For Release March 29, 2006
As expected, the Federal Reserve Board raised the Fed Funds rate to 4.75% on March 28. The Fed stated the reason for the increase: "Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures. The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance." We believe there will be a further increase to 5% on May 10 and probably to 5.25% (20% odds) on June 29. However, most economists still believe the Fed will leave the rate at 5% for the rest of the year. GDP is expected to grow 4.7% in 1Q06, up from 1.6% in 4Q05. This means there could be possible further increases in the Fed Funds rate up to 5.5% before such increases stop. Future meetings of the FOMC are on August 8, September 20, October 24, and December 12. We think by December 12 the overnight rate will reach 5.5%. This suggests the 30 year fixed rate mortgage will hit 7% by June and 7.37% by December. The spread between the 30 YFR (6.32%) and the 10 year Treasury (4.80%) is currently 152 bp. We believe the Fed wants to eliminate inflation in housing and not just inflation as measured by the CPI. That measure is understated. Inflationary psychology is too rooted in public perceptions and needs to be reversed by taking more investor demand out of the housing market.
The 10 year Treasury has risen from 4.38% in January to 4.80% on March 28. This is a sharp increase in a rate that has been flat for the prior year. Hourly earnings rose 3.5% in the past year, which suggests inflation is a problem and that Fed Chairman Bernanke will halt it by raising interest rates. For several months, the Treasury yield curve has been either inverted or flat. On March 13 the two year bond yielded 4.73% and the ten year yielded 4.77%. On March 28 the two year bond yielded 4.79% and the ten year yielded 4.80%.
The European Central Bank raised its overnight rate to 2.5% and Japan's Central Bank indicated they would start raising their rate later this year. These two indications lifted rates in the U.S. a bit.
A weak retail report for February suggests to some analysts that the U.S. economy is weakening and therefore tightening of credit by the Fed is near its end. Other analysts state that the seasonal pattern is distorted. If January and February are averaged together, retail sales are still strong. We shall have to wait for the March report to find out which view is true.
Housing permits fell 3% in February to a 2,145,000 annual rate. Housing starts fell 8% to a 2,120,000 annual rate. This suggests a slow reduction in housing. However, a strong showing for resales of existing homes, which probably reflects the unseasonably warm January, seems to contradict the decline in starts.
U.S. home resales rose unexpectedly to a 6.9 million seasonally adjusted annual rate in February, up from 6.5 million in January. This was probably due to mild temperatures bringing buyers out early. This suggests tight monetary policy will have to remain longer to bring down the rate of housing inflation. The median increase in existing home prices was 10.6% over prices in February 2005. Existing home sales peaked at a 7.05 million annual rate in October 2005 and are now down to a 6.4 million rate in February 2006. Despite the relatively strong February showing, the inventory of unsold homes has been rising.
The new home sales report for February showed a 10.5% decline to an annual rate of 1.08 million, the lowest since May 2003, from a revised 1.207 million in January. New home sales peaked at 1,345,000 in October 2005 and fell to 1,200,000 in February. The rate of price increases for new homes is down to 3% from 15% last October. The number of homes for sale rose to a record 548,000 from January's 525,000. Inventory was up to 6.3 months, the largest amount in more than a decade. The median selling price of a new home last month was $230,400, a decline of 2.9% from a year earlier. By region, sales in the West fell 29% to 252,000 and fell 6.4% in the South to 575,000. Sales rose 12.7% in the Northeast to 71,000 and 5.2% in the Midwest to 182,000. The National Association of Realtors predicts 7.85 million new and existing home sales in 2006. They predict new home sales to fall 7.7% in 2006.
KB Homes reported a 12% decline in new home orders in their fiscal first quarter (ending in February). They blame a softening of demand especially on the two coasts. Selling by investors has increased supply.
Inflation and Unemployment
The CPI rose 0.1% in February and the core CPI rose the same amount. The core rate rose 2% on a year-over-year basis. The all item CPI rose 3.6% year-over-year.
Initial claims for unemployment rose 2% in mid-March, suggesting a mild slowdown in the economy. The four week moving average of initial claims for unemployment was 304,000 on March 18, up from 282,000 on February 18, indicating a gradual weakening of the economy.
Risk of ARM Resets
We are concerned about the resets of existing ARMs. Somewhere between 7% and 10% of all outstanding mortgages are ARMs that will reset this year. Not all the holders will be able to afford the new higher payment. A high proportion of these loans are in California. We expect many homeowners will be forced to sell, which should increase the inventory of homes on the market and slow down home price increases. We should also see higher delinquency and foreclosure rates. First American Real Estate Solutions research director Christopher Cagan predicts $200 billion in foreclosures (which equals 2.5% of mortgages outstanding) over the next couple of years. This is fueled largely by losses where borrowers' outstanding mortgage is greater than the value of their house. Normally about 1% of mortgages outstanding ($80 billion) is lost in foreclosures each year.
As of year end 2005, there was $8.4 trillion in home mortgage debt outstanding. Of this, more than $2 trillion was ARMs with interest-rate resets in 2006 and 2007, according to Moody's Economy.com. A recent study by First American Real Estate Solutions projects that one of eight households with ARMs, those that originated in 2004 and 2005, will default on those loans. There are 7.7 million of such loans, worth $1.9 trillion. About 1.4 million of those households face a jump of 50% or more in their monthly payments and an additional 1.6 million face smaller increases that are still likely to strain their finances. About 1 million households eventually will default and lose their homes to foreclosure. That would cause about $110 billion of losses (55% of the value of foreclosures) for lenders. Subprime borrowers are most at risk. Many of these borrowers used 2/28 loans. Once that introductory period ends, the interest rate is reset every six months for the remaining 28 years of the loan at a margin over interbank rates, the rates banks charge one another for short-term money. Some of these borrowers will have increases of 40% to 50% or from 7.1% interest to almost 11% interest.
Real Estate Prices
National City believes 42% of the U.S. residential market is overpriced and 24% is extremely overvalued. California and Florida have the biggest concentration of what National City deems to be the most overvalued properties.
Delinquency and Foreclosure Rates
Delinquency rates for 1-to-4 family mortgages rose to 4.7% in 4Q05, up from 4.44% in 3Q05 seasonally adjusted. The seasonally adjusted rate for new foreclosures rose 1 bp from 0.41% in 3Q05 to 0.42% in 4Q05. Hurricane Katrina had a big impact on raising the rate of delinquency. The states with the highest rates of delinquency and foreclosure are Louisiana and Mississippi, which were most directly hit by Katrina. Indiana, Ohio, and Michigan were most directly affected by a downturn in manufacturing particularly that related to automobile manufacturing by the "big three" automakers (GM, Ford, and Daimler Chrysler) and their suppliers. Serious delinquency for FHA loans was 6.13% in 4Q05, which is close to the 6.32% rate for subprime loans. This shows how FHA has in practice become the same risk as subprime. The states with the lowest rates of serious delinquency are in the west, particularly California at 0.43%. Other areas of low delinquency are in the Northeast, such as Virginia and DC. These areas benefit from the growth in the federal government.
As the Federal Reserve Bank continues to raise interest rates, we expect to see declining employment in home construction, and rising rates of unemployment, which was 4.8% in February 2006.
Since June 2005, the total outstanding HELOCs has been flat at banks, which hold most of the loans. This suggests a cooling off of this market. From December 1999 to June 2005 there had been a big increase in these loans. But now the yield curve is flat, so the rate of interest on HELOCs is about the same as for fixed rate loans, causing many borrowers to switch over to fixed rate loans. Due to the steady increase in short rates, and thus the indexes that underlie HELOC rates, the rates for HELOCs for consumers are considerably higher than they were just 18 months ago, which has dampened demand for new loans.
Longer Run Issues
Bill Gross of PIMCO has been very pessimistic about the future of the U.S. economy. The rising cost of pensions, healthcare and defense will drain away a growing share of GDP. Meanwhile, the quality of our workforce is weakening relative to the international market. U.S. high school graduates rank at the bottom compared to our competitor nations. We have squandered our savings and educational heritage. The only solution is currency devaluation, inflating away of long-term pension liabilities, and the payment of rising healthcare expenses via higher personal and corporate taxes. This will hurt investment markets. Therefore Gross advises investors to diversify globally, which means a reduction in investment in U.S. stocks and bonds.
Federal Regulatory Guidance
The proposed guidance on nontraditional mortgage products by the three federal financial regulatory agencies is not expected to be finalized until May, according to the MBA at its meeting of the secondary marketing committee on March 14. The comments it has received have been in agreement that the proposed guidance was too proscriptive. The OTS and OCC disagree with the Federal Reserve Bank, which suggests the final guidance will be weak.
Over the period 1992 to 2005, the average profitability of U.S. banks has been 14% ROE and 1.1% ROA. However, from 1983 to 1992 average ROE was only 6% and ROA 0.4%. That was a period of flat real estate prices before the fall in interest rates and surge in mortgage credit. Is the high mortgage growth era over as we move to lower growth in real estate prices? Will there be slower growth in consumer and mortgage debt as growth in savings and income catch up to debt? We believe bank profits will be under pressure due to the flat yield curve, the slowdown in consumer lending, excess capacity in banking, and the slowdown in real estate. Mortgage profits are very weak now but we don't have a good historical series to measure those profits except through our benchmarking series which only goes back to 1993. We believe mortgage profits were also weaker prior to 1993. According to reports coming from the MBA-Stratmor meeting, mortgage lenders are still optimistic about 2006 production. First quarter 2006 production was strong and most mortgage firms now believe originations this year will remain at the $3 trillion level. We disagree and see a cooling off as the Fed acts to bring down the high degree of speculation in the market. This will prove to be a better policy in the long run and prevent a bigger housing market collapse in the future.
According to a study by the American Electronic Association, U.S. companies are spending $35 billion annually complying with Sarbanes Oxley ("Sarbox" for short) as opposed to original federal estimates of $1.2 billion. This law was supposed to address corporate crimes, but since 2002 there have been over 70 prosecutions and not one conviction due to Sarbox. It is now evident that the cost clearly outweighs the benefits. Democrat leaders have openly attacked this law. The Public Company Accounting Oversight Board says that it violates the separation of powers principle and the Federal Constitution's Appointments Clause. This may cause the entire law to be thrown out by the courts as unconstitutional. Until then, it is a financial drag on the U.S. economy.
The economy continues to grow strongly while the housing market slows down. If all continues to go well, the Fed will stop raising the Funds rate at 5% and hold it unchanged the rest of the year. But if any of a series of shocks occur, we are vulnerable to a slowdown in the economy. The big vulnerabilities are the high level of consumer debt, the low level of personal savings, the huge trade deficit, the even bigger federal deficit, and the ever spiraling war in Iraq. The best scenario is for housing prices to remain fairly flat for the next five years, permitting incomes to catch up to them.
Mike Ryan, head of equity research at UBS, believes the Fed will peak out its Federal Funds rate at 5% on May 10. It will hold it flat for nine months and then start a decline in March 2007. Based on this analysis, long rates will remain flat over the next 12 months. Ryan also predicts that real estate prices will continue to appreciate at a 6% annual rate, down from a 12% rate. This is probably the standard economic projection for the housing market.
Based on the economic picture, we believe the profit squeeze in the mortgage industry will continue at least to September and probably to the end of the year. Mortgage originations have been slowing down, especially refinances. Wholesale Access has been forecasting $2 trillion in mortgage originations for the year. We see the biggest slowdown in ARMs due to the shape of the yield curve.