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December 01, 2005

The Times They Are (About To Be) A Changin'

Oh Say Can You OCC? ...As you might know, the OCC (Office of the Comptroller of the Currency and one of the chief banking system regulators) is set to hand down guidelines regarding bank commercial and residential real estate landing practices prior to year end. Given the fact that interagency discussions about the initial draft of the guidelines has really only just begun, don't be surprised if it's somewhere in 1Q 2006 that final guideline commentary is made public. Nonetheless, it's clear to us from recent comments by the Comptroller himself that in terms of residential real estate credit availability, the times they are about to be a changin'. At least as far as the banks are concerned. For the full version of his recent comments made on October 27th, just follow the link. Of course we couldn't help but excerpt a few lines here and there from the text that will give you the feel for the raised level of OCC concern regarding recent bank real estate lending practices. It's absolutely clear to us that these folks want to see "new era" residential mortgage lending products reigned in rather meaningfully. And unless the US banks are desirous of unwanted audit scrutiny, they're going to get in line with the guidelines. Here are just a few unedited excerpts directly from the text we linked above that, if you will, sets the tone in terms of the regulatory level of concern.

"But it's at the top of the credit cycle where stresses and weaknesses typically appear, so what we are seeing today should not surprise anyone. With liquidity pouring into the market, we would expect to see increased competition for loan customers - and we are. With competition intensifying, we would expect to see underwriting standards easing - and we are. And we would expect to find emerging concentrations in some loan categories, such as commercial and residential real estate. We are most definitely seeing that. One of the striking findings in our 2005 underwriting survey was the breadth and extent to which banks had relaxed their lending standards.

"But while the trend toward increased credit risk is visible across the portfolio and across the country, it really stands out in two product areas. The first is commercial real estate; the second, residential first mortgages.

"Such concentrations by themselves would warrant supervisory concern under any circumstances. But in order to attract new business and sustain loan volume, banks have made many compromises and concessions to borrowers along the way, resulting in commercial real estate credits with structural weaknesses that go beyond discounted pricing.

"It seems like only yesterday when a 5/1 ARM was considered a risky mortgage product. And it was - but primarily for borrowers, who, in turn for lower initial payments, assumed the interest rate risk that had previously been borne by lenders. Today's non-traditional mortgage products - interest-only, payment option ARMs, no doc and low-doc, and piggyback mortgages, to name the most prominent examples - are a different species of product, with novel and potentially risky features. I don't have to explain those features to you, because these products have come to dominate the mortgage originations that many of you look at every day.

"The dominance is increasingly reflected in the numbers. By some estimates, interest-only products constituted approximately 50 percent of all mortgage originations last year. In the first half of 2005, IOs started to decline in favor of payment-option ARMs, which, according to one source, comprised half of new mortgage originations. And roughly every other mortgage these days is also a "piggyback" or reduced documentation mortgage, which points to another development that concerns us: the trend toward "layering" of multiple risks."

The charge of the OCC is to maintain a safe and sound banking system. There's simply no question that in 2006, they will be carrying the banner of real estate lending practice concern as they charge into US banks from sea to shining sea. What will this do to the character of mortgage lending in the US broadly? Of course that remains to be seen. The OCC is concerned with the banks. It's not the regulator of subprime lenders such as New Century. After all, despite the fact that NEW's stock price is down over 40% this year alone, New Century can go right on making any kind of loans it chooses. Remember, as we've told you many a time now, the largest source of mortgage credit creation in the US over the last few years has been the asset backed markets. The ABS markets themselves will ultimately dictate the terms of mortgage lending to the non-bank players such as NEW. ABS investors will react when delinquencies spike and perhaps defaults begin to occur. But for now, what's important in watching for change in the residential real estate markets is to watch all sources of credit creation and how the character of that lending changes ahead. For now, at least according to the OCC, the US banking system is going to be taking one step back from imbibing in "new age" mortgage lending practices of the last three to five years. That's one small dent in the armor of overall credit availability. One last comment. We're absolutely convinced that private capital, which supports the asset backed securities markets, will turn the credit spigot off entirely if default trouble begins to brew in residential mortgage lending land. Remember, as we've told you ad nauseum over the last half decade at least, liquidity is inherently a coward. There's always too much when it's least needed and it's never around when it's needed most. (Admittedly, in the greater picture of the moment, the FED may be changing this little rule, at least for now.)

At the moment, US banking system exposure to both commercial and residential real estate is approximately 53% of total loans and leases outstanding. If we include current HELOC (home equity line of credit) exposure, which is not included in the chart below, the number below moves to just over 60%. And if we include bank investments in mortgage backed paper, the numbers move even higher. No wonder the folks at the OCC believe it's a topic of current interest.

It'll Soon Shake Your Windows And Rattle Your Walls, For The Times They Are A-Changin' ...There is absolutely no question at all that capital extraction from home equity values has been meaningful to US consumers over at least the last half decade. The super folks at Freddie Mac recently revealed their cash out refi numbers for 3Q a while back. Again, we'll let the pictures to the talking. As of the end of 3Q, the gang at Freddie was estimating that happy US homeowners were currently on track to extract over $200 billion in cash via only the cash-out refi mechanism in 2005 alone. If indeed this comes to pass, it will be a record amount. And this is despite the fact that refi activity in terms of specific volume count is not particularly vibrant at the moment at all. As you'll see in just a minute, this magnitude of cash extraction is really a function of folks yanking ever larger percentages of "equity" out of the current values of their homes. After all, as the TV commercials and assorted realtor community spokesfolks continue to remind us in the media, anyone sitting on unused equity in their homes is simply not maximizing investment opportunities, right? Apparently those individuals doing refi's seem to be listening to that very message.

As we mentioned above, those undertaking refis at the moment are taking ever larger percentage based "cash draws" relative to new loan amounts. 2005 up to this point is another record.

Perhaps the most important chart of this little series lies directly below. We've taken the numbers used to create the chart of cash outs over the years in dollars (including the $200+ billion we mentioned for 2005) and looked at them as a percentage of the year over year nominal dollar change in personal disposable income. If you ask us, this is some meaningful stuff. Despite the fact that we're well off the highs of a few years back, cash being extracted from equity in residential real estate via the refi process alone continues to exceed 20% of the year over year change in disposable personal income. Add in HELOC loans and it becomes a much larger percentage number benchmarked against changes in DPI. Just to keep ourselves honest, the 2005 disposable income number we used for the denominator of the value in the chart below was indeed annualized. We've kept this an apples to apples comparison across the board.

Again, it's important to remember that in the numbers above, we're only looking at official refi activity and the cash extracted there from. What's important to keep in mind is that current HELOC balances approximate $400 billion at the moment. You'll remember that in the recent Greenspan co-authored Fed study on MEW (mortgage equity withdrawal), he cited an annualized current number of close to $600 billion. Greenspan was including both refi and home equity line of credit activity in the study, just as he should have. Let's put it this way, if the coming OCC actions are the beginnings of greater mortgage credit restrictions across the entire US financial system, the now newly popular term (as a result of the Greenspan study) "mortgage equity withdrawal" is about to take on a whole new meaning.

At Your Financial Service ...Well, as you know by know, when the recent FOMC minutes were released last week prior to the Thanksgiving holiday, the mere intimation that future FOMC statement wording might be changed gave the equity and bond markets reason to gobble even louder than they have been in the post October equity market low period to date. Could it really be that the Fed is about to draw their current rate tightening episode to a dramatic conclusion? Well, after twelve measured blips up in the Fed Funds rate since June of 2004, it's a darn good bet that we're closer to the end of the ride than not on the pure basis of statistical chance, let alone predicated on some change in statement wording. And as "everyone" knows, once a Fed rate tightening cycle reaches its cyclical conclusion, there's only one thing to do - anticipate the next rate easing cycle, right? If you've been watching the markets as of late, you already know that the financial stocks have been one of the best sector performers since mid-October. In other words, with the financials in the lead, hasn't the market already been discounting the end of the Fed rate tightening cycle at least a good month prior to the announcement of a potential shift in forward Fed verbiage? For now, we believe it's very important to keep a sharp eye on the financial sector. Why? Any disappointment in the expectations being built into financial sector stocks driven by forward perceptions regarding either inflation or the end of the monetary tightening cycle may be a tell tale sign as to the mood of the broader market as we move forward. The following are a few comments we hope are helpful.

A number of weeks back, the folks at the Fed released the Senior Bank Loan Officer Survey for 4Q. We'd like to roll over just a few tidbits of the report as the messages are broader than perhaps for just what's happening with the banks. But before getting started, we hope this portion of the discussion is meaningful in that a number of the financial related equity indices or benchmarks have recently broken out to new price highs as of late. The NYK (the New York Financial Index), the XLF (the financial sector ETF) and the BKX (the Philly Bank Index) have all broken to new all time highs as the current rally has progressed. Stepping back for just a second, financial sector upward price breakouts have usually occurred most prominently under two scenarios. First would be the beginning of a new bull market not only for equities, but really reflective of an improving and accelerating broader economy. The second scenario of noticeably higher financial stock prices would be in anticipation of a conclusion to a Fed tightening cycle. Quite simplistically, what both discounting scenarios have in common is a supposition that the financial sector as a whole would be moving into an improved environment for lending and/or better interest rates spreads (a steepening yield curve). That's the big ticket. Let's say the Fed does stop dead in its monetary tightening tracks perhaps in January of next year or at the very least verbally tells us that the end is near, so to speak. Does a better lending environment automatically lie ahead based on a change in FOMC statement wording? Let's say the economy is about to reaccelerate upward in '06. Does that mean consumers and corporations are now ready to increase their borrowing on a simple rate of change basis? Of course the reason we are asking these questions is that during the recent recession of 2001 and into the years that followed, credit expansion in the US never really turned down, as it had exactly done in so many recessionary cycles past. So although the historic knee jerk reaction of the equity markets to an end of a Fed tightening cycle would be to buy the financials, is a much better fundamental environment for lending volume or interest rate spreads really what's to play out ahead in the current cycle? Or will this time be different (as have been so many macro post recessionary experiences of the last four years)? As you'll see directly below, the financials look like they are bolting from the starting blocks. The key question being, is this a false-start? If so, we believe this has much broader ramifications for the entirety of domestic financial markets. One item to notice is the chart of the XLF (financial sector ETF). It's the only one where we can capture volume data. And, as you'll see in the weekly chart, over the past few years, volume has accelerated on sell offs and retreated on advances. Not exactly a bull market pattern, now is it?

Let's take a quick look at recent rate of change patterns in broad credit expansion and where the banks are, or where they say they are, in the lending officer survey in terms of both consumer and corporate lending.

CONSUMER LENDING

You know from our prior discussions that the banks are top heavy in real estate loans at the moment - both residential and commercial. These loans have really been their bread and butter throughout this entire current lending cycle (since the end of the last recession in 2001). In addition, home equity lines of credit have become big business for the banks over the last two to three years. So how do things look ahead? First, the chart below is the year over year rate of change in household mortgage debt outstanding, not inclusive of home equity lines. Although mortgage debt through the second quarter of this year is still up 10% on a year over year basis, it's now trending lower from cyclical growth rate highs seen late last year. We won't have the numbers for 3Q for a number of weeks, but we'll update you when we do. As you know, this is where household borrowing excesses reside in the current cycle. Can we really expect an all new upcycle in lending to start so soon? Especially given the fact that it sure looks like real estate prices and sales volume activity are cooling now as never before in the current cycle, to mention nothing of the fact that affordability indexes are pushing decade-plus lows and the OCC is about to lower the boom on aggressive bank driven mortgage lending practices?

As you know, home equity lines are most often tied to the prime rate. With a 300 basis point increase in the Fed Funds rate, and a commensurate move up in prime (with more to come on December 13 and probably beyond), is it really any wonder the following chart looks like it does? Again, without a large and immediate drop in the Fed Funds rate and a coincident prime rate decline, can we really expect another meaningful upcycle to get under way for HELOC lending as the financial sector stocks seem to be broadly suggesting?

What about straight out non-mortgage related consumer credit? It just so happens that in the month of September, we saw the month over month outstanding card debt in the US actually contract. A rare occurrence these days. Certainly a part of the reason as to why were lower car sales (non-revolving credit). But as you'll see in the chart below, as of September, the year over year rate of change in consumer credit (cards) was up only 3.6%. This is the lowest number experienced since 1993 (and that was during an improving economy with credit use on the upswing, not the downswing). Could it be that consumers are coming to grips with the changes in the bankruptcy laws that are now in place?

Moreover, in the recent bank lending officer survey, the banks themselves are telling us that they are less willing to make consumer loans at the moment. And this is despite the fact that it theoretically should be easier for them to ultimately collect ahead with the recent change in the bankruptcy law.

The banks are telling us that they are less willing to make consumer loans and the real world is showing us that the rate of change in demand for consumer lending is slowing. These are the facts. We have to ask ourselves with these facts in front of us, just what the heck are the financial stocks discounting as of late? Again, is some change in FOMC statement wording about to reverse growth rates of consumer credit trends in general? In our minds, we've already done that over the last five years. An encore performance at this point of significant credit expansion in the face of continuing negative real wage growth and a stalling in the housing market in the US is going to be a very tough act to pull off. The Fed under the new Bernanke regime may indeed stand ready to flood the markets with liquidity at any time, but will consumers be ready to automatically accelerate their borrowing of that "liquidity" so soon after gorging themselves on cheap credit of the last half decade? That's the issue plain and simple for the real economy. And at least as of now, consumer credit trends are headed in the opposite direction on a rate of change basis.

COMMERCIAL LENDING

In the 4Q Fed bank lending survey, the lending officers told us that they are seeing less demand for both large company and small company demand for commercial loans. The history of this portion of the survey lies below. (We're only showing you the large company C&I lending survey results. Trust us, the small company survey results and history are virtually identical.)

Is this really a drop off in commercial loan activity? Or is this response more reflective of the fact that corporations in general are flush with cash these days and don't really need to borrow? Well, it just so happens that the directional year over year rate of change in nonresidential fixed investment (a broad proxy for corporate capital spending) very closely mirrors what has been seen over time in terms of bank lending officer responses to commercial lending demand in the Fed survey. In other words, the banks are corroborating the rate of change slowdown in corporate cap spending as of late.

So although the financial stocks have been heading higher, perhaps on hopes that the Fed is near done for this cycle or that the US economy is about to improve in a big way, the facts of the real world also reflected in the responses of bank lending officers tell a different story. They tell a story of a rate of change decline in the demand for credit both at the household and corporate level. Here's a case where near term price volatility (in this case to the upside) does not seem to be corresponding with current facts and circumstances. Is this just a case of hedge and proprietary desk trading activity on a short term basis reallocating speculative investment capital to a sector that has been underperforming for some time (the financial sector)? Or is there simply an incredible amount of pent up demand for additional credit expansion in the US that is about to explode higher on the first hint that the Fed may halt its assault on short term interest rates? Which do you think it is? Watch the financials. They have led the current rally up. If this is a new bull market and the beginning of a new and ever greater magnitude of credit expansion stateside, the financials will continue to lead. They have led in almost ever cyclical bull episode for equities over the last two-plus decades. Alternatively, if the financials turn tail and head south post the knee-jerk "Fed is done" reaction rally, it's a good bet they're going to have some broader sector company on the way back down. As we've mentioned many a time, the financials continue as the largest sector weight in the S&P by a good measure. Don't take your eyes off of them as we round the turn into 2006.

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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