FYI | Jul 02 2009
By Greg Peel
Recent housing data in Australia has been somewhat confusing. Yesterday’s shock collapse in building approvals suggests a market contracting rapidly, yet this week we have also learned Australia’s median house price has fully recovered the 10% lost in the previous year. The median house price is back to the pre-credit crisis level.
Every other developed economy is witnessing a collapse in housing prices. The Case-Shiller index of 20 US cities shows a 33% collapse from its peak. Australia may have appeared to have weathered the GFC storm better than other developed economies, but does it make sense our house prices should be back at such dizzy heights?
The usual explanations have been trundled out once more: Australia has booming population growth and land releases and construction are far from adequate. You could also throw in that Australia is seen by the rest of the world as a nice place to live, and most recently that Chinese investors, pockets bulging with cheap Chinese finance, have been targeting Australian homes. Obviously, house prices have been pushed up by the rapid reduction in the RBA cash rate. And further ignited by the government’s various first home buyer hand-outs.
In the case of the hand-outs, it is universally agreed – even by the government – that a $7000 freebie will immediately push house prices up by $7000, thus rendering the exercise ill-considered. However the government will argue that such stimulus has flowed through to providing jobs in the housing sector, and is thus valuable. This may be the case, but what happens when the hand-out period expires?
In the case of lower interest rates, one must remember the RBA is only doing its bit to stimulate the economy as well. We have yet to see unemployment peak, and while the cash rate may yet hit 2.5%, rest assured the only way will be up thereafter. What looks like a cheap loan now might not be cheap for too long. The Big Four banks have already been forced to increase their fixed loan rates, have started increasing variable loan rates, and may yet increase further.
The Big Four banks have also been basking in the glory of seeing off their upstart non-bank competition in the GFC. Yet when one might expect lending standards to be strenuously tightened in the face of rising bad debts, and the given need to raise fresh capital and cut dividends, the banks have been criticised for barrelling head long into mortgage lending once more with the government stimulus as the impetus. Already such criticism has led to a rethink on loan-to-value ratios.
Back in the sixties and seventies, banks typically lent only 60% of the value of a home. The buyer was expected to stump the other 40% as deposit. The buyer was also expected to prove almost security of job tenure in order to even be considered for a 60% loan. But securitisation had changed all that by the nineties, and suddenly the competition in lending meant less and less apparent job security was required (think lo-doc and no-doc) and less and less deposit was required. Pretty soon banks and non-banks were lending all of the deposit as well. Loan-to-value ratios (LVRs) hit 100%. Then when buyers complained of all the added costs associated with buying a house, banks decided to lend on those as well. LVRs went to 105% or more.
What this means is a mortgage holder is already 5% underwater on his investment at Day One. If, for some reason, he was forced to sell the house a week later for the same price, he would carry an ongoing debt to the bank. But during housing bubbles, house prices never go down, of course. A mortgage holder could always sell for a higher price. Housing bubbles occurred in the sixties and seventies as well, but back then house prices could in theory fall 40% before a mortgage holder would be underwater on a sale.
While the current GFC is realistically testament to the entire developed world’s insatiable hunger for debt, the US subprime crisis is considered the trigger. The bubble was surely confirmed when mortgage brokers started rolling out the now infamous “Ninja” loans – no income, no job, no assets. But even at the level of what are considered “prime” mortgages – those with full documentation and creditworthiness – LVRs were still stretched over the 100% mark. Were the housing bubble to burst, latecomers to the party would start their homeownership experience underwater from Day One. As US house prices fell and fell, one by one the buyers of earlier years were sent into the red. If forced to sell, they would still owe the bank.
The advent of cheap and high LVR loans perpetuated the bubble, but thus also guaranteed the big drop on the other side. Even prime mortgage holders were jumping over themselves to sell lest they end up with a net debt. The snowball had begun, and on the other side of the equation unemployment began to rise. House prices do not like rising unemployment.
In the US, 50%, or some US$5-6 trillion worth of mortgages, were on issue by the “government sponsored” entities of Fannie Mae and Freddie Mac. To understand these bizarre creatures, see Fannie And Freddie Who? published last July. Despite only being permitted to issue “prime” mortgages, by last July Fannie and Freddie were themselves set to go under. The Bush Administration was forced to act. While it may have been considered a “moral hazard” under the tenets of capitalism, the Republican Administration ultimately stepped in and provided up to US$100bn to each entity as a guarantee, in return for a preferred stockholding. Fannie and Freddie were deemed simply “too big to fail”. The Administration tried to spin the deal as assistance, but it was nationalisation by any other name. And this all occurred even before Lehman Bros went under.
It also occurred a good 12 months after the beginnings of the subprime crisis – a crisis which rapidly removed other lenders from the mortgage space and forced commercial banks to pull down the lending shutters. In this vacuum, the underfunded (by government permission) Fannie and Freddie went ahead and sold up to 70% of new mortgages in the collapsing market. In a sense, this was seen as providing stimulus, but it also sent the two to the wall. In August last year, the CEO’s of both (listed) companies were taken out and shot.
The Obama Administration has inherited ownership of Fannie and Freddie. When the Bush Administration had nationalised the two (in a rather unprecedented move within the “lame duck” period), President Bush also announced as part of developing stimulus that the Administration would “encourage” banks to renegotiate impaired loans with mortgage holders.
Encourage.
It’s no great leap of logic to realise nothing came of this request. Pretty soon, in the process of cutting its funds rate to zero, the US Federal Reserve was forced to itself buy mortgage securities – with freshly printed dollars – in an attempt to turn back the tide. When the subprime crisis hit, your average US 30-year prime mortgage rate was around 6%, with a cash rate of 5.25%. The Fed dropped the cash rate to zero, but until it stepped directly into the market mortgage rates remained little less than 6%. Eventually they were to fall to around 4.5% as the Fed threw more and more at the problem, but printed money has recently caused inflation fears, sent US bonds yields higher, and thus sent mortgage rates on the upswing once more.
Something more still needed to be done.
The whole point of massive US stimulus is to prevent the collapse of the US economy. Critics steadfastly decree that the economy should be allowed to collapse, but no one disagrees with the ramifications that would follow. The Fed, the previous Bush Administration and the present Obama Administration have all worked on the principle that the snowball of collapse must first be halted before the root of the problem can be addressed. It was up to the authorities to “catch the falling knife” (pardon my mixing metaphors).
Under government management, it has been Fannie and Freddie – owner of more than half of all US mortgages – which has led the charge on loan renegotiation and refinancing. There are many ways more manageable terms can be introduced on a mortgage. A bank might simply write-off part of the value of the loan to bring the LVR into line, given they would rather keep a mortgage holder afloat than try to sell on foreclosure in a collapsing housing market. Another way is to extend the duration of a mortgage, thus reducing the annual interest payment. All things being equal, a mortgage holder could simply refinance a 6% fixed loan at 4.5%, but that’s not the sort of relief that’s going to save everyone. At the end of the day, lenders can simply refinance by lending more money.
And that’s what Fannie and Freddie are going to do. Last night it was announced the government-run bodies would increase their LVRs on refinance from 105% to 125%.
In order to issue a mortgage, a bank holds the house as collateral against the loan. Once upon a time it would require a cash deposit as well, yet still lay claim over the full value of the house. In the sixties, if you lost your job and the bank foreclosed on your mortgage, the bank had a 40% buffer before it would actually lose money. In refinancing a mortgage, there is no logical reason why a bank would lend any more than the house is deemed to be worth. In a falling market, surely that would be suicide.
So if a mortgage holder bought a house for US$625,000 on a US$625,000 loan, but that house is now worth US$500,000, then one would not expect a bank to provide refinancing for any more than the US$500,000 it assumes the house to be worth. Yet the way is now open for Fannie and Freddie (ie the US government) to lend US$625,000 on a house worth (at least count) US$500,000.
The idea, of course, is one of catching that falling knife again. A re-fi of only the new, lower value of the house is not going to help the struggling mortgage holder. Such re-fis would not stop house prices from falling. The only way to stop house prices from falling is to lend as much as the mortgage holder needs at a cheaper price. The desperate hope thereafter is that house prices would stop falling and begin to rise again.
Under the new scenario, a refinanced mortgage holder will need to see a 25% bounce in house prices before he’s even back to breakeven. And remember, the Case-Shiller index indicates US house prices have fallen a net 33% from their peak (obviously some states, such as Florida and California, have been hit hardest). For that index to return to its peak level, house prices must rise 43%.
Similarly, if you receive a 125% re-fi and that takes you back to the original value of your house, your house can only have fallen 20% in value.
And the trade-off for this new deal? Mortgage holders will be “encouraged” to take a 25-year loan instead of the usual 30-year.
I mentioned early that Australia’s Big Four banks had copped criticism for being too eager to lend on mortgages once the government started handing out grants. The response has been for Australian banks to start reeling in their LVRs – back to 95%, 90% or less – so as not to provide a mortgage to someone with only government support as a deposit. Another step has been to require a deposit of some degree that is not represented only by the government’s largesse. In other words, mortgage applicants must legitimately have savings in the bank, or a guarantee from a parent, or some such. The reasoning is a fear that such lending only sets up the unsuspecting and wide-eyed young first home buyer (one who may never have been able to afford a house otherwise) for financial difficulty down the track, particularly as first unemployment, and later the RBA cash rate, rise.
In the US however, the story is the other way around. While it seems apparent that the world is still prepared to continue lending money to the world’s largest and most indebted economy (buying Treasury bonds) it thus seems apparent the US government sees no danger in simply printing more and more money and fostering the growth of more and more debt. When will it all end?
Are we setting up for another, bigger, GFC some time in the future?
