Wednesday, September 30, 2009

FHA - Leverage Ratio Exceeding Bear Stearns

As indicated in the chart above (courtesy of yesterday’s WSJ), the FHA’s leverage ratio has increased from a modest 14: 1 in 2003 to an expected 50:1 by the end of 2009. This far exceeds Bear Stearn’s 33:1 leverage at the time of its rock bottom sale to JP Morgan. While the FHA continues to insist that they won’t need a federal bailout, similar to the claims made by Fannie and Freddie prior to their government takeover, a mere 2% loss rate would wipeout the FHA’s capital position. Given that its loan delinquency rate (more than 30 days due) exceeds 14%, a national unemployment rate slowly creeping towards double digits, and the agency’s subprime like borrowers (who only have to come up with a mere 3.5% to qualify for a loan) I remain highly skeptical that the agency will avoid seeking some sort of federal assistance.

While yesterday’s Case Shiller index provided yet another positive data point for housing (only 2 of the 20 regions in the index posted sequential declines in housing), it is important to emphasis how dependent housing has become on the government. As I indicated in my prior post, the FHA’s market share has increased from a mere 2.7% in 2006 to approximately 25% today (and 40% in August alone!). The agency insures approximately $750 billion of mortgages today from $410 billion in 2006. Even more concerning is the projected growth in the agency’s portfolio, which is expected to exceed over $1 trillion by the end of next year. As a point of reference, Fannie and Freddie collectively insure approximately $5 trillion of mortgages or half all of all home mortgages.

Remember how fragile this housing recovery is the next time you see those shady infomercials encouraging you to refinance into an FHA loan. However, instead of some faceless pension fund in Japan taking a loss on its portfolio of securitized subprime Countrywide mortgages, US taxpayers will be left holding the bag from these busted FHA loans.

Japan's Demographic Time Bomb

This weekend’s Barrons featured a very grim article on Japan’s demographic time bomb (Is the Sun Setting on Japan?). Although I have always appreciated the structural debt & population challenges facing the country, I never really understood how grave they were. Some scary data points from the article include:
- Japan's gross national debt now equals 217% of its gross domestic product, compared with 81.2% for the often-maligned U.S. and an average of 72.5% for the G-20 nations (the 19 largest economies, plus the European Union), according to the International Monetary Fund.
- The latest United Nations median forecast estimates Japan's population will fall from a current 127 million to just 101.6 million by 2050 (a decline of 20%), while the U.S. count will rise from 317 million to 404 million.
- The number of Japanese of prime working age (15 to 64), which totaled 83 million in 2007, is likely to tumble to 49 million in 2050, while the over-65 cohort jumps from 27.5 million to nearly 38 million. This implies more than 77 elderly dependents for every 100 workers by 2050, compared with just 33 per 100 now.
- Japan's household savings rate—more than 20% in the early 1970s—has dipped to about 3%. That's less than U.S. households' 4.2% as of July.
- Japanese businesses are highly inefficient and shielded from domestic and foreign competition by complex regulations. Output per man-hour in Japan trails that of the U.S. by approximately 30%.

While many pundits are encouraged by the strong victory of the Democratic Party of Japan (DPJ) in last month's national elections (which has promised to implement badly needed structural reforms to the country’s ailing economy) it will be extremely difficult to overcome the demographic tsunami facing the country. If you are not a Barron’s subscriber and would like to read the article please send me an email and I will be more than happy to forward along.

Friday, September 18, 2009

Government Involvement in Housing Market

As noted repeatedly over the last few months, several recent data points suggest the housing market has begun to improve off the unprecedented lows reached in April. Seasonally adjusted housing starts are up 25%, standing inventory of existing homes has been whittled down to 9.4 months (vs. over 11x months at the peak, though well above the 4-6 months indicative of a healthy housing market), and pricing has begun to firm, with the Case Shiller Index posting its first sequential monthly increase since July 2006. Although some regions of the country continue to experience declines (Vegas and Phoenix being amongst the most troubled), the recovery has generally been broad based, with some of the hardest hit markets (southern California, western Florida) demonstrating the strongest hints of recovery.

While a stabilization in the housing market is encouraging, investors must realize how critical the government’s role has been in driving this improvement. Firstly, the $8,000 tax credit for new homebuyers has significantly brought forward demand. This is particularly the case in California where residents also benefited from a $10,000 state-specific tax credit (though the program’s funding was exhausted in July). Further, mortgage rates have been artificially suppressed thanks to the Federal Reserve’s program to buy $1.25 trillion of mortgage-backed securities and up to $200 billion of Fannie & Freddie debt securities by year-end. With a combined $810 billion expended to date on these two programs (see below), the Fed has kept conforming interest rates below 5.5%. Low mortgage rates and 30% peak to trough declines in home prices have resulted in off the charts affordability. However, once these spending programs are exhausted, we are very likely to see mortgage rates creep up. Even a 50-100 bps widening could have a meaningful impact on the housing market, particularly as unemployment moves towards double digits.
Despite the one-time tax credits and government orchestrated effort to suppress mortgage rates, no federal program has been more distortive than the Federal Housing Administration (FHA). Created during the Depression to help minority and poor households realize the promise of homeownership, the FHA has become the government’s vehicle to prop up the housing market. With required downpayments of only 3.5%(much of which will be recouped through the $8,000 tax credit), the FHA has essentially taken the place of subprime in providing financing to at-risk borrowers. In 2006, the FHA insured 2.7% of all loans in the United States. Year-to-date, the agency has provided a government guarantee for 23% of all new mortgages and nearly 40% in August. Many of the public builders suggested in their most recent earnings calls that between 40% and 75% of all their buyers received FHA-insured mortgages last quarter. In fact, when combined with Fannie and Freddie, the government is now insuring close to 90% of all home mortgages and probably close to 100% for all new home buyers (see chart below)!
Several recent articles have highlighted the problems festering in the FHA. In fact, this morning the Washington Post ran an article suggesting that the FHA could breech its minimum capital ratio of 2%. Further, some 7.8% of FHA loans at the end of the second quarter were 90 days late or more, up from 5.4% a year ago. Even more perplexing is that the agency has never operated with a chief risk officer and has only recently sought to fill the position (even AIG Financial Products, Countrywide, and Lehman had chief risk offers!).

While the government will likely continue to support the housing market through the FHA, particularly with the 2010 election around the corner, I would be extremely wary of the headlines suggesting that the housing market is on stable footing. Just as Fannie, Freddie, and later subprime massively distorted the housing market over the last decade, so too has the FHA.
I will continue to report on this organization and Ginnie Mae (the government agency whose primary function is to guarantee mortgage backed securities comprised of FHA-insured mortgages) over the coming weeks and months. While I will also continue to highlight the improving trends in housing, it is always with an eye towards the government’s overarching influence that my enthusiasm will be vastly tempered.