article below offers the essential elements of the argument. Hopefully it gets traction……

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Have taxpayers already bailed out the housing market? An argument can be made that they have. From FT:

Fannie Mae and Freddie Mac and other government-sponsored mortgage companies have become the backbone of the troubled US mortgage market as purely private sources of finance have all but dried up.

Fannie, Freddie and the Federal Home Loan Banks , a network of bank co-operatives founded during the Great Depression, provided 90 per cent of the financing for new mortgages at the end of 2007, according to the Office of Federal Housing Enterprise Oversight, which regulates Fannie and Freddie.

The increasing role of the government-sponsored enterprises, or GSEs as they are known, reverses years of declining market share. Fannie and Freddie provide financing by buying mortgages and packaging them into securities. The FHLBs lend money to their member banks against mortgage collateral.

Availability of fresh mortgage funding is seen as crucial to provide support for US house prices, which have fallen sharply from their peak against a record pace of foreclosures and the resulting credit squeeze among private-label lenders.

Fannie and Freddie accounted for a record 75 per cent of new mortgage financing at 2007’s end – twice the share they held at 2006’s end when the private-label mortgage securitisation industry was booming.

Stressed mortgage lenders increasingly accessed funding from the FHLBs in the second half of 2007, pushing government-chartered mortgage finance to about 90 per cent of the market by the year’s end, Ofheo said.

The FHLBs have pumped hundreds of billions of dollars into the mortgage industry in the form of advances against mortgage collateral. They made $875bn of such loans to depository institutions in 2007, up 36 per cent on the previous year.

With record FHLB purchases of mortgages guaranteed by Fannie and Freddie, this helped offset some decline in mortgage purchases by buyers such as structured investment vehicles. Their role will increase as Fannie, Freddie and the FHLBs are under pressure to provide greater support and liquidity to the stricken US housing market, by buying more or larger US home loans.

The FHLBs were last week authorised to boost temporarily their holdings of Fannie and Freddie mortgage-backed securities by more than $100bn.

Bottom line is that the U.S. taxpayer now guarantees the vast majority of new mortgages.

Take a look at Countrywide’s latest balance sheet to get a sense for just how crucial the FHLB can be for private lenders. Note 15 on page F-58 offers details on CFC’s “notes payable,” a growing source of debt capital CFC is using to fund its own lending.

In the latest CFA Institute Conference Proceedings, Paul McCulley’s article (“The Liquidity Conundrum”) has a superlatively readable discussion of economist Hyman Minsky’s work on financial instability. Minsky’s theory goes a long way toward explaining the housing bubble, in particular the creative mortgage products that blew it up.

Minsky’s core thesis is known as the “financial
instability hypothesis.” Translated very simply, the
hypothesis states that stability is inherently destabi-
lizing because stability leads to the extrapolation of
stability into infinity, which encourages more risk-
seeking financial structures, particularly with debt.
Therefore, the more stability a market has and the
longer it lasts, the more unstable the foundation of
the stability becomes. Stability is destabilizing
because it begets more unstable debt structures….. (more…)

Rs and Ds in the Senate have agreed on the basic framework for a new housing bill, according to the NYT. The basic framework appears to include the follwing:

• $100 million to expand counseling for homeowners at risk of defaulting on their loans
• tax-exempt bonds to let local housing agencies refinance subprime mortgages
• $4 billion in grants for local governments to buy foreclosed properties
• several tax provisions, including a credit of $7000 for purchasers of foreclosed properties that have been sitting vacant, and a break for struggling home-builders, allowing them to claim current losses against taxes paid in earlier, more profitable years
• a cap on mortgages insured by the Federal Housing Administration at $550,000 in the most expensive real estate markets. The cap had been $363k before Congress “temporarily” raised it to $730k as part of the Stimulus package passed in February.

So far, so good. No behemoth bailouts above. But there are two more contentious provisions being pitched by Democrats that are likely to be introduced as amendments:

• Connecticut Senator Chris Dodd wants the federal government to insure $400 billion in new loans for homeowners. Scary.
• Illinois Senator Dick Durbin wants to give bankruptcy judges the power to alter the terms of certain mortgages. Also very scary. This would raise the cost of mortgages for everyone else as lenders boost interest rates to compensate for future risk that loans could be written down by judicial fiat…..