Housing and the Future of GSE's

* Yesterday’s drop in Pending Home Sales (PHS), which is reported by the National Association of Realtors, showed a 30% month over month drop to an all time low. This reading is even lower than the low from last year, when the stock market was making a low. (See the attached graph). Of course, this probably has more to do with an expiration of the Home Buyers Tax Credit (HBTC), than anything else. You will notice that PHS dropped dramatically in early 2010, after the first round of tax credits for First Time Home buyers expired. The drop in May goes a lot lower than what was seen earlier this year. While we can site reasons for the dramatic drop, it does give us an idea as to what might be yet to come. The tax credits have been useful devices to pull sales into the months right before these credits expire, but at what cost? A new version of the HBTC has passed by the House with an resounding 409-5 vote in favor. And this will likely forestall the a total collapse in the housing market, but not prevent it.


* Moving onto more fun topics, we have the topic about what to do with GNMA, FNMA and FHLMC, the GSE’s which are now providing 90% of all mortgage financing in this country, ostensibly with government guarantees. So far, the GSE losses add up to $150 billion, with various estimates suggesting that this number will rise to $400 billion. Everyone in Congress says we need to address the issue of what to do about the GSE’s, yet no one will take the heat of what might happen if the GSE’s disappear. There is talk about using the GSE’s as a platform for securitizing mortgage debt, and to then let Wall Street price out the credit and interest rate risk components. The problem is that if you did that, who knows how much of a risk premium the market would put on underwriting that risk. And even if you found counterparties to underwrite those risks, who is to say that those counterparties would be there to stand up to the losses over the course of a 30 year mortgages life?


If you think the HBTC is a waste of money, then what do you think about the GSE’s? The bottom line is that government programs to support housing have been part of the landscape since 1938, and I am not sure how easily the GSE’s can be dismantled. Perhaps the government can come up with a program to insert a layer of credit support between the government backed mortgage backed securities, and the owners of the securities backed by these mortgages. Here is how such a program might work:



1>  The Home Buyer pays 5% interest rate


2>  The mortgage originator keeps 0.5%, of which 0.25% goes into a reserve account to be held as a reserve against potential future losses, and 0.25% they keep;


3>  Mortgage insurers take an additional 0.25%, in exchange for an insurance carve-out against 2% of losses on the pool of loans they have written insurance against. 


4>  The GSE’s keep 0.25%, as an insurance premium for the government, which is the ultimate guarantor. 


5>  The originator is left with a 4% coupon, which is then converted into a MBS pass-through, with the government guarantee.


This might sound like a fairly high spread to get between the origination loan rate and the ultimate coupon passed onto the investor, but that is probably the amount of spread needed to create a viable program which will minimize the cost to the government as liquidation in the housing sector continues. I have inserted an element of a reserve account which will ultimately accrue to the originator, as an incentive for making good loans. I am not sure how much of insurance the private insurers will underwrite for the 0.25% fee I mention in #3 above, but that will have to be determined by market factors. Lastly, the government will be on the hook for whatever losses after the originator reserve fund, and the private market insurers carve-out, are exhausted. This will be a better set-up than is currently getting done. As for the large spread between the borrower’s rate and the investor’s rate, this is exactly what the originators are currently making. The originators can sell a 4% MBS pass-through above 101-00 for July, and the average national mortgage rate is 4.6%, so it seems to me that the originators, which are mostly large banks these days, are making outsized profits. These profits needs to be redirected to underwriting the credit component of these mortgages.


* As for alleviating the housing conundrum and government’s underwriting risk, a reader wrote in with this brilliant suggestion:


“Stream-line refi program: FNMA, FHLMC & GNMA should allow banks/mortgage brokers to refinance all agency held/(guaranteed) mortgages without additional credit / job verification and regardless of the loan to value (LTV).  The government, (via its agencies), reduces the risk on its mortgage book (by increasing debt service coverage via reduced mortgage coupon) and homeowners / consumers receive a break in the form of greater disposable income without further deterioration of the government’s fiscal budget.  


The stream-line refinance program breaks the deadlock between the deterioration of borrower positions and the lower rate environment engineered by monetary policy, effectively increasing the elasticity of monetary policy.” (end of reader’s suggestion)


I think this is a great suggestion. Investors of MBS securities will be the folks who suffer from implementation of this plan. It will however take an act of Congress to appropriate part of the investors coupon payments, which will result in massive pre-payments and the issuance of lower coupon MBS securities.


* Trading points: Yesterday saw big reversals in the Euro (higher), Yen (higher) and Gold (lower). My gut tells me that the early rise in the Euro triggered many hedge fund traders to cover their short position in the Euro. As the Euro gained ground, these same accounts likely bought back their Yen shorts and liquidated their gold positions. The moves were dramatic and violent to the point where it appears that there had to be some unwinding of speculative positions in these three sectors. I am still look for Euro weakness and gold strength, although perhaps not today.


* Stocks – continued lower through the important 1040 support level and made a low yesterday at 1010. The sign of a bear market is when it goes down, even when I, a resolute bear in this environment, is looking for a correction, as I have been for a couple of days. I am still looking for a dramatic free-fall at some point in time, soon, but trying to predict such an event is tricky, and difficult to trade, except through the use of puts. In the meantime, I am looking at the current chart, with an eye for good places to sell against (ie – a place to convert puts into outright shorts). Initial chart resistance starts in the 1040s which is also the top of the trend channel displayed on the attached chart, by the end of today. Better chart resistance exists between 1070 and 1085, which is the 50 and 61.8% retracement of the 9 day sell-off, and clearly a viable target for the upside. Despite my hopes of a place to re-set my short, I am concerned that this is a bear market, and in this context, surprises will occur to the downside.