Wisest of the crowds

I keep getting asked what will happen to home prices with the Federal Reserve lowering rates to banks. The question implies:

1. What is the relationship of cost of money to prices?
2. Can we identify trends and/or turning points based on this macro-economic variable?

The sub-prime crisis was not born of a real change in cost of money. Rather, it folded under its own weight as artificial borrowing conditions expired and came head-on with artificially inflated home prices. The recovery, on the other hand, may very well be born of a change in cost of money (at least the Fed Reserve is hoping as much).

I believe the past relationship of cost of money and prices is fairly strong and so we should probably consider it. However, the mortgage market is based on long-term MARKET rates (5 year, 10 year, and 30 year US Treasuries) and not DIRECTLY related to the short-term cost of money. Having said that, banks typically borrow short-term and lend long-term and so decreases in their short-term borrowing costs generally will lower mortgage rates - particularly if they WANT TO BE COMPETITIVE. Recently they have not wanted to lend and so lower rates just means increased banking profits. In essence, the Fed is using rates to improve the capitalization of banks. This will eventually flow back into the economy and hence to mortgage borrowers but the immediate impact is less clear.

The National Association of Realtors reported that their “Pending Home Sales Index” for July fell to its lowest level since the post Sept. 11, 2001 period as a result of tightening credit for Jumbo mortgage loans (loans over $417,000).

So what is this index? Directly from the NAR release:

“The Pending Home Sales Index is based on a large national sample, typically representing about 20 percent of transactions for existing-home sales. In developing the model for the index, it was demonstrated that the level of monthly sales-contract activity from 2001 through 2004 parallels the level of closed existing-home sales in the following two months. “

It seems that Three Stooges of the mortgage ecosystem, lenders (Curly), Wall Street mortgage underwriters (Moe), and mortgage buyers (Larry) all woke up after a night of drinking and decided never again (well, at least for a few weeks!) ! These Jumbo loans are NOT purchased by the quasi-government agencies Fannie Mae or Freddie Mac whose job it is to purchase loans from lenders so that lenders have the funds to make more loans - a mechanism to facilitate home ownership for average and lower income home buyers. Jumbo loans do not qualify so they must be either held by lenders or sold to investors via wall street. Since Fannie and Freddie have continued to support loans at the low-end while the high-end has lost free market support, Jumbo’s have shut down for the minority and have gotten MUCH more expensive for the majority. Not surprisingly, the Western part of the US, which has the highest home prices and presumably the most Jumbo loans, got hit hardest being down a whopping 20.8% to 82.3 versus 89.9 nationally.

Will this last? No way. This is a temporary disruption as people reorient their perspective to risk. Will the cost of jumbo’s (as a spread to treasury securities) increase? You can bet on it!

A couple of things I read this weekend are reinforcing something that I have been thinking about the contrasts of old-school business models and (the promise) of new school businesses. I don’t want to quibble about who is “old” and who is “new” but I guess the test is this: “Do you make a truthful promise to your customer?” Take at a look at theses facts, as an example, below:

- 50% of sub-prime borrowers could have qualified for prime rates, according to Fannie Mae

- “Yield Service Premiums” (kickbacks from lenders to mortgage brokers) are present in 85-90% of sub-prime loans.

- US Dept of Housing and Development estimates that 1 in 9 middle income and 1 in 14 upper income families have sub-primes

Are you kidding? As my kids would say “Sheezamageezza!”

This is old school businesses doing its thing of false promises (of their product or service) and lies (not disclosing dangers or conflicts of interest). Someone posing as an “agent” to a mortgage consumer “advises” that a specific product is “best” and the naive consumer accepts this as fact. Even corroboration with another mortgage broker may not yield substantially better terms because, well, the incentives are the same. The “agent” can sell 6.5% loan and make $3,000 or the 9.5% loan and make $15,000. Easy choice for the “agent”.

The issue is this: consumers are directly or implicitly promised one thing and given another. Bait and switch. Unfortunately, false promises are devastating people everywhere - like in the in sub-prime loan sector. Sadly this isn’t new - this is how business has been done forever and this still happens everyday. Think about all those commercials for processed food claiming to be healthy. This cereal or that snack bar. What do you think when you see this?

The company’s website says “symbols of quality, great taste, and nutrition”. Yet if you look into the ingredients you will see:

Its all crap yet somehow people trust that Quaker is a trusted source of nutrition. The brand promise is improved health and the delivery is poor health. The mortgage broker category promise is best rates and the delivery is, for some, the worst rates. False promises and lies - everywhere.

The business people I meet everyday don’t conspire against consumers but rather are reacting to and responding to duplicitous commercial behavior. This is a market response that will win - eventually.

Interestingly there are others looking at this as well. One the one side are those, like Greg Swann in this wordy post, that believe that regulation should be replaced with personal responsibility and free market solutions as it relates to, for example, real estate agents.

On the other hand, there are those like Elizabeth Warren, a Professor of Law at Harvard Law School, that make an argument for more regulation in a post entitled “Unsafe at Any Rate” referencing the dangers of various consumer financial products and services.

Swann makes the argument that there should be no licensing requirements for real estate agents and that the industry is using regulations to benefit themselves rather than consumers. I agree that the there is a false promise made to consumers with the agent “licensing” scheme but am undecided if removing licensing makes sense for the very same reason that the sub-prime market is a mess - consumer ignorance and bad actors (although not necessarily illegal actors) yield substantial problems. Matters of health and safety are basically the governments job and so just where the lines of safety end is very debatable. Should financial safety be elevated to bodily safety?

Warren thinks so. Her argument is basically that consumers are subjected to too much complexity - complexity meant to trick consumers or keep them ignorant. For example, most people need not scrutinize consumer products at an engineering level because the government sets saftey guidelines and requires clear saftey disclosures. Yet for financial products it is essentially caveat emptor. Consumers must do the equivelant of engineering (and law) to understand the products they are buying and the risks that they are taking. Adding conflicts of interest, common in the mortgage brokerage and payday businesses, makes consumers that much more vulnerable.

The free market rebuttal to Warren is that a market solution will evetually emerge, which I agree with, but the issue really is how many people must suffer in the interim? How many false promises and lies must people endure before a market solution kicks in? What is an acceptable casualty rate?

Kenneth Harney pens another interesting piece entitled How ’systematic inattention’ led to subprime fiasco. My favorite line:

Ninety percent of the appraisers in a 2006 national survey by October Research Corp. said they had experienced threats, nonpayment of fees and other forms of coercion. Many said they had lost business by refusing to play the game.

Harney also details a few scams worth a read but perhaps the key point is that the commercial incentives of banks and other intermediaries are wrecking havoc on the reputations of appraisers. Is it time to re-examine incentives and better structure the industry? Should buyers hire appraisers rather than bankers and agents? I discussed this earlier here.

Will CFC (Country Wide Financial) be a reasonable indicator that the sub-prime market is truly spilling over to the whole housing market? If you believe that the markets are the best aggregators of information and are forward looking, then keep your eye on the stock. It looks like a break of $30 dollars a share could indicate that investors believe that the housing landscape is still working its way through the mess and that the much discussed resetting of ARM’s may get uglier. This, in the context of a broad consensus that the Federal Reserve will lower fed funds - hence making ARM’s cheaper - is a staggering thought. Take a look at the chart below to get a sense of how well CFC has done over the last 8 years.