Rabu, 26 September 2012

The housing market deal of a lifetime

This chart of the yield on current coupon FNMA collateral and 10-yr Treasury yields, and the spread between the two, is good evidence that the Fed has finally managed to distort market pricing. MBS spreads are now almost zero—implying that FNMA MBS are as rock-solid and as attractive as Treasuries. Which of course they aren't. Mortgage-backed securities have nasty characteristics that Treasuries don't: when yields fall, their duration shortens (because homeowners can prepay their mortgages), and when yields rise, their duration extends (nobody will ever want to prepay a 30-yr mortgage with a 3% rate). That's called negative convexity, and that's one big reason why MBS yields are almost always higher than Treasury yields. Investors require an extra yield on MBS to compensate for their erratic cash flow risk. Not to mention, of course, that they don't have an explicit U.S. government guarantee.

If MBS spreads remain near zero, then 30-yr fixed rate conforming mortgages (orange line in the first chart above) could fall to 2.25%. (Over the past 15 years, the average spread between FNMA collateral and 30-yr conforming mortgages has been about 60 bps, which when added to today's 10-yr yield of 1.62%, gives you an idea of just how low conforming mortgage rates could go.) At that outstanding, almost unimaginable level, everyone who doesn't own a home should be willing to stand in line outside a bank for however long it takes to qualify for a mortgage, and then turn around and buy just about any home on the market. The Fed has succeeded in creating the housing market's biggest "blue plate special" of all time. Come and get it! A once in a lifetime opportunity to lock up unbelievably low fixed-rate financing and buy a home at a price that's not going to last much longer.

The one thing standing in the way of what should be a stampede of new home buyers is that it's not so easy to qualify for a loan. Banks have been loaded to the gills with reserves, and thus able to make an almost unlimited number of new loans, but they haven't—because they are still very risk-averse. You need 20% down to qualify, and your credit scores need to be good, and your employment solid. Not everyone can qualify, and many can't.

Regardless, this is a situation that can't last for very long. When market prices are distorted artificially, powerful arbitrage forces are set in motion. Large institutional investors are going to want to sell their MBS holdings at what could be record-setting high prices. Yields going forward are paltry, downside risk is enormous, and upside potential is extremely limited. The Fed's promise to buy $40 billion per month of MBS could be swamped by the decision of money managers to lighten up on their MBS holdings, which are measured in the many trillions of dollars. In other words, the big decline in MBS yields could quickly reverse, because the Fed can't permanently distort the yield on a market that is many trillions of dollars in size by buying a paltry $40 billion per month.

Meanwhile, those who can get loans are going to be putting that money to work in the housing market, and that's one reason why prices are firming in many parts of the country. The new mentality: buy now, before prices go higher. (Banks with tons of REO on their books will be thinking: no rush to sell now, maybe prices will go higher. Homeowners who are currently underwater will be thinking: maybe I can hold out a little bit longer and things will get better. It all adds up to less selling pressure and more buying pressure and the outcome can only be higher prices.)

And of course, banks are at some point going to be relaxing their lending standards. If they don't do it on their own initiative, then you can bet some politician is going to figure out a way to force them to. There is a precedent for this sort of thing in the U.S., after all, and that's one reason we got the housing market bubble.

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