Fed, Mortgages, Housing

Fed, Mortgages, Housing
September 22, 2011
David Kotok

“The Lord giveth and the Lord taketh away.”  –Job 1:21

We shall paraphrase.  The Fed giveth and the Congress taketh away.

First the Fed.

By now, everyone between here and Mars knows about “Operation Twist.”  Simply put: the Fed is selling short-term securities and buying longer-term securities.  The overall size of its portfolio remains the same.  Markets reacted with a lowering of longer-term interest rates.  The 10-year benchmark US Treasury note traded to a record low yield; it is currently 1.78%.  The 30-year bond broke below a 3% yield and is currently at 2.89%.

Shorter-term rates are unchanged.  Worldwide dollar flows coupled with huge excess dollar liquidity balances combine to keep these rates near zero. The 2-year Treasury note yields 0.19% this morning.  The Fed is committed to maintaining its very low short-term rate strategy for two more years.  BTW, Bernanke’s term as Fed Chairman ends in 2013.  Every Republican candidate has indicated he/she would replace him if elected president.  Bernanke has the votes (seven affirmative) to continue his policy; he is now accustomed to three dissenting voting presidents.  The market is used to them, too.

The Fed also committed to rolling its mortgage portfolio by reinvesting cash flows into more qualified mortgage paper.  This policy action was a surprise to many observers.  The mortgage paper originates with the federal agencies (GSEs).  It is riskless because of the US government backstop of Fannie Mae, Freddie Mac and FHA.  Residential mortgage rates reacted by falling.  We are about to see the 15-year conforming mortgage interest rate below 3% and the 30-year below 4%.  This policy is designed to help the real estate market stabilize.  Thus, the Fed giveth.

Now to the Congress, where the lunatics we elect to represent us taketh away.

Congress has been in a fight over funding FEMA, which needs money.  It is dealing with hurricane and flood damage from South Carolina to Vermont.  It also needs to be prepared for the next event.  The post-Katrina FEMA cannot exist as a “pay as you go” and/or “wait until we need you” agency.  It has to be forward-looking so it can react to crisis in a timely way.

But Congress is stymied by those who will not fund emergency appropriations without cutting something else.  So FEMA sits in limbo while Washington fiddles, Texas burns, and Vermont tries to dry out.  What has that got to do with housing and the Fed?  Answer: a lot.

Here is an excerpt from a research note penned yesterday by Charles Gabriel of Capital Alpha Partners, LLC.  We thank Charles for giving us permission to share this note with readers,  and for providing the links to see the details.

Readers: please take a few minutes and examine the information in the links below.  This is huge.  In New Jersey, as an example, every county is negatively impacted by the Congress’ inability to reach common ground decisions.

“Last Chance Hopes for a Loan Limit Reprieve Are Now Dead – What Does ItMean?
“… Separately, Feinstein’s decision to hold back her last-ditch amendment was said to be due to a lack of Republican votes, although as we wrote earlier, the measure would likely have gone nowhere in any event. This means that the higher loan limits can now be considered all but officially dead, unless they are reinstated retroactively later this year (a prospect only in the event of another sharp implosion in the economy).
“… perhaps the most worrisome effect could be that in some 620 of 3143 U.S. counties, or 20% of the total, an average drop of as much as 14% in FHA loan rates might ensue, with an even bigger impact (per the National Association of Home Builders) ‘because these counties include significant concentrations of population and housing.’ Thus, the FHA-related change might impact as much as 59% of all owner-occupied housing in the U.S. [See a useful NAHB study summary here and chart of affected U.S. counties here.]“

Many thanks again to Charles Gabriel, his partner Jim Lucier, and their colleagues for superb research.

As for our elected Washington lunatics, we fear that Congress may undo all the Fed is trying to do.  It seems to me that the finger-pointing by Congress at the Fed is aimed in the wrong direction.  House Members and Senators of both parties need to look in the mirror.

We are headed to Helsinki and Stockholm next week.  Helsinki for brief meetings (one day) and then to Stockholm for the Swedbank annual global economic outlook meeting.  It will be followed by the Global Interdependence Center conference (www.interdependence.org).  European sovereign debt issues and resolution options will be the subject of both the public portion and the private discussion.

Some thoughts on stocks before we leave for Stockholm.

It looks like markets are going to test the 1100 level of the S&P 500 index.  That was the intraday low reached on August 8 and retested twice in the futures market.  Was it an interim selling climax or was it “the” selling climax?  History suggests it was the final climax, if we are not going into another recession.  If we are heading into recession again, history suggests that the bear market will be longer and the bottom deeper.

We are on the “no recession” side.  Slowdown yes, but steep recession, no.  We admit that uncertainty is very high, and all expectations have wide confidence intervals.  We look at the S&P 500 Index dividend yield and see it higher than the riskless 10-year Treasury note yield.  We look at conservatively estimated earnings yields and compute an equity risk premium of 600 to 700 basis points.  That is an extraordinarily high reward for anyone willing to invest in stocks.  History shows it is a bargain.  We will seize it.  Our longer-term target for the S&P is above 2000 by the end of this decade, if not before.

Skoal.

David Kotok, Chairman and Chief Investment Officer