Wednesday, April 9, 2008

Week of March 31, 2008--Income Trends Must Improve

Now we know just why Santa Barbara's Montecito and Hope Ranch home values have continued to rise while the rest of California's South Coast housing values have fallen slightly.

Two well-known economists who specialize in national incomes, Thomas Piketty and Emanuel Saez, found that the concentration of incomes at the top rose again in 2006. Average incomes of the top 1 percent (with a $450,000 average annual income) increased by $73,000 from 2005-06, while incomes of those in the bottom 90 percent of households rose just $20. That’s right, just $20.

This is why the median-price of Montecito homes rose to $2.5 million and Hope Ranch’s median soared to $3.5 million in 2007 when the median single-family price for the rest of the South Coast was $950,000, according to the Santa Barbara Assoc. of Realtors.

And to qualify for a $1million mortgage requires at least a $265,000 annual income, at today’s rates. This is the approximate income of the top 10 percent of households, which are therefore those who can afford those homes in Santa Barbara and the South Coast.

The current credit crunch will surely redistribute some of those income gains. But the trend that favors upper income households actually began in 1976. From 1946 to 1976 average incomes of the bottom 90 percent rose faster than the top 1 percent—90 percent versus 25 percent for the top 1 percent. But from 1976-2006 incomes of the top 1 percent surged 239 percent while that of the bottom 90 percent rose just 64 percent through 2006.

Those with mid-range incomes can still afford conforming and jumbo adjustable rate mortgages in most areas in California. And the mortgage market is coming back to life with the introduction of ‘jumbo-conforming’ Fannie Mae/Freddie Mac loans in April. The jumbo-conforming 30-year fixed rate with a loan amount to $729,750 is just one-quarter percent above conforming loans with a maximum limit of $417,000 for a single unit.

The Federal Reserve’s moves to stabilize the mortgage-backed securities market have caused a drop in interest rates. Mortgage refinances surged 82 percent and purchase applications rose 10 percent in the week ending March 21, according to the Mortgage Bankers Association (MBA).

The week’s activity was highlighted by the 80,000 drop in payrolls and rise of the unemployment rate to 5.1 percent from 4.8 percent in February. January and February’s payrolls were also revised downward for a total 232,000 jobs lost this year. Only healthcare, food services and mining added jobs. Construction and manufacturing lost the most jobs. This will certainly cause the Federal Reserve to lower their short-term rates another notch at the April 30 FOMC meeting.

Good news, though, was that the Institute for Supply Management’s March service sector index actually rose slightly, with production, new orders, and export orders all higher.

The surge in mortgage applications could also benefit the economy in months to come. And mortgage applicants are opting for more fixed rates, as adjustable rate mortgage applications actually fell to 3.8 percent of all applications, down from 7.9 percent in the prior week.

Copyright © 2008

WEEK OF MARCH 24, 2008—Scare Tactics

Much economic doom and gloom is in the news lately, but how much of it is real and not an attempt to make headlines? We can be sure the economy has slowed, but growth has not yet contracted for 1 quarter—when it has to contract at least 2 quarters (6 months) to be called a recession. And even then we won’t know until months after the fact.

There is no question that consumer spending has slowed and consumers are more anxious. But the Univ. of Michigan’s latest consumer sentiment survey showed current conditions improved, while its expectations index of future business conditions fell. Consumers’ main anxiety seems to be inflation, which consumers expect to rise from 3.7 to 4.5 percent over the next year.

The retail Consumer Price Index was unchanged after seasonal adjustments in February, but is up more 4 percent this year. Yet consumers are spending less, so the Fed is not as worried about inflation down the road.

Many ask me if the Fed’s actions will be enough to bring economic activity and real estate back this year. My answer is that Bernanke is the best qualified Fed Chairman we have had in many a year, Dr. Greenspan included. This is because Bernanke has extensively studied the Japanese deflation of the 1990s that took Japan more than 10 years to cure.

Japan’s problem was that it did not reinflate the economy fast enough after its twin stock market and real estate bubbles burst in 1990-91, causing the massive devaluation of stocks and real estate. That, and keeping too many bad loans on their books crowded out lending on good investments. Bernanke, on the other hand, has opened the Fed’s monetary printing presses wide to prevent asset prices from falling further, and insisted that bad loans be written off sooner rather than later.

In fact, Q1 may already be the bottom. Existing home sales actually rose 3 percent in February, in part because the national median single-family home price fell another 8 percent. And February new residential construction rose 4 percent in the south and 5.1 percent in western states. This is because of a 14.5 percent surge in apartment construction, which is now up 23 percent in one year.

And so some parts of the economy are still chugging along. Automobile sales are predicted to be in the 15.5 million unit range, hardly recessionary when 17 million units was tops.

An actual decline in consumer spending has not yet happened, in other words, and it is unlikely to do so with so much fiscal stimulus in the pipeline. This is in addition to the tax rebate checks coming out in May. We also have the Fed opening its loan window for banks and brokerages who haven’t been able to sell the mortgages and mortgage backed securities (MBS) on their books. They can now trade them for Treasury Bonds to use as collateral in order to originate new loans.

Then we have further rate decreases that have brought ARM indexes below 4 percent, and so most ARM rates somewhere below 7 percent, depending on their margins. A Prime Rate that have dropped to 5.25 percent will also help those with car loans and home equity lines.

So I believe that though we may bump along the bottom in Q1, the rest of the year may already see us in a recovery mode.

Copyright © 2008

WEEK OF MARCH 17, 2008—Curing the Credit Crunch

The Federal Reserve’s bailout of Bear Stearns is a rescue of one of the largest issuers of mortgage-backed securities, the securities backed by many of those subprime mortgages now in default. And it is rising defaults that have made banks reluctant to lend more. The Fed therefore stepped into the breach. It issued $200 billion in credit lines to banks and brokers with the very same mortgage-backed securities as collateral, which means that the Fed will replace banks as the lender of first resort until financial markets settle down.

The Fed’s action caused financial markets to rally, because it could break the logjam that is causing the credit crunch. But the real problem is too much leverage in the system. To illustrate, let us say that Bank A makes a loan of $100,000. In order not to tie up its capital, it sells the loan to a Wall Street firm, such as Bear Stearns, so that it can make more loans. So far so good.

But Bear Stearns, instead of using its own capital to buy that mortgage, in fact only put up $1,000 of its own money and borrowed the rest--$99,000! It used borrowed money to buy borrowed money, in other words. This is the essence of the problem. So if the original $100,000 mortgage defaults, then Bear Stearns loses more than $100,000. It could lose up to $200,000, since it still owes the $99,000 it borrowed. This is a gross oversimplification, but you get the idea.

So until much of the debt that was run up since 2001 is either paid back or written off, the financial markets—and housing—won’t return to normal.

Meanwhile, running to the rescue are Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Association). Purchasers of conforming loans, they now seem to have the only affordable loan programs at present, while rates on many of the jumbo loan programs are sky high.

Why? Because Fannie and Freddie have not lowered their underwriting standards and so still retain a AAA rating with investors, the same rating given to government-guaranteed Treasury bonds.

It does seem that housing is settling down in some parts of the country. February construction (housing starts) was up in California and the South, while builders’ sentiment tracked by the National Association of Home Builders has remained stable for 4 months. All eyes are on housing starts and new-home sales in the coming months, since they are an early indication of economic recovery.

"Our latest surveys of single-family builders reveal that many prospective buyers are looking into a home purchase at this time, but that they are unwilling or unable to make their move with conditions in the overall economy and financing arena what they are," said NAHB Chief Economist David Seiders.

Regionally, housing starts were unchanged for the month in the Midwest, up nearly 4 percent in the South and up 5.1 percent in the West, while the Northeast posted a 27.7 percent decline that offset a large boost in the previous month. However, every region was down on a quarterly basis in February.

"The Federal Reserve's latest moves to shore up financial markets have certainly been welcome developments, and a significant interest rate cut following today's FOMC meeting will be more positive news," Seiders said. "Beyond this, Congress and the Administration should follow up on the recently enacted economic stimulus package with additional measures aimed directly at boosting the housing market. If prompt action is taken in the direction of a home buyer tax credit, FHA modernization and GSE oversight reform, a housing recovery could take shape by this year's second half and the benefits of that to the overall economy would be substantial."

History will tell if the Fed’s actions will be enough to ease the credit crunch. Estimates of the costs vary for curing the credit crunch—from $200 to $400 billion. This will be about the same cost to taxpayers as the S&L bailout of the 1990s, when inflation is taken into account. So history will be repeating itself.

Copyright © 2008


We are learning more about the new mortgage guidelines issued by U.S. Dept. of Housing and Urban Development (HUD), the agency that regulates housing and mortgage lending. The new guidelines will bring mortgage relief to hundreds of thousands of homeowners and buyers who cannot now find a reasonably priced loan during the ongoing credit crunch.

The Federal Housing Administration (FHA) will be allowed to purchase mortgages from banks and other lenders on properties up to 4 residential units with higher loan amounts in so-called high-price regions of the country, including 14 counties in California, for the rest of 2008.

HUD is also allowing “Jumbo-Conforming” mortgages with amounts to $729,750 for single residences to be purchased by Freddie Mac and Fannie Mae, two other Government Sponsored Enterprises (GSEs) that buy so-called conventional mortgages. ‘Freddie and Fannie’s’ mandate is to buy mortgages that meet stricter qualification criteria from banks and other lenders, and so have slightly lower interest rates than ‘jumbo’ mortgages.

The relief is needed because the credit squeeze was caused by rising loan defaults on jumbo loans that had very easy qualification criteria, such as not requiring any verification of income. This boosted jumbo mortgage rates more than 1 percent above conforming loan rates, restricting home sales in California’s high-priced regions that include Santa Barbara, Ventura and Los Angeles counties.

The new “jumbo-conforming” loans are designed to ease the jumbo credit crunch by allowing the AAA credit-rated Freddie Mac and Fannie Mae into the jumbo mortgage market. Maximum loan-to-value on the new jumbo-conforming loan products will be 90% for fixed rates and 80 percent for ARMs. One to four units are allowed on FHA loans, with Fannie/Freddie allowing only single residential units. Fannie/Freddie jumbo-conforming loans will also add 0.25 percent to the rate of normal conforming loans (those with the current $417,000 maximum loan) that Fannie/Freddie will also continue to buy.

We still offer ‘super jumbo’ stated income loans to $3 million, even with negatively-amortized teaser rates, to 80 percent loan-to-value (ltv). Credit standards are being tightened along with reduced loan-to-values for super-jumbo fixed rates with some programs only allowing a 75 percent maximum ltv.

A federal government working task force led my Treasury Secretary Paulson is also recommending that all states should implement strong nationwide licensing standards for mortgage brokers—already the case in California. Other recommendations designed to boost confidence in the mortgage industry are:

Federal and state regulators should strengthen and make consistent government
oversight of entities that originate and fund mortgages and otherwise interface
with customers in the mortgage origination process.

• The Federal Reserve should issue stronger consumer protection rules and mandate enhanced consumer protection disclosures, including disclosures that would make affordability over the life of the mortgage more transparent and that wouldfacilitate comparison of the terms with those of alternative products.

What borrowers must do before taking on an adjustable rate mortgage (ARM) is to seriously consider the risks of rising interest rates and be honest about what they can afford today and down the road.

"Everyone wants to treat all ARMS as a toxic product, but they're not," said Keith Gumbinger, vice president of HSH "ARMs have almost a 30-year history and there are times they can be very valuable ... in the proper application of the product."

By definition, ARMs have interest rates that change at set intervals, depending on the type of mortgage. The five-year ARM, often referred to as a 5-1, is among the most popular ARMs. Payments are fixed for the first five years of the mortgage, at a rate below the prevailing 30-year loan. At the start of the sixth year the interest rate is reset based on an index that varies from lender to lender; generally any movement is capped at 2 percentage points per adjustment and there are usually lifetime caps as well.

These types of mortgages are at the heart of much of the housing turmoil that is now rocking the U.S. economy. Many consumers who took out adjustable-rate mortgages at the turn of the century when interest rates were at historic lows saw their monthly payments surge, sometimes doubling, when their mortgages reset.

Thanks to the Federal Reserve's successive interest-rate decreases since September, Treasury-indexed adjustable-rate loans of 4.85% made in March 2003 are resetting at 4.41% for the next year. ARM borrowers are getting a valuable reprieve, which gives us reason to believe the credit crunch may be over sooner rather than later.

Copyright © 2008


The second ‘estimate’ of fourth quarter Gross Domestic Product growth, the sum of all goods and services produced domestically, was unchanged at just 0.6 percent. This caused interest rates to plunge one-quarter percent in a day, as fears of a further economic slowdown rose. But the report also showed us how growth is continuing, as the weakness lies in imports and consumer spending—areas that can turn around quickly—while exports that support our manufacturing sector continue to expand.

The slowdown, affecting about 80 percent of U.S, households, seems to be caused in large part by rising inflation. Exports, which make up about one-third of our economy including high technology, have been largely shielded from inflation since the falling dollar has made U.S, goods cheaper overseas.

Consumer spending is still rising at more than 2 percent, which would normally mean 2 percent + economic growth. But an inflation rate of more than 4 percent—mainly in food, energy and health care costs—is soaking up all the excess monies, bringing down the real, after inflation growth rate.

In addition, the Federal Reserve raised their interest rates seventeen consecutive times from 2004-2006, until the real estate bubble burst and damaged the credit markets. Consumers are out of sorts because real, after inflation household incomes have fallen 5.6 percent since 2000 while their borrowing costs rose along with the interest rates. And homeowners can’t continue to borrow against their homes since the Fed’s credit tightening moves.

So Bernanke, et. al., are now trying to undo the damage by dropping interest rates back to 2004 levels. This has already happened with fixed mortgage rates, which briefly dipped to 5 percent for 30-year conforming fixed. But the Fed’s so-called funds rate, now at 3 percent, would have to near its 1 percent low in 2003 to really grease the wheels of a recovery.

Will all the talk make the ‘R’ word a self-fulfilling prophecy? Probably not, as inventories have declined as well, which took a huge 1.5 percent bite from growth. Had producers replenished their inventories at the normal rate, real GDP growth would have been above 2 percent. Exports rose 4.8 percent in Q4, contributing 0.9 percent to growth. “To the extent that the fourth-quarter mix includes stronger sales and weaker inventories than previously assumed, the figures were modestly good news for the economy,” said one well-known economist.

The jury is out on when the inflation-caused slowdown will end because it requires some hard polital choices to cure the inflation surge. This is because its major cause is the rising demand for energy at the same time that we have twin trade and budget deficits that have driven the dollar’s value to new lows. This in turn has driven oil prices to new highs because oil producers are paid in dollars that have declined about 30 percent in value on the world markets.

What will bring the dollar’s value back? Some very disciplined actions by a much more fiscally conservative government that substantially reduces the budget deficit. Need we say more?
Copyright © 2008


The so-called Treasury yield curve (see above chart), a chart which tracks the percentage yields of treasury bills and bonds from 3 months to 30 years, has righted itself. This is important because it shows an economy pointing to a longer-term recovery, in spite of the current credit crunch.

Banks do most of their borrowing from the U.S. Treasury, their depositors, and/or bond markets on the short end of the yield curve; say 3 months. Today that rate is slightly above 2 percent. But it lends money at longer term rates; say a 30-year mortgage that is now between 6-6.5 percent.

The difference in yields between what banks borrow and what they lend is their profit. Over most of the past 2 years—before the Fed began to lower its short-term rates (2.25 percent to date)—short-term rates were higher than long-term rates. For instance, the 3-month rate was about 5.25 percent, while the 10-year bond fluctuated between 4 to 5 percent.

That meant banks’ costs were higher and profits lower, so they went looking for riskier investments, such as more subprime mortgages. The search for higher returns was in fact a direct result of the Federal Reserve credit tightening, after holding down interest rates too long in its attempt to fight the phantom of a Japanese-type deflation that enfeebled Japan’s economy for more than 10 years.

The 4.25 percent increase in the Fed’s short-term rates over 17 consecutive FOMC meetings under Alan Greenspan from 2004 to 2006 helped to provoke the current credit crisis, in other words. Not only did the Fed’s actions reduce bank profits, but jacked up adjustable rate mortgage indexes too high, resulting in a 50 percent increase in foreclosures (from 1 percent to 1.5 percent of outstanding mortgages).

It is because the Fed’s tightening proved to be too much for both banks and consumers, that the Fed has been trying to undo the damage it wrought. Righting the yield curve by continuing to lower short-term interest will do just that—increase banks’ profits and capital base over time. The question is how much time it will take for the banks to recover, and so ultimately unfreeze the credit markets.

There are already signs that housing may recover this year. Both the National Association of Builders sentiment index and housing starts have begun to slowly revive.

NAHB INDEX--Builder confidence in the market for new single-family homes edged marginally higher in February as traffic of prospective buyers through model homes improved considerably, according to the latest NAHB/Wells Fargo Housing Market Index (HMI). The HMI rose a single point to 20 in February, though still close to its recent historic low reading of 18 (the series began in January of 1985).

HOUSING STARTS—January new-home construction also edged up slightly to 1.01 million annualized units, after being flat since November. This was the first rise since the fall from its 2 million unit high peak in April 2006. This is another sign that customers are returning to the market.

The current credit crunch will be over when banks are assured that profits (and the value of their stocks) will rise again. Once credit becomes more readily available, consumers and homebuyers will increase their spending. The righting of the yield curve should assure banks and other lending entities that this will happen in the not too distant future.

Copyright © 2008


President Bush has signed the economic stimulus package that includes a temporary increase in the conforming loan limit and the upper threshold for FHA loan programs to as much as $729,750 in high-cost areas. The question now is who will be affected, and how.

This legislation allows increases in the loan limits for FHA, Freddie Mac and Fannie Mae to 125 percent of the median house price in the area of the property for the period 7/1/07-12/31/08, resulting in new loan limits from $417,000 to $729,750 for single family properties. The legislation requires HUD to publish revised median house prices and principal obligation limits to implement the legislation "as soon as practicable", which should be within weeks after the bill is signed.

Krista Pleiser, the Santa Barbara Association of Realtor’s Government Relations Director, has calculated that the maximum limit will be $587,500 for Santa Barbara, since it is calculated from the median price for the county as a whole.

As we stated last week, conforming loans require some kind of income verification, which will limit those able to use the program. This may still make qualification for the higher conforming loan amounts difficult, as median home prices are now more than 3.2 times the national median family income of $54,000 ($64,500 in Santa Barbara County), vs. 2.8 in the 1980s, according to the National Association of Realtors.

One positive indicator of a housing recovery is a higher National Association of Realtors national affordability index. It has risen from 104 last June to 122 in January. This means that today a household with a median income can afford 122 percent of the median price of a home, vs. just 104 percent last June. This is because the median price has dropped 10 percent at the same time that interest rates have fallen more than 1 percent over that time.

Mortgage rates and programs are still plentiful, with only stated income programs in short supply. But some stated income, stated asset programs still exist, including negatively amortized Option ARMs, 3-10-year fixed rate ARMs, as well as 30-year fixed rates. And adjustable rates continue to decline in line with the major indexes that control them. The COFI 11th District Cost of Fund index has now fallen to 4.07 percent, while the MTA is down to 4.33 percent.

The economic news continues to be mixed. A huge plunge in January’s service sector activity by the Supply Management index and a plunge in the U. of Michigan sentiment survey was countered by higher retail sales in January. Also, a lower fourth quarter trade deficit from higher exports means that last quarter’s GDP growth may inch upward from its initial 0.6 percent estimate.

The fourth quarter surge in exports is keeping manufacturing and GDP positive, which means no near-term recession. For the year as a whole, the U.S. trade deficit narrowed 6.2 percent to $711.6 billion from 2006's record $758.5 billion -- the first reduction in the annual trade gap since 2001 and the biggest percentage decline in 16 years.

And exports in December rose to a new record high -- up 1.5 percent to $144.3 billion -- while imports declined for the first time in four months, slipping 1.1 percent to $203.1 billion. This is why some of the Federal Reserve Governors, including Chairman Bernanke and Janet Yellen predict slower growth, but no recession.

Copyright © 2008