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April 01, 2005

Seconds Anyone?

Seconds Anyone?...The folks at the National Association of Realtors (NAR) have done us a big favor. For the first time ever, they recently released a detailed study of the complexion of second home ownership. What they found was that in 2004, 23% of all homes purchased in the US were "second homes" for investment purposes. Moreover, another 13% of all home purchases were "second home" vacation properties. There you have it, over 1/3 of all residential real estate purchased in the US last year were not primary residences at all. Unfortunately, since there is no longer term definitive data broken out in terms of second home purchasing patterns over time, we have little data with which to compare prior history of second home purchasing. What we do know is that according to the folks at the NAR, second homes purchased for investment were up 14.4% last year and vacation home purchases surged 19.8% year over year. Those are pretty big numbers. We also know that in terms of polled sentiment, many an individual believe real estate is now a good investment. The chart below comes from University of Michigan consumer sentiment survey data and pretty much tells the story of current bullishness regarding residential real estate as an asset class. As you would imagine, after prices have already skyrocketed, it's now that the public is convinced that real estate is a great investment. Quite analogous to the fact that the public always tends to buy equity mutual funds after prices have already risen. At least one thing's consistent, public money always chases the inflating asset, until it stops inflating, of course.

Certainly it's really little wonder that 36% of total home sales in the US last year were "seconds", so to speak. What explains it logically and clearly is what you see below. The gracious folks at the OFHEO (Office of Federal Housing Enterprise Oversight - the GSE regulators) early last month put out year end housing price data for 2004. Very quickly, these are the results. Down a bit from 3Q, the full year 2004 year over year rate of change in US housing prices was 11.2%. As you know by now, this number beat the performance of the Dow, the S&P and the NASDAQ in 2004. Certainly after a near vertical rate of change move in prices over the last few years, the big question is "have we peaked in terms of rate of change in residential real estate prices?" Of course, only time will tell.

A Tale Of Two (Or More) Cities...Before leaving the OFHEO data, a few more quick items. First, this is really an FYI more than anything else. The following table depicts regionally specific 2004 home price acceleration as well as long term house price changes since 1980. As you can see, we've arranged the table from the East coast to the central part of the country and back to the West coast.

Incredibly enough, in some parts of the country such as the West South Central region, one would have been economically better off in a money market fund rather than owning residential real estate since 1980. We wonder if the folks responding to the Michigan Survey above are aware of that? It should be no surprise to anyone that the action in residential real estate appreciation has been a bi-coastal phenomenon.

Lastly, and again this is just perspective, when adjusting the OFHEO housing price data for inflation, the following is what we get. As you can see, we're deflating residential real estate price changes quite simplistically using the CPI. As you know, it's our feeling that the current CPI calculation is at best bastardized, but it's all we have in terms of headline historical inflation data. As is plain, what we have lived through in the current cycle is one of the longest real residential home price bull markets in three decades at least. Again, it's no wonder residential real estate buyers have currently been gorging themselves on seconds, so to speak.

The Foundation...Recently in our subscriber portion of the site we reviewed the US homebuilders. When we look at housing price change numbers as you see above, when we look at current sentiment regarding housing, and look at the number of non-primary residential homes sold last year, it's not hard to understand why the homebuilding group continues to move higher. That and the large short positions in the stocks that are continually being squeezed, which is certainly helping the upside cause. It's not hard to understand why residential housing has taken on mania like characteristics these days. But, as always, trying to call an end to any asset class mania is one tough job. Who knows, perhaps the rate of change price charts above from the OFHEO data tell us that peak rate of change pricing in residential real estate has already been seen. But we believe one of the keys to the future of the residential real estate price inflation party can be found in the financing infrastructure. If you ask us, the financing mechanism is the foundation to the current price mania. We see mainstream commentary after commentary questioning whether or not there is a bubble in US housing. We suggest an alternative and perhaps broader view of life. As opposed to a more narrow bubble in US housing prices, are we simply experiencing a massive credit bubble, of which housing is simply a headline manifestation? To be honest, that's how we see things these days.

Having said that, let's have a look at a quick chart for clues as to what may be "different this time" in terms of the housing cycle. Below is the four decade chart of new home sales in units (expressed in 000). Overlaid on top is the year over year rate of change in M3.

Although it's a bit of a rough approximation. you can see that up until recently, the directional change in new home sales and the year over year change in M3 have been quite coincident. In fact, there was only one directional divergence in the early 1980's as the rate of change in M3 moved higher for a while with new home sales continuing to fall. At the time, the Fed was raising interest rates significantly to crush inflation, but allowing money to grow in an attempt to cushion the interest rate blow. Simultaneously, the US consumer was plunging into one of the worst recessions in memory up to that point. Hence, the temporary divergence. Outside of that, the directional coincidence has been quite consistent until recently. Since 2001, the year over year rate of change in M3 growth has been in decline, yet new home sales have gone almost vertical. What's going on here?

First, we've used M3 as a rough approximation for money and credit generated by the banking system. Money the Fed can influence with changes in monetary policy over time, so to speak. It's our belief that the current residential real estate market is being fueled not only by mainline bank lending, but quite importantly also by "new age" credit creation that is found in the broader financial markets. Specifically in financing vehicles such as the ABS (asset backed securities) and GSE guaranteed markets (the broad mortgage backed securities - MBS - markets). Have a look at the following table.

Now, let's drill down just a bit further for a true picture as to just who has been leading the mortgage financing footrace over the last year (ended 4Q 2004 from Fed Flow of Funds):

There you have it. Here's the big change in our minds. And we think it's super important. It's the asset backed securities market that was responsible for the bulk of US home mortgage financing for the year ended 4Q 2004. It wasn't the banks. It wasn't the S&L's. And it wasn't even the GSE balance sheets proper. It was the conduit ABS market that was generating the bulk of the liquidity. Furthermore, there is absolutely no question in our minds that the Fed is fully aware of these dynamics. They are fully aware of the circumstances surrounding the turbocharged change in residential real estate mortgage liquidity. Why? Because this is their data. It comes directly from the Fed Flow of Funds report. And, as you already know, the fact that conduit markets such as the ABS market are primarily responsible for this type of credit creation is one of the primary reasons the financial derivatives complex (primarily interest rate derivatives) in this country continues to grow at accelerated rates over the last few years. Twenty years ago, the ABS markets didn't even exist. Ten years ago, the ABS market was a rounding error in the greater scheme of systemic credit and liquidity creation. In 2004? Well, the ABS issuers simply took center stage when it comes to the US residential real estate market, now didn't they? On a combined basis, the GSE-backed MBS (mortgage backed securities) pools and the ABS pools make up a whooping 53% of total US financial sector debt outstanding and 17% of total US credit market debt outstanding as of year end 2004. These numbers are far from trivial and exist entirely outside the mainstream US banking system. We're clearly at the point in the greater credit cycle where credit examiners (banks, etc.) are now an afterthought. Purveyors and participants in modern era "structured finance", along with their hedge fund brethren, are now calling the shots. In many senses the structured finance crowd must be thinking to themselves, "Hey Al, move over, you're yesterday's news, brother. Get out of our way, we'll show you how it's done."

So, just who do we find when we pull back the curtain on the ABS and MBS markets? Folks with solid financials like GM and Ford, to mention just two of the larger participants. Non-traditional mortgage lenders are big players. Moreover, as we mentioned, credit expansion in these markets simply would not have been possible without the supposed financial risk management backstop that is the interest rate derivatives markets. As a very quick tangent, we believe it is very telling to note that US banking system notional derivatives exposure as of year end 2004 stood at just shy of $88 trillion. But what we believe is really important is what you see below. Without belaboring the point, US banking system derivatives exposure has doubled since year end 2001 and tripled since the LTCM blowup. In our eyes, the interest rate derivatives markets are the unequivocal backbone supporting credit expansion stateside. Wanna see a powerful and as of yet uninterrupted bull market? Good, simply have a look below.

So, to quickly and very simplistically complete the circle of thought, can we say that the US residential real estate markets have been quite dependent on mushrooming US banking system interest rates derivatives exposure over the last two to three years? You better believe it. Credit expansion in the ABS markets are simply living proof. As we have said far too many times now, the US credit markets and the financial derivatives markets are not co-dependents, they are Siamese twins who just happen to share the same heart, lungs and brain. In today's modern world of structured finance, neither can live without the other.

Take A Load Off Fannie, And You Put The Load Right On Me...As you know, the news regarding Fannie seems to get a little worse with each passing month. $9 billion in unreported losses related to derivatives. Another $2.8 billion in further capital problems a few weeks back. Have we heard the end of the story? Don't count on it. Even Greenspan got into the act recently when he suggested legislatively capping the ability of Fannie and Freddie to expand their balance sheets. That's all well and good, but the Fannie and Freddie's of this world do not just trade for their own account, so to speak. They also act as essentially off balance guarantors. Yes, Fannie and Freddie do buy mortgages to hold as investments. That was their raison d'etre when they were originally set up. But, much like an MBIA or Ambac who "insure" muni bond issues, Fannie and Freddie also act as guarantors in mortgage pools that are created but not actually held on the balance sheet of either FNM or FRE, in whole or in part. These pools of mortgage backed paper are owned by commercial banks, insurance companies, pension funds, etc as investments. No problem as long as there are no losses. In traditional days of mortgage lending when buyers actually had to come up with real down payments, the pools could look to companies like PMI (the private mortgage insurers) to make good on the first 20% of a potential loan default anyway. What a sweet deal. Like MBIA and Ambac, acting simply as a mortgage pool guarantor is almost like coining money.

So as we look ahead, although Fannie and Freddie may indeed be restricted from mushrooming their own balance sheets by buying up mortgage paper as they did over the past decade, there's nothing to stop them from "guaranteeing" mortgage pools as we move forward. Nothing. And whether FNM and FRE are actually buying physical paper or simply guaranteeing paper, do you really think financial market participants are not assigning the ultimate implicit guarantee ticket to the US government? Don't fool yourself, that's exactly what's happening.

Again, we are absolutely convinced that the Fed is fully aware of this situation. They are implicitly sanctioning it. Without belaboring the point, it's the reason we remain convinced that the US credit cycle is the key to what lies ahead. And that credit cycle includes the very significant influence of the mortgage and ABS issuer "paper pools", as well as the derivatives complex so necessary to the perceptual hedging of risk inside these massive pools of capital. The future will not be found strictly in business cycle dynamics alone because the business cycle is being driven by the greater credit cycle. Again, thinking in terms of a singular US housing bubble may be far too narrow minded.

For now, the structured finance markets are driving the real estate mortgage credit liquidity bandwagon. But what is important to remember is that they are dragging the ultimate credit exposure of many other mainline financial institutions right along with them. Not only are JP Morgan, Citigroup and BofA providing the bulk of US banking system derivatives juice to facilitate the structured finance markets, but many a plain old ordinary bank themselves are players in the residential real estate market both in terms of real world lending and also in terms of holding MBS paper as a good part of their bank asset portfolios. And for the US banking system as a whole, much like US households of the moment for that matter, literally nothing is more important looking ahead than the value of their loan collateral, otherwise known as the market value of real estate. See what we mean?

We've often suggested that psychologically and emotionally, residential real estate values are extremely important to households. As you'll see in the paragraph and graph below, home values appear more important to household net worth than are equities by a factor of nearly two to one. But based on the picture above, just how do you think the banks feel about real estate values? At the moment, their real estate exposure is approaching three times their loan exposure to commercial and industrial loans. The exposure of banks to consumer loans is less than one quarter of their exposure to real estate. In summation, to suggest that the market value of real estate is important to the US economy as a whole is a wild understatement. It's just a good thing that the new age structured finance markets are leading the charge in terms of helping to inflate real estate values from sea to shining sea. We're absolutely dead sure that if any mishaps in the structured finance market were to appear, holders of MBS and ABS securities would sit tight as long term investors, right? No jumping off the side of the ship if the opposite side of the leverage sword begins to cut. After all, somebody has to support those real estate values collateralizing the bulk of bank lending and portfolio investment in this country, no?

As you know, there are a number of pundits out there who have characterized the US economy as one big hedge fund. We won't go that far. But the fact that the structured finance markets are heavily driving credit availability for and ultimately prices of probably the single most important asset class in the US doesn't exactly warm our hearts. One last comment. The last time we saw the year over year change in OFHEO home price data at as high a growth rate level as was experienced as we ended 2004 was back in 1979. As you may recall, 1979 can be characterized as a period where there was no structured finance market. There was no derivatives market. My how times have changed. Could anyone even have imagined in 1979 that in 25 short years the US banking system singularly would be exposed to almost $88 trillion in notional value of derivatives contracts? Quite humbly, we think not. But what do we know? We still think folks should actually put down payments on homes they purchase. Sheesh!

The Weight Of The Evidence...We thought we'd leave you with one last chart concerning household asset class perspective. For now, residential real estate is about twice as meaningful to households in terms of size as a percentage of total net worth relative to equities. Never in modern US financial history has residential real estate meant so much to so many. And, as you know, never has the US residential real estate market been so dependent on large pools of speculative capital found in the asset backed and mortgage backed securities markets. Lastly, never have these speculative pools of capital been so dependent on the derivatives markets for the ability to continue to "create" liquidity. C'mon, US residential real estate is definitely not a house of cards. It's a house of paper. Seconds anyone?

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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