Safe as houses

7 min read

I was taken by a cutting from a recent newspaper article, which said Americans refinancing their mortgages are taking cash out in the process at levels not seen since the financial crisis..

Supported by data published by Freddie Mac the article in The Wall Street Journal revealed that now 50% of people who are refinancing their home loans are also taking the opportunity to raise their mortgages as opposed to 17% in last year. It was forwarded to me by a New York-based chum and equally retired old bond dog, Mike “the guillemot” Gilmore. He was particularly disturbed by the paragraph that read: “To some housing market observers, the fact that more homeowners are tapping their homes for cash represents a healthy confidence in the economy. It comes against a backdrop of continued gains in employment.”

I’m with Mike.

The dangers of using one’s home as an ATM were suitably demonstrated in 2008 when it was revealed to many people’s total astonishment that the value of houses can go down as well as up. It had always been assumed that with the 30-year fixed-rate mortgage American borrowers were well protected against the vagaries of short-term interest rate moves. But that does not mean that they are any better off in a cyclical economic downturn and when the job market turns sour. The purpose of a mortgage is to borrow today against future earnings in order to acquire a home and the key tenet of mortgage borrowing and lending should be that the loan ought be paid off as fast as the borrower can do so.

SAME-SAME BUT DIFFERENT

Tuesday’s Case-Shiller housing data exceeded forecasts with the 20-city year-on-year index reporting a rise of 5.9% versus consensus of 5.7% and the index itself now stands at 195.39. Extrapolating future house price development from past figures is a risky game although if one takes the March 2016 reading of 184.52 and draws a line through this March’s figure, one ends up a year from now very close to the pre-crisis peak of 206.52. And that, given the size of the housing bubble that ended up leading to the near destruction of the financial system, is pretty scary. The overall national house price index, also for March, reported 186.95, a new all-time high taking out the old record of 184.62 of July 2006. Of course we all know that this time it is different.

US housing, especially non-urban residential, is a different game to that in the UK and Europe because most properties have next to no intrinsic value. Houses are built with chipboard and staple guns and not with bricks and mortar. The land they stand on is, in many cases, not worth a pile of beans as there is so much of it. Europeans went sailing into the mortgage crisis in general and the sub-prime mortgage crisis in particular completely ignorant of the differences in both the property market and the structure of mortgage lending. Lessons were learnt the hard way – as European taxpayers know well to their detriment – and as non-US banks pulled out of the US mortgage lending business the Fed stepped in filling the gap as part of the broad quantitative easing programme. I think about one-third of all QE has gone into buying mortgage-backed securities so let’s assume that to be around US$1.2trn. This was all part of the mega-shift in credit risk from the private to the public sector even though it is rarely acknowledged to be so.

If the Fed begins to withdraw from the mortgage market new lenders will have to be found. That will necessitate either US direct lenders or MBS investors to significantly increase their exposure to the housing market or the foreigners will have to come back in. From where I stand, I can’t see either of the two being imminent, not least of all because regulators will be extremely wary of the concentration of abstracted risk.

Not for the first time in this column I refer to a meeting I had at the Bank of England in the early naughties. At the time the bank was very excited by the growth in securitised mortgage lending as it spread the idiosyncratic default risk far more evenly across the financial system. What it had failed to appreciate was that that also meant that nobody knew who actually held all that risk and the collapse of the money markets and the demise of Bear Stearns and then Lehman Brothers and, de facto, Merrill Lynch in the US and the near death of Northern Rock here in the UK were the result of the opaqueness of that risk exposure.

RISK

Readers of my fellow scribbler Bill Blain’s Morning Porridge column will be acquainted with Blain’s first law, which states that “the market’s only objective is to inflict the maximum amount of pain on the maximum number of people”. I should like to add to that Peters’ first law that “credit risk can be sliced, diced, repackaged and restructured but it can never be removed”. In other words, it is not possible for someone to default without someone else, somewhere in the financial system losing the equivalent amount of money plus the structuring costs and other fees that have been paid along the way.

It is quite right to be disturbed by the contents of the WSJ article as the tone of it reminds us of the mood of boundless optimism in the early years of the past decade where today’s growth in consumption was being financed by expected though unrealised future asset values. Add that to the stories swirling around about rocketing default rates in student loans and more recently of rising delinquencies in auto loans and one might be well advised to start to ask some harder questions. And now, into this, the Fed wants to begin to sell its own holdings. Fluke or very smart market timing?

Finally back to Europe where the hawkish Jens Weidmann, president of the Bundesbank, is keeping up the pressure on the dovish Mario Draghi. Weidmann does not see the creeping rise in inflation as a flash in the pan and is already pushing for the ECB to open the debate on its future policy stance. As much as I respect Weidmann, I do have to warn against being too hard on inflation. It made my generation and that of my parents rich and its absence threatens to impoverish generation X, generation Y, millennials and whatever the ones who follow end up being called.