Are we nearing the bottom of housing correction?


Changes in the US Mortgage Market The new regulator takes the decision of CONSERVATORSHIP The Housing and Economic Recovery Act of 2008 was signed into law on July 30, 2008. As a part of this legislation, the Federal Housing Finance Regulatory Reform Act of 2008 established a new regulator for housing GSEs, the Federal Housing Finance Agency (FHFA), with enhanced regulatory authorities relating, among other things, to the minimum and risk-based capital levels and business activities of GSEs, including portfolio investments, new products, management and operations standards, affordable housing goals, and executive compensation. Now, FHFA has taken the decision to place the GSEs, Fannie Mae and Freddie Mac into conservatorship. A conservatorship is the legal process in which a person or entity is appointed to establish control and oversight of a Company to put it in a sound and solvent condition. In a conservatorship, the powers of the Company’s directors, officers, and shareholders are transferred to the designated Conservator. In this case, FHFA assumes the role of a conservator. The immediate consequences of placing Fannie Mae and Freddie Mac in conservatorship are as follows: •    The GSEs conduct "business as usual," only with stronger backing for the holders of MBS, senior debt and subordinated debt. •    The GSEs will be allowed to increase their MBS guarantee books without limits, and can purchase replacement assets for their portfolios without capital constraints. FHFA estimated that would amount to $20 billion per month •    FHFA assumes the power of the GSEs' boards and management •    The current CEOs of both Fannie and Freddie will be replaced by new CEOs with “significantly lower” pay packages. Other management changes will be limited for now • To conserve over $2 billion in capital each year, common and preferred stock dividends will be eliminated, but the common and all preferred shares will remain outstanding. However, during conservatorship, FHFA said that while the GSEs' equity would continue to trade, the powers of stockholders are suspended until conservatorship is terminated. Principal and interest payments on subordinated debt will continue. •    All political activities including lobbying will be halted immediately. Again, it would be hard to ask taxpayers to assume risk for companies that are lobbying Congress. Apart from the FHFA’s decision to place GSEs under conservatorship, three other significant developments came up from the US Treasury desk. ?    GSE Credit Facility ?    GSE Preferred Stock Purchase ? MBS purchase program Treasury-GSE Credit Facility According to the Treasury announcement, to ensure credit availability to the housing GSEs, a lending facility that will provide “secured funding on an as needed basis” will be established. This facility will offer liquidity to these GSEs until December 31, 2009, under the authority granted to the Treasury under the Housing and Economic Recovery Act of 2008. The funding of this facility will come from the Treasury's account maintained at the FRBNY (Federal Reserve Bank of New York). Borrowings will be collateralized with Fannie and Freddie guaranteed MBS, as well as Advances from the FHLBs. This collateral will be accepted with haircuts to be determined by the Treasury Department. ?    The FRBNY will serve as fiscal agent for the Treasury in administering collateral arrangements. ?    All loans will result in a debiting of the Treasury's account at FRBNY, and an offsetting credit in the GSE's account at FRBNY. ?    All loans must be approved by the Treasury Department after collateral verification by FRBNY. ?    Details will appear on the Daily Treasury Statement ?    Any additional borrowing by the Treasury to facilitate these loans will be subject to the Federal Debt limit According to the Treasury, loans will be of a short-term duration, typically less than one month, but longer than one week. ?    Specific maturities will be tailored to the individual loan request. ? The term of the loan will not be extended, but a maturing loan may be replaced with a new loan. ?    Loans may be pre-paid with two days notice ?    Loan amounts will be based on available collateral ?    No loans will be made with a maturity beyond December 31, 2009. The loan interest rate will be based on the daily Libor setting with a similar maturity, plus 50 basis points. Preferred Stock Purchase Agreements Preferred stock purchase agreements are agreements between Treasury and the GSEs. The Treasury will receive senior preferred equity shares and warrants. Under the agreement, common and preferred shareholders absorb losses before Treasury. "Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS." – Henry Paulson, US Treasury Secretary To address this responsibility of supporting GSE debt and mortgage backed securities holders, Treasury entered into a Senior Preferred Stock Purchase Agreement with each GSE which ensures that each enterprise maintains a positive net worth. Treasury won't make just a one-time equity injection. Initially, the Treasury will receive $1.0 billion in preferred stock in each GSE along with warrants for the purchase of common stock, representing 79.9% of the common stock of each GSE. The preferred stock will accrue dividends at 10% per year. The rate shall increase to 12% if, in any quarter, the dividends are not paid in cash. After the initial $1.0 billion purchase from each GSE, the Treasury will buy preferred shares on an as-needed basis in amounts necessary to ensure that the GSEs maintain a positive net worth. Treasury said it could buy $100 billion in preferred shares from each GSE, but that that amount was chosen to "demonstrate a strong commitment to the GSEs' creditors and MBS holders." Treasury said the amount wasn't related to its current assessment of the GSEs' financial condition. Each GSE’s retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion. This requirement will produce a drastic reduction in the size of the GSEs' balance sheets over time. As of July, Fannie Mae's retained portfolio was $758 billion, and Freddie Mac's retained portfolio totaled $797 billion. The agreement with Treasury to cap the portfolio at $850 billion at the end of 2009 would allow average growth in Fannie Mae's portfolio of about $5.4 billion per month from August through December of 2009, and growth for Freddie Mac of about $3.1 per month. MBS Purchase Program Treasury will begin buying GSE MBS later this month. Treasury said the amounts will be based on developments in capital markets and housing markets. We imagine those amounts could be sizable if the Treasury wants to give the housing and mortgage markets a significant shot in the arm. (Currently, Freddie Mac's holdings of its own PCs make up about half of its retained portfolio and Fannie Mae's holdings of its own MBS account for about a third of its portfolio.) GSEs’ Holdings of GSE MBS Source: SMRA In the very near term, there has been a talk about an initial purchase of $5.0 billion. As of July, the GSEs holdings of their own and each other's MBS accounted for just over half of their retained portfolios. By deciding to buy MBS, the Treasury is opting to grow its own balance sheet to support the mortgage market, rather than permitting more rapid growth in the GSEs' portfolios. Since Treasury will hold MBS purchases to maturity, it is felt that "there is no reason to expect taxpayer losses from this program, and it could produce gains" due to the spreads between Treasury cost of funds and GSE MBS. NAR Affordability Index The National Association of Realtors (NAR) compiles a monthly Affordability Index that takes into account home prices, as well as mortgage rates. A value of 100 means that a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home. From 1985 through 2000 the Affordability Index has average 121.1, at the peak of the housing boom, this index dropped to about 100. For July 2008 this index at 118.5 was about 2-1/2 points below the 1985-2000 average. For the Affordability Index to return to the 1985 to 2000 average (assuming constant income) there would need to be a small further downward adjustment to home prices of about 2%, or an edging lower of mortgages rates of about 1/4%. Source: SMRA Using this criterion, the home price correction still has a little bit to go, but is mostly complete. If this criterion is the most appropriate gauge of the alignment between home prices and economic fundamentals, the GSE package may quickly stop the bleeding. Also, a look at the trends in the mortgage rate and the sale price for existing single family homes indicate a reversal of sorts, implying that there is a possibility of stability returning in the market. Both the Mortgage rate and the sale price are creeping back! Source: Markaz Research, NAR Housing Inventory Home prices, like any other good or service, will ultimately depend on the balance between supply and demand. In the long run, the supply of homes is elastic, that is, builders can simply construct new homes. But, in the short run, the mismatch between supply and demand is captured in variations in inventory levels. Here the story is complicated by the role of foreclosed properties bloating the inventory on unsold existing homes. Instead, considering the inventory of unsold new homes, from 1990 to 2000 the average inventory of unsold new homes was about 300,000. At the peak of the boom it rose to about 575,000. By July 2008, it retreated to 418,000, in other words, about 60% on the new home over-hang has already been worked off. Housing Starts and Permits In July, the housing starts touched a new low of 965K, while, building permits dwindled to 937K. Based on the housing starts and building permits data, housing will be a continued drag on GDP. Typically, Residential Fixed Investment spending lags housing starts by 2 to 3 quarters. This is simply because it takes about 8 months to complete a home after the actual start. Thus, the labor input, and construction cost is spread out over time. The drop in housing starts is bad news and shows that homebuilders are cutting back on new projects because they don't feel confident enough that the houses will sell upon or before its completion. The good news is that cutbacks on construction will help narrow the high inventory of homes on the market. Housing Starts and Building Permits still down! Source: Markaz Research, US Census Bureau ### About Kuwait Financial Centre "Markaz" Kuwait Financial Centre S.A.K. 'Markaz', with total assets under management of over KD 1.4 (USD 5.32 billion) as of June 30, 2008, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997; and has been awarded a BBB+ corporate rating by Capital Intelligence Ltd.