Conflict of Visions: Housing Market Reform and Recovery

Dan Alpert at Westwood Capital just published a hopeful report on the housing market — but optimism here is relative. Hope is defined as a recovery after the next dip. Below is the summary from his report:

Beyond the Double-Dip in Home Prices: The Future of Housing Demand and Pricing
Dan Alpert/Westwood Capital
February 7, 2011

With last week’s release of Q4 Housing Vacancy Survey by the Census Bureau and prior week’s release of the November S&P Case Shiller Index data, two things are clear: i the housing market is in the midst of what will be at least a several quarters long, double-dip in home prices as the final act in the five-year tragedy of residential real estate price re-rationalization and ii it is time to look beyond this final stage, to the future of housing demand as excess inventories are slowly absorbed.

We believe that the final leg of price adjustments can be expected to be over by the end of this year and will result in price declines to a level that is between 5% and 8% below the lows of April 2009 to a Case Shiller 20 City Index reading of between 125 and 130, as we have published previously.

The final fall to a level of sustainable home pricing is the result of continued supply/demand imbalances and a buildup of properties in the foreclosure pipeline. The demand for new homes, however, is more impacted by the continued existence of an outsized unutilized vacant housing inventory (the vestiges of the overbuilding during the middle of the past decade) and the dramatically reduced levels of net household formation caused by the Great Recession, than it is by price.

Based on a continuation of the pace of new home construction in 2010 and modest recovery in net household formation (as well as other assumptions set forth herein), we expect that the current excess vacant unutilized inventory of approximately 1.4 million housing units will have a substantially lower impact on pricing levels by 2012 and should be reduced to absolute zero within approximately 2.5 years. We see a slightly more favorable situation in demand for new owner occupied housing than we do for rentals beginning in the second half this year with residential construction seeing a substantial recovery, overall, in spring of 2012.

There are, however, potentially more positive factors set forth in this report that should be taken into account with regard to the likely pace of absorption of the excess housing units created during the bubble period particularly with respect to owner occupied homes. Our recent experience in studying the housing industry also shows us that, even though our medium-term macroeconomic view of the U.S. economy maintains a slow deflationary bias, the development of new housing units will recover without much regard to generalized levels of wage and price changes, as residential land, building materials and construction labor costs are, and will remain, very elastic in the absence of the renewal of excessive and irresponsible mortgage lending (although we expect required loan-to-value ratios on most mortgages to remain at conservative levels).

Since March of 2007, when we first sounded the alarm bells on the length and depth of the then-impending housing crisis, we have been identified as housing bears. We believe we were more realistic than bearish, and while others were assuming that the housing market had stabilized in mid-2010, we were not declaring victory over a massively dislocated market. Nonetheless, there is light at the end of the long tunnel of housing price retrenchment and we see emergence out of the darkness following this final year of the Great Re-pricing.

Dan’s views on housing always get our attention. Like many folks on the Buy Side, he does the work to parse reality from fiction, measured in dollars and cents. In relative terms, the community of large and small funds are advocates of truth vs. the large banks and regulators, who benefit from obfuscation and lies. Whether your issue is valuation or inflation, the Buy Side community is ultimately focused on reality while the Sell Side dealers are focused on appearances. But at least there is money involved.

But when we turn our attention to Washington and the supposed debate over the mortgage industry, GSE reform and especially new standards for selling and servicing mortgages to investors, the picture becomes muddy and vague. Part of the reason, of course, is that few people inside the Beltway actually understand the mortgage market — especially as it exists today as opposed to how we’d like it to be in a perfect world. Part of the issue in terms of clarity comes because the participants are horribly conflicted and almost never actually feel the effects of their decisions.

Chuck Gabriel at CapitalAlpha Partners notes that the Obama Administration is preparing to propose a gradual shrinkage of the housing GSEs to below 50% market share, a proposal that is “more prescriptive than expected regarding the Obama administration’s goal of transitioning away from reliance on federally-backed mortgage financing.” But one of the things we emphasize to our friends on all sides of the housing reform debate now shaping up in Washington is that we need to begin the dialog with a sober assessment of where the secondary market for selling and/or guaranteeing homes loans is today.

If you inspect the recent earnings disclosure from the largest US banks, what you find is that 99% or more of new residential loan originations are going into either FHA, Fannie Mae or Freddie Mac subsidized risk buckets. There is minimal private mortgage origination and private securitizations are non-existent, thus one wonders about the happy atmosphere at the Asset Securitization Forum Convention in Orlando. What’s more, even though the overall mortgage loan market continues to shrink, the balance sheets of Fannie and Freddie are growing, especially loans held for the portfolio. In the case of Fannie, to over $400 billion at Q3 2010 vs. $250 billion at the end of 2009. The defaulted loans are held at cost, BTW.

Much of this increase in the size of Fannie’s balance sheet is repurchased defaulted loans from securitization trusts, grim evidence of the generosity of Secretary Geithner in letting Bank of America (NYSE:BAC, Q3 2010 Stress Rating: “C”) off the hook for mere single digit billions in terms of loan repurchase liabilities. The taxpayer will have to pay the cost of this gift to BAC shareholders, with interest. But excluding this inflow of financial detrius, the balance sheets of the zombie GSEs would be shrinking on ebbing industry new loan origination volume. The run-off from existing RMBS portfolios is so brisk, we hear in the servicing channel, that a prolonged drop in new origination volumes could see the mortgage sector shrink dramatically in 2011 and 2012, this as loan repurchase volumes hopefully slow.

The funny part is that the largest banks are still selling all of their production, just so that the bank can purchase the same paper in the RMBS market for portfolio. One part of the mortgage department of BAC originates the loan, another sells pools of loans to Fannie or Freddie or purchases guarantees for private placements, and then the BAC treasury goes into the market and buys RMBS for the portfolio. And these different part of the largest servicer of mortgages in the US never speak to one another. This example just begins to describe some of the wonderful efficiencies in the US mortgage sector cartel that includes the GSEs, BAC and the other large banks.

But the more important point to make to the GSE refomistas in Congress is our favorite warning: Be careful what you wish for when it comes to “privatizing” the housing sector, especially now. Today the rump of the private label mortgage market is collapsing onto the GSE market, plain and simple. Speaking in Orlando at the ASF conference Monday, Rep. Scott Garrett (R-NJ), vowed to reduce the role of government in the mortgage sector. If you can imagine the guarantee fees for the GSEs doubling as apparently proposed under the Geithner and various GOP reform plans, this implies a shrinkage in the available supply of home credit that is truly horrendous. And you can kiss that 2012 housing market recovery goodbye as well.

Likewise if we follow the conservative plan to run off the retained portfolio and allow the GSEs to “whiter away,” to use the Leninist imagery, then this also implies a dramatic shrinkage in the supply of credit — shrinkage that may render inoperative the cautiously upbeat scenarios such as the excerpt from Westwood Capital above. We are all in favor of “reform,” don’t be mistaken. Like we said, just be careful what you wish for.

OR as one very senior investment banker told us some months ago, the first task in reforming the housing sector is to find somebody at some price willing to take the first loss positions in these theoretical privatizations of RMBS. Once we have that conversation, then all of these discussions about shrinking Fannie and Freddie start to take on some credibility — especially if we really want the US housing market to stabilize next year.

Chris Whalen was Wall St. Cheat Sheet’s Top Banking Analyst in 2009 and the co-founder of Institutional Risk Analytics.

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