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Today's Market WrapUp 04.13.2007 Mon Tue Wed Thu Fri Pretti Archive Jumping the Fire
Lines? I’ll try to keep this discussion relatively short, as there are more than a good number of charts to wade through that clearly tell a story. I’ve spilled far too much digital ink and have spent far too many hours writing about housing and mortgage credit for some time now. Important if you believe, as I do, that we are running on a credit cycle, not a traditional business cycle. Well, we’re finally starting to see a number of credit market chickens looking for roosting perches, if you will. And what has been a bit of a surprise, even to myself, is the speed with which change has occurred in certain pockets of the credit market over the past few months. It goes without saying that sub prime is essentially a poster child for this abruptness of deterioration phenomenon. But with the announcement by American Home Mortgage last week of a severe earnings shortfall, we have to anticipate that the fire in the world of sub prime lending has now jumped the fire lines and is smoldering in the woods of Alt-A mortgage credit. So much for mortgage credit problems ultimately being “contained” to the world of sub-prime. Stepping back just a bit, I believe the much larger conceptual issue of importance here is credit availability, plain and simple. How else could private equity deals currently be getting done in what have otherwise been considered very cyclical industries such as semiconductors or possibly one of the largest chemical companies on the planet if not for ease of credit availability? How could hedge funds lever at multiples of equity, and then be levered again inside fund of funds vehicles if not for ease of credit availability? And in this process we see rhyming in terms of how assets are being levered. In the world of mortgages, credits were sliced, diced and sold to investors, generating big fees for those “repackaging” and marketing these credits. In private equity deals, newly created corporate leverage is again often sliced up into collateralized obligations, once again generating big fees for those “repackaging” and marketing these credits. See the pattern? As you know, many financial services providers, to use a characterization, have a huge vested interest in keeping the macro leveraging game going, regardless of market or economic sector it touches at any point in time. Again, without sounding overly simplistic, it’s all about credit availability and the collateral that supports those credits. But now, the collateral in the land of mortgage credit is turning dark, just as will ultimately be the case when levered up private equity deals hit a meaningful economic downturn accompanied by cash flow contraction. But that’s a story for tomorrow. Today, it’s about the changing nature of mortgage credit availability. I want to spend the rest of this discussion quickly looking at the most recent mortgage refi data. Why? Because at least in terms of the most recent data, we’re still seeing a good number of extremes that will surely change as we move ahead. Admittedly this is 4Q 2006 data at present, and you know that most of the damage in sub prime occurred this year, as will damage in Alt-A credit availability if indeed American Home turns out to be the proverbial canary in the coal mine for Alt-A credit paper. What seems set to specifically change that is indeed important to the consumer driven US economy is the complexion of cash out refi trends. One would have thought that, with stagnant housing price appreciation really over the last year or so, households would have stopped cashing in on cash out refi loans. But as always, it’s a mistake to underestimate the determination of the US consumer to continue doing what they do best – borrowing and spending...at least for now. Let’s get directly to the data that is largely self explanatory in terms of still painting the picture of extremes. Right off the bat, in 4Q of last year, 84% of all refi's were cash out refi's resulting in a loan at least 5% greater than the loan being refied away. Important, though, is current context relative to the greater cycle. Just have a look at where we are relative to historical experience in the chart below. Every single time we have been at these levels and have declined as part of the overall cycle, we've hit the 35% cash out area as the cycle bottomed. If that's to be the case again moving forward, there's a whole heck of a lot of cash that's not going to come out of residential real estate equity and into the general consumer based economy ahead. It’s fair to suggest we've just seen a very important peak in this trend. And if this is to be the case, the risk in terms of mortgage debt finding less and less of its way into consumption lies ahead of us, not behind. So when will we ultimately hit the bottom of the cash out refi cycle if we're now at the top? As the chart below screams at you in its own historical tone of voice, years. Again, suggesting that the worst is behind is at the moment in terms of mortgage credit fall out vis-à-vis the real economy seems sheer ignorance (of history, at least).
Important to keep in mind as you look at the chart above is the chart below. Also as of the end of 4Q 2006, equity as a percentage of the market value of US residential real estate hit yet another new recorded history low. This has to be comforting to homeowners as well as mortgage lenders everywhere, right?
Although it may sound a bit hard to believe, the median appreciation of refied property in 4Q of last year was 28%. That's a big number set against current housing cycle circumstances. We won't drag you through another series of home price appreciation charts as you already know that year over year price changes are anywhere from subdued to negative. Just where did the 28% appreciation come from? Of course the answer to that question is simple and also opens up yet another important macro economic question about what lies ahead. The average age of property refied in 4Q of last year was 3.4 years. As we move forward, we already know that homes purchased or refied in the last year or two have very little to no appreciation. We truly have to step back a good number of years now to see point-to-point appreciation. So here's what is important in terms of the longer term trends. First, have a look at the following chart.
At the prior peaks of mortgage cash out refi experience in the late 1980’s/early ‘90’s and in 2000, only those who had either been in their homes for ever longer periods of time or had not refied for longer and longer periods of time were able to refinance. We're seeing exactly the same thing right now. And what do both of these prior periods have in common with the present? They were directly in front of official US recessions. Could we be approaching something similar at the moment? The dominoes of historical experience simply keep stacking up one by one. Of course the consensus keeps dismissing each one on a singular basis as opposed to having a good look at the whole stack. As always, watching the trees as opposed to the forest. We all know that there are still one heck of a lot of folks that are going to have to refi their mortgages in the 12-24 months ahead, or be faced with coughing up much higher nominal monthly payments as interest rate resets occur. All of the ARM's written years back are coming home to roost and the numbers have changed in a big way in terms of financing costs. In fact, we live in the aftermath of one of the greater mortgage financing anomalies ever seen in recent times. Historically, when conventional mortgage interest rates have been low, use of ARM debt collapsed, as it should have done, and vice versa. But crazily enough, with conventional mortgage interest rates from 2004-2006 at what were close to the lowest levels of a generation, over one third of all mortgages written were adjustable. The long-standing correlation between the level of conventional mortgage financing costs and ARM usage simply collapsed. Were these folks who took on ARM's during generation lows in conventional financing costs simply brain dead or idiots? Maybe a few, but for most it was a necessity in terms of establishing affordable monthly payments given that prices had inflated well beyond reason. In other words, prices were simply too far out of hand for most to qualify under conventional terms. Unfortunately, now it's time to pay the piper for this breakdown in what had been the longstanding relationship between ARM usage and mortgage rates. And the recent blow up in sub prime will make it all the tougher for many an ARM holder to avoid what will be a meaningful upward reset in nominal dollar monthly payments. If deterioration in Alt-A mortgage credit availability spreads meaningfully, I believe this problem starts to compound exponentially. This lies ahead, not behind. Again, what is "the worst is behind us" cheerleading squad smoking? The next chart is cash out dollars as a percentage of the new refied loan in 4Q. So, okay, here's the important deal; we know that average appreciation of homes refied in 2006 was about 28% (as mentioned above). And we know from the data below that the cash out dollars as a percentage of the new refied loan in 2006 was also quite near 28%. Get the picture? As hard as this is for even me to believe, is it really the case that almost all of the existing appreciation in homes refied in 2006 was simply borrowed away one more time? Unbelievable. If this isn't the case as per the data, then what is? This says either US homeowners who refied in 2006 are extremely confident about their financial futures by levering up anew in a meaningful manner, or we are looking at a good bit of financial desperation on the part of US households. It sure seems it's either one of the two. Which do you think it is?
As you know, the pattern of financial behavior for so many US households has been to refi the house every "x" years and in that process pay off (refi) the interim build up in credit card debt, auto loans, etc. So, as we move forward and assume not a heck of a lot of price appreciation in residential real estate to come, the question becomes what happens next when folks can't easily refi or roll all of the ever ongoing build up in card and car debt that was once so easy to make disappear into yet another new home loan? Perhaps the most thought provoking chart of this entire series is the last one that lies below. It's the refi cash out dollars we've seen each year, as per the official data, as a percentage of the year over year change in total disposable household income. In '05 we were clocking in near 85% and last year near 70%. That's a huge amount of "extra" household liquidity relative to ongoing income generation. For many, it had to seem like getting a 70-86% "raise" for each year. Once again, the important issue is what lies ahead? If this supercharging of household liquidity (which is really an acceleration in leverage) seen in 2005 and 2006, and more broadly really since 2001, dissipates in a big way as we move forward, do you expect households to rush right out and spend more on consumer goods, or perhaps pull back on the spending reigns just a bit? Seems pretty darn self-obvious, now doesn't it?
As the data clearly show us, the cyclical reconciliation in mortgage credit borrowing has not yet been felt in the broader US economy. The process appears to be just beginning right now as per the longer term trends we've presented. Secondly, we already know this process is now beginning at exactly the same time broader mortgage credit availability is tightening. Moreover, depending on how zealous financial regulators may become in terms of handcuffing mortgage lending practices in the US ahead, the credit tightening here could really be quite the sight to behold, making an already bad situation even worse. But, as you know, at least according to the script of history, this is one thing government regulators seem to do extremely well and extremely consistently over time. Will it be so again? Finally, mortgage credit excess of the last few years and really decade to date has delivered extremes in terms of nominal dollars extracted from residential real estate equity values in addition to dollars extracted relative to alternative sources of income to US households. On so many fronts it appears that the mortgage credit acceleration game as an important force in the US economy during this decade is coming to a dramatic conclusion. Remember, it’s all about credit availability…until it’s no longer available, of course. Many moons ago, Ray DeVoe penned a thought that liquidity is a coward. There’s always too much when it's least needed, but it’s never around when needed most. Are we again learning this lesson as per the current mortgage credit cycle? And will we be treated to further lessons when the magnitude and multiplicity of current private equity financings (borrowings) ultimately meet up with the next macro economic contraction? It’s a very good bet. Brian Pretti Copyright © 2007 All rights reserved. CONTACT
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