Since the lows of June, financials have rebounded more than 10 percent, even as trade and the flattening Treasury yield curve have dominated the Wall Street narrative. The bloom is off the rose in real estate, as prices for high-end residential and commercial assets have faltered. Lower prices mean higher loan-to-value ratios, rising loss given default, and eventually increased loan default rates.
While backward-looking measures such as the Case-Shiller 20 City Composite Home Price Index do not yet show the turn, granular measures such as the Weiss Residential Research index show the number of homes rising in price is decelerating rapidly. This trend seems mostly confined to high-end properties, but past experience shows that market turns in home prices typically start at the top, where there are relatively fewer buyers versus the available supply.
In beautiful Orange County, for example, home sales in luxury venues such as Newport and Laguna Beach have slowed to a trickle. As in New York and Connecticut, luxury-home prices in Southern California have experienced price compression, especially since this year’s first quarter.
Anecdotal reports from real-estate brokers suggest the asset-price bubble created by the Federal Open Market Committee (FOMC) is starting to deflate. The “aspirational pricing,” to paraphrase Jonathan Miller of Miller Samuel, is basically done. Prices for high-end homes are being marked down rather than up, as sellers are forced to capitulate to close the deal.
It is worth reviewing what led to this latest bubble in residential real-estate.
First and foremost, the FOMC has not only forced down short-term interest rates, but also explicitly manipulated the yield curve via “Operation Twist.” As pundits have noted recently, Operation Twist is still affecting the markets, suppressing long-term interest rates and flattening the Treasury yield curve.
The compression in credit spreads caused by the FOMC’s ill-advised market manipulation has reduced profits for lenders and curtailed residential lending volumes. Hundreds of banks and non-banks focused on mortgage lending, confronted by operating losses, are laying off employees and shutting down operations. The 4 percent GDP statistic last week was definitely not a reflection of business realities in the mortgage sector.
In the current regulatory environment, when non-bank lenders fail, the lender banks won’t buy the non-banks and take over the servicing portfolio, as in days gone by. The non-banks will instead file for bankruptcy and the secured-creditor banks will simply take the loans pledged as collateral on warehouse lines and walk away.
The other factor that has inflated house prices is increased subsidies from government-sponsored enterprises (GSEs): Fannie Mae, Freddie Mac, and Ginnie Mae. Ed Pinto at the American Enterprise Institute (AEI) lists actions by these GSEs that have exacerbated the home-price bubble and created risk for the U.S. taxpayer, including the following:
- Greater availability of income leverage, which allows borrowers to compensate for faster home-price appreciation. This trend has been fomented by the qualified mortgage exemption for government agencies, and Fannie Mae’s decision in August 2017 to raise its debt-to-income limit.
- A shift toward lower-down-payment loans. For Federal Housing Administration (FHA) loans, oftentimes such low-down-payment loans are combined with down-payment assistance.
- A greater presence of cash-out (CO) refinances. As homeowners’ equity has increased, the share of COs has increased in tandem. COs by nature are riskier than other loan products, and they are getting riskier rapidly.
“The multiyear surge in home prices, particularly for entry-level homebuyers, continues unabated and is fueled by high-risk mortgages guaranteed by taxpayers,” notes Pinto.
Other factors that have driven the sharp spike in home prices since 2012 include the increase in the number of people who can qualify for a mortgage under various government programs. Writing in The Scotsman Guide, 10 years after the Lehman Brothers failure, industry veteran Dick Lepre reminds us that government programs to encourage home ownership that began in the 1990s caused the 2008 mortgage bust. Similar efforts are again setting the stage for a crisis in housing finance. He writes:
“There are at least two things already happening that are allowing people to obtain loans who would not previously qualify.
“One was instituted by the Consumer Financial Protection Bureau last year, which persuaded credit bureaus to remove most civil debt liens and tax liens from credit reports. [This improved] credit scores for 12 million individuals, some by as much as 40 points.
“Another is the expansion of Fannie Mae’s HomeReady program … aimed at low- to moderate- income borrowers. … [Its] liberal interpretation of income …allows lenders to consider the income of non-borrowers living with a borrower—such as adult children, friends, or extended family.”
These programs to expand home ownership have added to the buying pressure on moderately priced homes, but that may not continue for much longer. When FHFA Director Mel Watt leaves the agency, the Trump administration intends to significantly cut back the loan-guarantee activities of the GSEs. Loan-size limits are likely to be reduced for Fannie Mae and Freddie Mac; financing for investment properties is likely to end; and the pricing of GSE loan guarantees may also change.
A final factor driving the next downward leg in U.S. home prices is the 2017 tax legislation, which has significantly increased the cost of home ownership in high-tax states such as California and New York. While the greatest pressure is felt on the luxury end of the market, the cost of living in the high-tax, blue states will over time drive broader emigration to other states.
With all the government programs put into place since the 2008 financial crisis to manipulate the credit markets and artificially boost home ownership, the fact of a bubble in home prices is no great surprise.
This year may be remembered as marking the peak in both bank equity valuations and residential home prices. Residential-loan default rates are unlikely to rise very quickly given the shortage of moderately priced homes, but bank net interest margins are likely to be as flat as the yield curve by year-end. The embedded credit risk in the financial system will continue to build with each passing day, largely due to the conflicting policy decisions emanating from Washington.
Christopher Whalen is the chairman of Whalen Global Advisors and the author of “Ford Men.” This article was first published by the Institutional Risk Analyst.