HomeEconomics

A journey into Main Street economics.

Changes coming soon…

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It’s been a while since I made a post here, but we’ll be back in action in 2010 with more content than before. I’m hoping to get this moved to a new domain to give me more freedom in designing the site and adding additional content, so stay tuned.

In the meanwhile, let’s look back at a couple of old entries and see what the latest developments are:

Time To Get Short: “My opening strategy: Find 3X long ETF’s and buy OTM LEAP puts. I’ll average down every month that the Dow and S&P stay above current levels and roll into longer maturities if these levels are sustained through Q1 ‘10.”

Status: Right now, about break-even. I brought some Jan ’11 puts on FAS (3x Financials) the day after this post, October 15th, and the S&P closed at 1,096 on that day. S&P now stands at 1,110 as I write this….. but this is where the magic of this play comes in…

10/15: FAS @ 91.96…. Russell 1000 Financials @ 817.26

12/15: FAS @ 70.81 (-23%)…. Russell 1000 Financials @ 755.92 (-7.5%)

As long as markets continue to track sideways, this position is faring well. I’m maintaining delta despite losing time premium and waiting for the inevitable volatility spike in 2010 to increase my option’s value. I’m hoping to add to this position in Q1 ’10 and maybe expand to some Jan ’12 puts.

House Hearing on FHA Capital Reserves:

“Because of the inherent risk involved with exiting the market completely, I’d be in favor of the following changes to protect the taxpayer against risk:

1. Raising downpayment requirements from 3.5% to 5% for loan values above the local median home price.

2. Lowering the loan limits to 125% of the local median home price, up to $417,000 in high-cost areas.

3. Increasing UFMIP from 1.75% to 2% in a declining market.”

Status: Apparently the FHA is taking this issue somewhat seriously and is exploring raising UFMIP and the amount needed to close (not necessarily downpayment as some have reported). However, without #2 in the above list I’m not sure what these steps accomplish other than taking more reserve money from their alleged target market (low-income borrowers). This simply confirms that FHA loans are the new middle-class product. One thing I do expect is for higher downpayment and UFMIP to have a negative impact on home prices in 2010 and 2011 as home buyer leverage is reduced.

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Written by Myron

12/15/2009 at 2:05 PM

Posted in Uncategorized

Existing Home Prices Drop 1.5% in September

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NAR just announced that the median existing home price fell 1.5% to $174,900 in September. Sales grew much faster than expected due to the first-time homebuyer tax credit, but this will likely be the highest sales pace for the year due to expiration of the credit and seasonal factors.

Is this the start of the next leg down? Sure looks like it to me.

Written by Myron

10/23/2009 at 10:07 AM

Posted in Real Estate

Tagged with , , ,

Time To Get Short

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I’m finally convinced that this mini-bull bounce is nearing its end.

Every major index is nearing critical resistance, the Fed’s treasury buyback program has reached its $300B limit, commercial paper markets have deteriorated even further since late ’08 despite this rally, unemployment hasn’t shown any signs of turning the corner, the Fed is talking about raising rates, and most importantly… the lack of “panic” in equity markets and housing has convinced many members of the public and Congress that it is time to worry about the public debt instead of more stimulus. Sentiment is far too positive and I’m about as contrarian as it gets, so now is the time to move.

If the Fed and treasury buyback programs end as scheduled, then I’m simply not convinced that other entities are going to completely fill those gaps.

I’ll dedicate some time later to explain in detail why this rally is soon coming to an end, but for now I’ll be buying puts and biding my time.

My opening strategy: Find 3X long ETF’s and buy OTM LEAP puts. I’ll average down every month that the Dow and S&P stay above current levels and roll into longer maturities if these levels are sustained through Q1 ’10.

There are some steals to be had out there in the leveraged ETF market. Just don’t go long any of these as the short-end (short position, not short ETF) always presents the most upside. If we end up going sideways from here as I expect (look at a Nikkei chart from ’92-99) then any shorts against leveraged long products should slowly gain in value. I’ll talk about some of the more attractive options in that market soon.

Tomorrow morning is going to be huge so I think I’ll take some smaller positions before the news releases and re-examine the situation after the market opens. Markets can remain irrational for a long time, especially backed by trillions of dollars, so don’t translate this as calling a top to the market. I just can’t see much upside from here unless dollar weakness is what’s driving the market.

Written by Myron

10/14/2009 at 10:52 AM

Buying A Home In Today’s Market: Reduce Your Risk Exposure

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So you’ve read all of the headlines about how “now is the time to buy” and you see the “For Sale” signs up at some nice looking houses on every block at prices you couldn’t have dreamed of just 2-3 years ago… you can’t let this opportunity pass you by. What’s the catch?

Well, to start with, judging affordability based on a comparison to past prices is a huge mistake. The mainstream media has been trying to convince the American public that a home should not be viewed as an investment but instead as a shelter. That theory works fine for the married household with children who intend on staying in their home for the full term of their mortgage, but unfortunately that is not who homes are being marketed to in today’s market. Today’s home buyer is either an investor or first-time home buyer in the majority of markets. Of these first-time home buyers, many are buying with the intent to stay in this home for the next 5-10 years instead of 15-30 years. Why are these buyers being told that now is the time to buy?

The fact is this: Buying a home IS AN INVESTMENT and it is likely the most important investment that the typical household will make in their lifetime.

Why? Let’s take a look at a few qualified households who are buying homes this month before the FTHB tax credit expires. For the purposes of this exercise, the following assumptions apply to all households:

  • Household income: $100,000
  • Monthly debt obligations: $1,000
  • Cash available for downpayment: $40,000
  • Location: High-cost metropolitan area (>$200,000 median price)
  • Household size: Two adults, both with incomes, and no children
  • Expected occupation of the home: 7 years
  • Property tax rate: 1%
  • HOA fees: $200/mo
  • Closing costs: Paid by seller
  • Qualifying credit score: 690

Household A

Household A has dreams of luxury and wants to get as much house as they can possibly qualify for with a fixed 30 year term, but don’t want their cash tied up in home equity. Household A chooses a 30-yr fixed FHA-insured mortgage at 5.00% interest and elects to pay the minimum 3.5% downpayment. If we qualify them at 31% front-end (PITI) and 43% back-end (DTI), which is the FHA standard, then here is a quick summary of this borrower and their obligations:

  • Maximum monthly payment at 31% PITI: $2,583
  • Maximum monthly payment at 43% DTI: $2,583
  • Sales price: $364,000
  • Downpayment (3.5% FHA): $12,740
  • UFMIP (1.75% FHA): $6,147
  • Loan amount: $357,407
  • Real/effective LTV: 98.2%
  • Monthly PITI: $2,583
  • Cash remaining as reserves: $27,260 (10.5 months)

Household B

Household B is fiscally conservative and believe that they have saved enough for a decent home in a “rough” neighborhood, but hope to upgrade in 7 years to put their children in a district with better schools. Household B chooses a 30-yr fixed conventional mortgage at 4.75% interest and elects to pay a 10% downpayment. If we qualify them at 28% front-end (PITI) and 36% back-end (DTI), which is the conventional standard, then here is a quick summary of this borrower and their obligations:

  • Maximum monthly payment at 28% PITI: $2,333
  • Maximum monthly payment at 36% DTI: $2,000
  • Sales price: $250,000
  • Downpayment (10% Conv.): $25,000
  • Loan amount: $225,000
  • Real/effective LTV: 90.0%
  • Monthly PITI: $1,675
  • Cash remaining as reserves: $15,000 (9 months)

Based on the facts above, we should expect Household B to be the more reliable and responsible borrower. I’m here to say that’s true, but it doesn’t make their decision to buy a home much better than Household A.

So let’s examine a scenario where home prices fall 20% over the next 7 years and each of the above homeowners would like to sell their home to take advantage of the now lower home prices and get more bang for their buck:

Household A: $364,000 sales price – 20% = $291,200

Household B: $250,000 sales price – 20% = $200,000

Household A had $27,260 remaining after the purchase of their home. Adding in the $8,000 tax credit gives them $35,260 in cash after closing. After 7 years, they now owe $314,321 in principal. This means that Household A needs to come out-of-pocket with $23,121 just to sell their home and walk away. This does not include the 6% ($17,472) they will need to pay agents to sell the home, which raises their out-of-pocket total to $40,593. In order for Household A to sell their home and purchase a comparable home at market value for 3.5% down, they will need to have saved an additional $15,525 over the 7 years they lived in their current home. At that point, they would have $0 remaining in savings. Household A has no choice but to remain in their current home and hope that home values rise again substantially over the next few years.

Household B had $15,000 remaining after the purchase of their home. Adding in the $8,000 tax credit gives them $23,000 in cash after closing. After 7 years, they now owe $196,855 in principal. Household B could sell their home and walk away with $3,145 from the sale. However, add in the 6% ($12,000) to pay agents to sell the home and now they must come out-of-pocket with $8,855 to walk away from their home. In order for Household B to sell their home and purchase a comparable home at market value for 3.5% down, they will need to take $15,855 from their savings. That leaves Household B with $7,145 from their original cash after closing plus any additional savings over the 7 years they lived in their current home. Household B would have saved $76,272 more than Household A over 7 years in their respective homes due to having a much lower PITI payment. This savings would likely be enough for Household B to purchase a new home on the market in a better school district for their children.

Household B look like the winners in this one, right? Well that depends on how you look at it. In pure dollars and cents, Household B is the winner. They should clearly have enough money saved to purchase the home they desire. On the downside, however, they sacrificed their safety and quality of life for 7 years and lost $50,000 in equity from the purchase and sale of their first home. The last part of that needs to be repeated… $50,000 lost.  I don’t know any successful investor who would pride themselves on such an investment.

Specifically here is the return on invesment for Household B:

$25,000 initial investment + $28,145 lifetime principal paid = $53,145 in equity – $50,000 loss = $3,145 return = -94% return on investment

Negative 94%!

I’d like to propose an alternate choice to Households A and B that most real estate professionals will never tell you about. I’d argue that now is the PERFECT time to buy a home if you’re brave enough and do your education on the investment products I’m going to mention below. If you aren’t familiar with trading in futures and are still interested in the following strategy, then please contact a professional to handle the execution of this strategy.

Household C

Household C knows that the housing market may not be at a bottom, but is afraid that interest rates will skyrocket in the next few years as inflation heats up. Household C believes that high interest rates will likely ruin their chances to live in the neighborhoods they prefer even if house prices are 10-20% lower. Household C is also afraid that house prices may drop too low and force them to sell their home at a huge loss. Household C chooses a 30-yr fixed FHA-insured mortgage at 5.00% interest and elects to pay the minimum 3.5% downpayment. If we qualify them at 31% front-end (PITI) and 43% back-end (DTI), which is the FHA standard, then here is a quick summary of this borrower and their obligations:

  • Maximum monthly payment at 31% PITI: $2,583
  • Maximum monthly payment at 43% DTI: $2,583
  • Sales price: $364,000
  • Downpayment (3.5% FHA): $12,740
  • UFMIP (1.75% FHA): $6,147
  • Loan amount: $357,407
  • Real/effective LTV: 98.2%
  • Monthly PITI: $2,583
  • Cash remaining as reserves: $27,260 (10.5 months)

Based on the above, you’re probably saying to yourself… Household C looks just like Household A, how is this any better?

Well, Household C made the decision to sell S&P Case-Shiller Index futures contracts equal to the value of their home. We’ll examine how this impacts their potential returns below.

Before we get into the technical details of this strategy, let’s discuss what these contracts do. A basic understanding of investing in futures and hedging strategy is assumed here, but for those who need an introduction I’ll place a few links here to get you started:

I’ll repeat this one last time: Do not attempt to execute this strategy on your own unless you have advanced knowledge and experience in futures trading!

S&P Case-Shiller Housing Futures are based on the Case-Shiller Home Price Indexes developed by the economists Karl Case and Robert Shiller. I won’t bore you all with the methodology behind the indexes, but these house price indexes are used to show the changes in house prices for single-family homes that have been sold more than once. They have separate indexes for condominiums, but we won’t discuss those in this post. If you’ve heard in the news that house prices have fallen x% in the last month or year, then it is very likely that they are referencing the data from these indexes. I’d advise anyone to go to the MacroMarkets site to learn more about these widely used home price indexes.

Back to the strategy: How does this impact a potential home buyer? If home prices fall 50% in the next 3 years, then that means these housing indexes will fall 50% in the next 3 years. It also means you’ve lost 50% of the value of your home. The futures products based on these indexes were designed to protect investors and home builders against the risk of volatile home prices by hedging the value of their property against these housing indexes. One of the less publicized purposes of these products was to protect home owners from losses on their homes.

The Case-Shiller Composite Index (Symbol:CUS) for July ’09 is at 155.85 (data is released with a two-month lag). One CUS futures contract is worth $250 times the value of the index, or $38,962 based on current data. The margin required to trade and carry one contract is $1,350.

Example

Let’s take the case of a home owner in Las Vegas where prices are in free fall. They bought at $200,000 before the housing boom and their home is now worth the same as what they bought for. They don’t want to risk losing any more equity and want to downsize to another home in about 2 years. This home owner could sell 6 Nov ’11 CUS futures contracts, currently trading at 149.20 and therefore worth $223,800, which would require at least $8,100 in margin to be placed into a trading account. If house prices fell 20% over the next two years from the current 155.85 index value, then those Nov ’11 futures contracts would be trading at approximately 125 points at expiration. This home owner would have made a profit of $36,300 on his trade and lost $40,000 in home value, thus leaving the home owner with a net loss of $3,700 in the two year period.

Let’s look at the flip side of that trade and say that the home owner incorrectly judged the market and house prices rose 20% over the next two years. Those same Nov ’11 futures contracts would be trading at 187 points leaving the home owner with a loss of $56,700 on his trade and a gain of $40,000 in home value. This same home owner now has a net loss of $16,700 in the two year period.

Some people are probably saying to themselves, how is this good if they lost money in both scenarios?

Well, this is all about eliminating downside risk.

If home prices fall 20%, then they lose $40,000 in home equity. That number is more than 10 times the loss in the hedged scenario.

If home prices rise 20%, then they lose $16,700 in the trade. That number is still less than half of the loss in the scenario where house prices fall.

This home owner was solely concerned with preservation of capital and reducing risk and that goal was accomplished with the above trade.

Household C (continued)

Back to our brave first-time home buyer Household C. They are concerned with home prices falling in the next 2-3 years and plan to sell their home within 7 years. Instead of trading illiquid futures contracts that expire in 7 years, Household C decides to sell Nov ’12 contracts (trading at 150) and will re-examine the housing market at that point to determine if additional risk management is necessary. Household C will need to sell 10 contracts (worth $37,500 each) to fully cover their purchase price of $364,000. This will require Homeowner C to place $13,500 in margin into a trading account, plus an appropriate cushion for additional margin in case the trade begins to go in the opposite direction.

Let’s look at a few hypothetical scenarios to see how Household C’s decision could turn out:

  1. Home prices drop 30% from now until Nov ’12: Contracts close at 109, profit of $102,500, home value loss of $109,200, now worth $254,800 = Net loss of $6,700
  2. Home prices drop 20% from now until Nov ’12: Contracts close at 124.60, profit of $63,500, home value loss of $72,800, now worth $291,200 = Net loss of $9,300
  3. Home prices drop 10% from now until Nov ’12: Contracts close at 140.20, profit of $24,500, home value loss of $36,400, now worth $327,600 = Net loss of $11,900
  4. Home prices remain the same from now until Nov ’12: Contracts close at 155.85, loss of $14,625, home value gain/loss of $0, now worth $364,000 = Net loss of $14,625
  5. Home prices gain 10% from now until Nov ’12: Contracts close at 171.40, loss of $53,500, home value gain of $36,400, now worth $400,400 = Net loss of $17,100
  6. Home prices gain 20% from now until Nov ’12: Contracts close at 187, loss of $92,500, home value gain of $72,800, now worth $436,800 = Net loss of $19,700

As you can see, this scenario benefits Household C the most when prices drop the most. In the cases where home prices gain by a substantial amount, they will be required to hold a large amount of money in the account to serve as margin against unrealized losses. But hidden among these simple calculations of profit and loss is the fact that they have been paying down their loan balance for 3 years and will have the same low 5% interest rate on their mortgage. The impact of this is enormous as we’ll show below.

If this home owner bought at $364,000 and the home value dropped by 20%, then they have a $63,400 profit from their trade and a $9,300 loss from the hedge. This home owner can then put all of the profits from the trade into a payment of principal on the mortgage which would bring their outstanding loan balance down to $276,866 in December 2012. This home owner now has $14,344 in home equity and the principal per mortgage payment has risen from $497 to $765 due to the huge extra payment. Household C planned to sell their home in 7 years and will have an outstanding balance of $237,238 at that point. In other words, house prices would have to fall an additional 19% from Nov ’12 to Nov ’16 in order for them to have to come out-of-pocket when they sold their home.  Household C could simply elect to open a new futures hedge to protect their equity if house prices were still in sharp decline.

Renting vs. Buying and Hedging

Comparing the above approach to the renting approach shows that renting is not necessarily a more attractive option to those who have the cash available to fully hedge their position. The monthly price to rent ratio is currently around 1.2, but we’ll round down and say that it would cost 75% of the PITI to rent a similar home. In this case, Household C would have paid $1,937/mo to rent the same home they bought. That translates into a $23,256 total savings due to housing expenses from today to Nov ’12 for the renter. Let’s say that housing prices are near a bottom in 2012 and the renter decides that it is finally an excellent time to buy. They could buy the same home at $291,200 and put 20% down ($58,240), but interest rates are likely to be much higher than they are today. We’re going to use 7.5% as the 30-year fixed rate which puts the PITI at $2,072/mo, a savings of $511/mo versus Household C.

This new home owner would have an outstanding loan balance of $223,317 in Nov ’16. Remember that Household C had an outstanding balance of $237,238, however the new home owner put $58,240 into the home as a downpayment while Household C only put $12,740 down.

Here are the areas where the renter has the advantage:

  • Renter’s savings from Nov ’09 to Nov ’12: $23,256
  • Renter’s savings in PITI from Nov ’12 to Nov ’16: $24,528
  • Renter’s outstanding loan balance improvement on Nov ’16: $13,921

TOTAL: $61,705

Here are the areas where Household C has the advantage:

  • Amount saved on downpayment: $45,500
  • Tax savings from Nov ’09 to Nov ’12 at 25% tax bracket: $13,107
  • First-time home buyer tax credit: $8,000

TOTAL: $66,607

As you can see, Household C has actually saved $5,000 more than the renter.

In addition, Household C is paying $926 per month towards principal while the renter pays only $232 in principal. This difference of $694 is greater than the $511 in PITI savings that the renter enjoys and the gap only grows larger as time goes on because Household C is further along in the amortization schedule and enjoys a lower interest rate. Moving the sales date back two years to 2018 would increase Household C’s principal balance by an additional $23,427 while the renter’s balance would only increase $6,017. Household C would have their mortgage paid in full in June 2031 while the renter wouldn’t have their mortgage paid in full until November 2042. This 11.5 year difference also displays the benefits to the buy and hedge strategy for the first-time home buyer who intends to occupy their new residence for a longer period of time.

Here are the amortization schedules for each approach:

Yearly Amortization for Rent and Buy

Yearly Amortization for Rent and Buy

Yearly Amortization for Buy and Hedge

Yearly Amortization for Buy and Hedge

Conclusion

Buying a home in today’s market is extremely risky for those who are putting their faith in the housing market’s recovery. The examples of Household A and Household B have shown the potential downside to any buyer who hopes to take advantage of this year’s advertised “low prices” while the market is still declining. This leaves only three legitimate options, in my opinion, for a potential first-time home buyer right now.

  1. Buy at a reasonable debt-to-income ratio with the intention of holding the home beyond the duration of the mortgage.
  2. Buy and hedge as discussed in this article.
  3. Rent, save your money, and wait it out if the potential risks outweigh the rewards of home ownership.

I don’t have statistics to back up this claim, but I’m fairly certain that most first-time home buyers are not considering option #1 since the days of living in the same home for an entire lifetime are long gone. Option #3 is the most responsible choice for most potential first-time home buyers today. Home prices are going to fall this winter and are projected by nearly everyone to fall through 2010. Perhaps a better deal can be had sometime in the next 2-4 years if sound fundamentals return to the housing market.

Option #2 would be my choice. It requires a more carefully planned approach to home ownership, but the risks are contained and the potential rewards far outweigh those in options #1 and #3. Another element of this strategy that I enjoy is the lack of volatility in the Case-Shiller futures contracts. Unlike most leveraged derivative investments, this trade has an extremely low chance of incurring a margin call within a span of minutes, hours, or even days. Therefore, this hedging strategy will require very little monitoring on a day-to-day basis and should be very hands-off as long as a conservative margin strategy is employed. There is no historical precedent for house prices rising or falling 10% in a single month and the largest recorded monthly change in the CSI was the 2.8% drop in Feb ’08. The largest yearly home price increase recorded in U.S. history was 24.1% in 1946 while the largest decrease was 18.3% in 2008 based on Robert Shiller’s research into home prices dating back to 1890. Based on this data, I’d advise keeping a cash balance in the trading account to cover a 5% move against your position ($34,106 in the example given for Household C). If house prices show a strong and sustained move to the upside accompanied by signs of a stabilizing economy (lower unemployment, higher wages, etc.), then the housing market is likely in the recovery process and the hedge can be closed. Closing the trade at the right time (aka calling the bottom) will result in the greatest reward from this strategy, but the conservative household should simply keep the hedge active for as long as the housing market is questionable to protect their equity. Calling market bottoms is more often than not a matter of luck than skill and shouldn’t be the basis of any investment strategy.

I’ve argued against the FHA’s weak downpayment requirements, but those downpayment requirements don’t hurt home buyers directly. Instead they hurt home buyers indirectly by propping up home prices that would otherwise fall. They also hurt the taxpayer as described in previous posts. Getting a home with 3.5% down can be a blessing for a lot of home buyers, especially ones who intend on owning their homes for a lifetime or have a risk management strategy in place. Now is indeed a great opportunity for those who are smart enough and have enough cash to take advantage, but not in the way that the mainstream media is pushing. Do your research before using any of the strategies mentioned in this post. This is not intended for the average American household, but hopefully this gives readers one more option to consider when buying a home in today’s rough market.

Written by Myron

10/12/2009 at 1:00 AM

The Week Ahead: 10/12 – 10/16

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Monday, October 12

Tuesday, October 13

  • Tentative: Federal Budget Balance for Sept.

Wednesday, October 14

  • 8:30 AM – Import and Export Prices for Sept.
  • 8:30 AM – Retail Sales for Sept.
  • 10:00 AM – Business Inventories for Aug.
  • ~2:00 PM – FOMC Minutes from Sept. 23 Meeting

Thursday, October 15

  • 8:30 AM – Initial Jobless Claims for week ending 10/10
  • 8:30 AM – Continuing Jobless Claims for week ending 10/3
  • 8:30 AM – CPI and Core CPI for Sept.
  • 8:30 AM – Empire State Manufacturing Index for Oct.
  • 10:00 AM – Philadelphia Fed Business Outlook Survey for Oct.
  • 10:30 AM – Natural Gas Storage for week ending 10/9
  • 1:00 PM – Crude Inventories for week ending 10/9

Friday, October 16

  • 9:00 AM – Net Long-Term TIC Flows for Aug.
  • 9:15 AM – Capacity Utilization and Industrial Production for Sept.
  • 9:55 AM – Prelimimary Michigan Consumer Sentiment Index for Oct.
  • 9:55 AM – Preliminary Michigan Inflation Expectations for Oct.

My Take

We get off to a slow start this week with a holiday, but have some very important data released in the latter half of the week. Thursday morning is the highlight of the week as either the jobless data or CPI could have a huge impact on all markets.

Things will get very interesting if we get a huge jump in CPI and the inflation concerns start growing at the Fed. The number one question right now in the U.S. economy is deflation or inflation. We’ll be one data point closer to answering that question after this week. Bond market action at the end of last week shows that inflation is a growing concern.

In the equity markets, we get earnings reports this week from Intel, Johnson & Johnson, JPMorgan Chase, Goldman Sachs, IBM, Bank of America, and GE. Obviously a lot of attention will be paid to the bank earnings and I don’t expect any bad news from them since they have been given every opportunity to turn risk-free profits for the past 12 months.

Written by Myron

10/12/2009 at 12:43 AM

Education in America

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NY Times columnist and economist Paul Krugman published an article today titled The Uneducated American which discusses the disappointing and deteriorating level of education in the United States.

I’d advise people to read the article for themselves as it touches on the huge issue of weak state and local government budgets which will likely hurt public education nationwide.

But what bothers me about this article and much of the recent campaigning from the Obama administration about stressing education is that they all seem to tiptoe around the huge issues.

Issue #1: Advanced education has indebted the public to levels which make it unrealistic for low-middle class families to afford college education for their children, thus creating a never-ending generational cycle of debt.

Issue #2: How can a government and economy completely dependent on the ignorance of its own people stress the value of a REAL education? Entirely too much of the material taught in public school systems and institutions is based upon the philosophies and theories of those in control instead of teaching a wider spectrum of theory. In some cases students are given books which twist the truth of historical events so much as to alter our “reality” and perceptions of right and wrong.

The typical high school graduate, for example, has no idea about the devastating effects on the U.S. during FDR’s presidency, the warnings against central banking from America’s founding fathers, the governing structure of the Federal Reserve, the true causes of the American Revolution, Lincoln’s disinterest in abolition of slavery, and many other very important events that shaped the country we live in. Based on my experiences, not many college graduates even have a grasp on much of the above list despite the various economics classes taught. I’m no history expert either, so I’m not completely immune to the above analysis.

Issue #2b: The privatization of education and the exploitation of media. For the purposes of this exercise, let’s remove the actual names of the leading colleges, universities, television networks, and newspapers. Look at the founders, executives, board members, and financiers of these operations and suddenly we’re looking at the same short list of families and inner circles from the banking and monopolized industrial companies of the 1900’s. Most of the names have changed as time has passed, but the founding principles remain the same. In other words, we only hear what a concentrated group of elitists want us to hear.

I’m all for capitalism and believe in diversification across industries and the building of generational wealth, but not when it results in the consolidation of control over a large population and the eventual destruction of human freedom. Before we blame the usual suspects for the problems in education though, why not look within?

Why do so many people today feel the need for third-party confirmation of intelligence? Why do so many people today run up hundreds of thousands of dollars in debt to pay for an education in a field that they never actually work in?

The answer, in my opinion, is that the American public has lost their sense of intellectual freedom. We refuse to educate ourselves about the fundamentals before seeking the advanced teachings of an expert. We refuse to believe in any individual theoretical or philosophical elements without simultaneously believing in the entirety of its creator’s theory or philosophy. We refuse to speak openly about controversial issues for fear of political correctness. We refuse to challenge the concepts taught in our education system. We refuse to stand up and take control of our own success as a country, but instead simply vote for the most charismatic lobbyist to think and act for us.

With all of the above, how does anyone expect education in America to be thriving? Perhaps this is why there is such a huge disconnect in American sentiment between us and the rest of the world. I don’t have the answer and I doubt anyone does, but hopefully the Internet and future technological advances help to further intellectual freedoms instead of stifle them as certain interested parties would like to see.

Written by Myron

10/09/2009 at 12:26 PM

Posted in Off-Topic

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House Hearing on FHA Capital Reserves

with 3 comments

A panel of economists and real estate industry executives spoke this evening at 2 p.m. about the state of FHA’s capital reserves and the implications of the current housing crisis on the future of FHA policy.

Here is a link to the webcast and prepared testimony: http://www.house.gov/apps/list/hearing/financialsvcs_dem/scmhr_100809.shtml

There have been varying opinions on the significance of the FHA’s announcement that they expect to fall below their 2% reserve limit in the near future, but the one thing that is acknowledged by nearly everyone is the need to mitigate risk given the current economic environment.

One thing that has consistently irked me throughout this housing debacle is how blatantly people employed or subsidized by NAR, NAHB, and MBA have falsely sold the public on the idea that everything is going to be alright and things will be back to normal very soon. It’s also becoming more apparent that the real estate industry as a whole fully believes this propaganda and the public hasn’t seemed to raise even an eyebrow at how counter-intuitive some of this jibberish actually is.

First, let’s start with some blasts from the past:

This annotated housing price chart was created by the blog “Lawrence Yun Watch“, a blog devoted to exposing the absurd propaganda vomited upon the American public by the Chief Economist and Senior Vice President of Research at the National Association of Realtors.

More quotes from a late 2007 interview with Yun (before he was promoted to Chief Economist… I sure wish I could completely fail at my job and get a promotion)

I’ll leave it to the reader to examine the accuracy of those statements and predictions made by the hypeman for NAR, but because this post is not about him in particular I’d instead like to focus on one passage from that 2007 interview:

RM:But what about all those subprime borrowers? Many of these are the first-time borrowers who helped fuel the growth we saw in home sales over the last few years. What are the options for them?

Yun: We certainly won’t see the number of subprime borrowers that we saw during the boom. But borrowers who can’t qualify for prime loans will still have options, particularly if we see enactment of reforms to the FHA that NAR has been championing. The FHA has historically been the safe and affordable financing option for these borrowers. Largely because it comes with a lot of red tape and lacks a big choice in products, lenders rushed to fill the void with their much-riskier subprime loans. So a reformed FHA can go a long way to returning moderate-income and first-time borrowers to the market.

The real estate industry’s “championing” efforts are a large part of the reason that FHA’s market share continues to rise in the face of the worst housing environment since the Great Depression. There can be no doubt from the above comment that NAR’s intentions were for the FHA to help replace the collapsing supply of non-prime mortgage loans since private insurers wanted no part of that market as long as their survival depended upon risk management. The risk to the taxpayer grows greater as long as this trend continues.

Let’s now move on to the prepared testimony for today’s hearing and extract some interesting comments. There is a lot of testimony, so I’ll focus on the few that interested me the most. Everyone should read the full testimony from all participants at the link above. The fun begins here (bolded passages are marked by me for emphasis):

Testimony of The Honorable David Stevens, Assistant Secretary for Housing and Federal Housing Administration Commissioner, U.S. Department of Housing and Urban Development

“A report released by the Federal Reserve last Wednesday, October 1, 2009 states:
Beginning in the early part of 2008, PMI companies started limiting their issuance of PMI insurance and raising prices because of rising claims and binding capital restrictions in certain states. As a consequence, Fannie Mae and Freddie Mac substantially reduced their purchases of loans with loan-to-value ratios (LTV) above 80 percent, which by statute require PMI (or other credit enhancement). Both GSEs [Fannie Mae and Freddie Mac] also raised their credit guarantee fees for such loans at this time as well.
These actions taken by PMIs and GSEs in reaction to losses on their historical portfolios have led to FHA-insured loans becoming relatively cheaper and more accessible to borrowers, compared to PMI-insured loans than they were during the boom. FHA’s increased market share is a result of this countercyclical market dynamic and not in itself a reflection of the riskiness or lack thereof of newly insured loans.

Calling mass risk aversion a “countercyclical market dynamic” is completely dismissive of the factors that led to the current situation and shows a surprising disconnect from the fundamentals of the insurance business. Insurance premiums are by design a product of implied risk. This is the reason that flood insurance has higher premiums in coastal areas, life insurance is more costly for the elderly, and auto insurance premiums lower as driving experience increases.

Therefore, it should be easy to determine that rising premiums indicate an elevated level of implied risk by the market. Options traders know this implied risk or volatility as beta and the increasing use of options pricing models in the private insurance industry is a testament to the accuracy of the approach. A business which ignores this implied risk and continues to price premiums at the same rate will have a portfolio that is exposed to greater implied volatility.

FHA market share growth is indeed cyclical as Mr. Stevens suggests, but that is largely due to their implied government guarantee which has resulted in complacency with regards to proper risk valuation. This valuation gap is exposed in times of economic crisis when implied volatility rises and FHA premiums remain cheap in comparison to the rest of the market. This business model does serve to assist demand in housing, but it is not something that any private enterprise would pride themselves on and it can actually hurt home buyers by artificially inflating house prices in times where default risk is elevated.

The bottom line here is that the increase in FHA market share is directly correlated with the decrease in private market share for insurance on non-prime loans. That correlation is not coincidental, but instead is a reflection of how FHA insurance has become the new preferred product for those seeking similar risk to what was seen during the housing boom.

“Today, FHA is critical to the recovery of the housing market for both existing and new homeowners. FHA’s single-family purchase-loan portfolio is currently 80 percent first-time homebuyers, of which 27 percent are minorities. FHA provides opportunities for first-time homebuyers who have good credit histories but may not have a large downpayment to purchase homes, which has a stabilizing effect on home values.

The first sentence explains how the FHA is critical to “homeowners”, NOT home buyers, because home owners stand to benefit far more from the “stabilizing effect on home values” which protects their equity. Home buyers simply want to purchase an affordable home, not buy into an artificially inflated market. Interventionist policies and programs generally have a poor track record and usually come back to hurt those they were intended to benefit in the long run. First-time home buyers, as I described in this post, are advertised to be the primary beneficiaries of these programs intended to derail true price discovery but will end up paying the greatest price.

“The primary reason for this increase in dedicated loss reserves is a new home price forecast produced by IHS Global Insight, which is one component used by the actuarial firm to project future losses, which shows the bottom of the market delayed from 2009 to 2010, and reflects an additional 8.4 percent price decline in the US Single Family housing market.

This was the real eye-opener for me in this testimony. Numerous economists who correctly predicted the collapse of the housing bubble have predicted far greater losses than 8.4% from current levels and nearly all economists have acknowledged that rising foreclosures and inventory pose significant risks to housing price stability in 2010. How can a reserve budget be based upon only a 8.4% decrease, which is one of the more optimistic forecasts that I’ve seen to date? But this is only the beginning… this same forecast model from IHS Global Insight predicts a return to the peak of bubble prices as soon as 2015. This chart below is the visual representation of an asset bubble.

IHS Global Insight Aug09 Home Price Forecast

“The drop in the capital reserve ratio below two percent is anticipated to be for a relatively short period of time and the ratio is expected to return above two percent within the next two to three years, on its own, even if FHA were to make no policy changes at all. The current drop in the capital ratio in no way indicates that FHA is at risk of needing an immediate capital infusion as it currently holds more than $30 billion in total reserves. To the extent that FHA’s newly insured MMI loans are expected to earn revenues in excess of expected losses on a present value basis further strengthens its capital position as new mortgage insurance premiums will continue to add to FHA’s reserves.”

This short-term revenue injection is a direct result of taking a larger market share and therefore increased UFMIPs.  It seems that they are primarily concerned with short-term results based on optimistic projections instead of planning for an adverse scenario. Foreclosure rates will almost certainly rise as FHA’s newly insured loans mature and that will be the period of potential crisis depending on how well the economy has rebounded, if at all.

“As newly insured loans are being underwritten at or close to the bottom of housing prices, there is potentially lower risk that housing values of these new loans will become underwater in the future.”

This is called averaging down… how Kerviel-esque of them! Great if it works… disastrous if it doesn’t. I fail to see how this is much different than selling a naked put option on housing prices and that would truly be a risky endeavor in today’s market.

Despite my disagreement with a lot of this testimony, there were some positive developments that I’ll point out:

“On September 18, 2009, FHA announced that it will be appointing a Chief Risk Officer, for the first time in FHA’s history.”

A long overdue move and hopefully a very risk-averse person is given the position.

“FHA’s appraisal validity period will be reduced to four months for all properties including existing, proposed and new construction.”

This along with the crackdown on cherry-picked appraisers should help mitigate some of the risk exposure when housing prices become volatile.

Testimony of Mr. Edward Pinto, Real Estate Financial Services Consultant

“My purpose in testifying today is to advise you of the growing fiscal crisis facing the Federal Housing Administration (the FHA). Many witnesses over the years have made repeated warnings to this and other congressional committees. By my testifying today, this subcommittee will not be able to say that no one told them of the magnitude of the impending losses at FHA.”

Ouch… not exactly the first thing you want to hear.

He follows up with this chart detailing the rising trend in foreclosure starts for FHA mortgages that precedes even this mortgage crisis.

FHA Foreclosure Start Ratio

“There is no amount of insurance premium that is sufficient to cover the losses incurred by deliberately insuring loans based on poor underwriting standards”

Now here is one place where I’ll disagree with Mr. Pinto. FHA underwriting standards may not be excellent, but they are certainly not poor or very similar to the UW standards seen in the bubble years from the private side. The FHA requires full documentation in all cases and that one step alone removes a lot of the fraud from the system.

Next, he drops the hammer with a startling prediction:

“Back to FHA – I believe it appears destined for a taxpayer bailout in the next 24-36 months”

I’ve already addressed why I don’t believe failure will come that soon for the FHA, but it’s certainly possible if prices plummet beyond their predicted 8%  and/or the employment situation deteriorates faster than expected.

Mr. Pinto states the reasons for this prediction along with many supporting statistics, but I’ll quickly summarize the few that caught my eye:

  • The FHA and VA now account for over 90% of all loans with 90%+ LTV (high-LTV) being made
  • “Total high LTV lending in the first half of 2009 was equal to 23% of all originations by all lenders. It was only 17% of originations in 2006, a year notorious for its high risk lending”
  • At the end of Q1 ’09, the average equity of all homeowners with a mortgage in the U.S. was only 10% (lowest level ever recorded)
  • FHA’s default rate for loans originated within last 24 months: 5.73%
  • For the month of August, four lenders were responsible for 85% of all FHA loans added: Wells Fargo, Bank of America, Chase, and Citi

Let’s go back to Bernanke’s quote earlier this month: “I think it is undeniable that the FHA loans, because of a low downpayment, are riskier than other mortgages made”. So the question must be asked… Why are 90% of the risky mortgages guaranteed by the government? Clearly this is not in the best interest of the American public, yet all we continue to hear is that the FHA is saving the day for the common American. Sure there are certain low-income households who need some assistance to become homeowners, but they aren’t going to be getting a $700,000 home at 3.5% down. Government entities or agencies stepping in to help the economy in perilous times is not a problem, but when they risk the taxpayer’s dollars to the tune of tens of billions of dollars it becomes hard to justify the decision as beneficial to the nation as a whole. I’m not going to go into much detail about who benefits the most from this economic backstop, but their names are listed above and they are some of the same ones that have been on the winning side of every legislative decision and and economic stimulus package for the past 24 months.

He finishes by giving the following suggestions to possibly avert a crisis for the FHA:

1. Raise the minimum FHA downpayment on purchases to 10% with reduced seller concessions.
2. Limit FHA volume of low downpayment loans to a 5-10% market share.
3. Reduce FHA max loan limits to a level commensurate with low and moderate income housing
4. Establish a coinsurance requirement of 10% for FHA lenders and raise capital requirements.

1. Raise the minimum FHA downpayment on purchases to 10% with reduced seller concessions.

2. Limit FHA volume of low downpayment loans to a 5-10% market share.

3. Reduce FHA max loan limits to a level commensurate with low and moderate income housing

4. Establish a coinsurance requirement of 10% for FHA lenders and raise capital requirements.

I’m not a huge fan of hard limits across the board for #1 and #2 because the FHA’s mission of helping low and moderate income households is something that can help a lot of Americans get their foot in the door. I am, however, in support of the logic behind these suggestions. There should clearly be higher downpayment requirements for higher loan values and such a tiered approach would reduce exposure to the high-LTV market throughout the financial industry until private firms have adjusted their risk pricing models to reflect a stable economy. As for #3, I’m fully supportive of this suggestion. It shouldn’t be possible for banks to give someone a government guaranteed mortgage for $700,000 with only a $25,000 downpayment. It is perhaps even more ridiculous that there is aggressive campaigning by Senator Dodd (can we get this guy out of office already?) and others to have these loan limits permanently extended for all GSE’s and FHA. Lastly, I can’t see the bankers accepting the first part of suggestion #4, although it would help, and the second part won’t matter as proven by the fact that the vast majority of FHA volume is generated by the “too big to fail” entities.

The Numbers Game

Now on to the numbers behind this potential FHA crisis:

FHA reserves stand at approximately $30 billion.

The FHA’s single-family portfolio of 5.8 million loans is $725 billion. ($125,000 per loan)

According to Mr. Pinto, Fannie Mae’s high-LTV defaults are averaging around a 50% loss of principal. It does seem, as he suggests, that it is safe to assume similar results for FHA defaults.

Therefore my basic math says that the FHA can withstand about 480,000 foreclosures before the reserves hit the zero boundary and the “full credit” clause of the government guarantee kicks in. The Q2 ’09 OCC and OTS Mortgage Metrics Report from the Treasury tells us that government guaranteed mortgages, of which FHA accounts for 77 percent, had 93,231 foreclosures in process, 194,934 defaults (90 days delinquent), and another 161,684 seriously delinquent loans (60-89 days or bankruptcies). If we just assume again that 50% of these 90 day defaulted mortgages are foreclosed upon then that brings us to 190,698 total loans to be foreclosed upon in the immediate future. 77% of that should be a fair estimate of the FHA’s share which would be 146,837 foreclosures.

Add that number to the 5.73% rate of default for loans originated in the last 24 months by the FHA (928,000 annual rate reported in May 2009 for FHA loans x 2 years = 1.856 million). Multiplying 1,856,000 x 0.0573 gives us another 106,348 foreclosures.

A rough estimate of 253,185 likely foreclosures based on the 90-day default and foreclosure in progress data from 4-5 months ago doesn’t bode well for the FHA reserves in the near future. The number of foreclosures and the unemployment rate have both continued to rise since Q2 ’09 and house prices are destined to fall again this winter due to seasonal factors alone. The FHA would need a truly immaculate turnaround for the American economy and the housing market to avoid depleting their reserves at this pace. It would be even better if the FHA and our government would instead dare to be proactive in reducing this risk instead of simply crossing their fingers and hoping for an improbable recovery in the near future.

Conclusion

The implications for the real estate industry are huge if the FHA does decide to reduce its risk in the markets. I’m in favor of them reducing market share in such rough economic times, especially in the jumbo and >95% LTV markets, but the FHA could quickly dig their own grave by reducing risk too quickly. If the FHA decided to dramatically cut market share then house prices could plummet for a second time which would increase their current book risk and potentially lead to an even greater loss than if they had stood pat. Such an exit strategy would have to be carefully planned and executed in a similar fashion to the massive stimulus plans of central banks.

Because of the inherent risk involved with exiting the market completely, I’d be in favor of the following changes to protect the taxpayer against risk:

1. Raising downpayment requirements from 3.5% to 5% for loan values above the local median home price.

2. Lowering the loan limits to 125% of the local median home price, up to $417,000 in high-cost areas.

3. Increasing UFMIP from 1.75% to 2% in a declining market.

Hopefully someone wakes up and starts doing something to protect us from another bailout before it is too late, but as Mr. Pinto said… it’s not as if there was no warning.

Written by Myron

10/08/2009 at 11:21 PM