It's almost impossible to pick up a newspaper or turn on the
tube without hearing about rising interest rates and the negative consequences
associated with their ascension. I
continue to read and hear that rates above 5% will stop the housing recovery
(assuming we're currently recovering) in its tracks. In case you skimmed over the last sentence
too fast I will repeat it because I believe it's very important; rates above 5% will stop the housing
recovery in its tracks. How? Why?
Are you kidding me? The
historical risk free rate of return is 4.5% to 5.0%. Are we suggesting that housing risk necessitates no, or even a negative, risk premium? Current and historical default rates suggest
otherwise...
I'm not that old or young for that matter, but I do remember
the interest rate on my first house; it was 8.6% which was a pretty average
rate at the time. I'm sure many of you
can remember paying rates well into double digits. How in the world could we afford to pay a
rate that was 72% higher in my case and maybe 200% higher in yours?
Leverage and affordability.
We bought what we could afford to buy under
normal circumstances - we had to have skin in the game (a down payment), and
our DTI ratio was actually representative of what we could afford considering
our fixed and variable expenses. Over the years consumers and companies have been
overleveraging at an alarming rate. Take
a look at the following slides:



Our consumption and debt are increasing while our savings is
decreasing a rate much faster than our income is increasing. Even my 12 year can look at these graphs and
fundamentally understand that this is a recipe for disaster. How did this happen? Basically, everybody wanted more for less. I'm not suggesting there's anything wrong
with more, after all, more is at the heart of capitalism. However, the undisciplined pursuit of more is
more indicative of our situation and another matter altogether.
Companies wanted more so they levered up and increased output. Consumers wanted more so they borrowed more
to get more of what the companies were producing. Financial institutions wanted more so they
got real fancy with all kinds of securitization vehicles and fancy acronyms
(SIV's, CDO's, CMO's MBS, etc), all so they could lend more money to both companies
and consumers so they could produce and consume more. This worked for a period of time, during which everyone was fat and happy, that is until..... good
times went bad. Now everyone, and by
everyone I mean the entire global economy, is in a world a hurt.
So what's our reaction to all this under-saving and
over-consuming?
Stimulus, aka borrow
more and spend more. The government is
planning to spend trillions of dollars in fiscal stimulus to spur the economy
and they're planning to pay for it by levering up. Sound familiar? What exactly is stimulus? Webster's defines stimulus as "something that
rouses or incites to activity". The
Federal Government is taking the place of companies and consumers and spending
where we can't. It's giving the money to
banks to lend because they ran out; literally in many cases. Does this make sense to anyone? Are we really solving are problems or are we
just adding to them and delaying the inevitable to a future point in time?
It was just reported that the foreclosure rate on prime mortgages has doubled in the
last year (now at 12.07%) and currently outpacing subprime defaults. According to First American Corelogic, loans
in default as of February totaled $717B.
Obama's Housing Rescue Plan calls for 75B in stimulus to be spent in
preventing foreclosures. This will
allegedly save about 10% of homeowners from going into foreclosure. However, if our future is indicative of our
past, we can expect over 50% of these modified loans to go back into
foreclosure within six months.
We all know why the subprimes and Alt-A's are defaulting -
these loans should have never been given in the first place, but what's going
on with these new defaults? Prime
mortgages are defaulting due to changes in employment or unemployment as the
case may be. It's not the rate that's
killing these deals it's the payment!
Look at the following graph:

House prices, automobile prices and so many other
consumables have simply outpaced our ability to pay for them. So we borrowed and borrowed and
borrowed. However, this debt is fixed -
it's not relative to our income. If your
income drops or even worse stops, your bank doesn't reduce your payment
relative to your decrease in revenue.
What do you do.... The best you can for as long as you can but at some
point, you default. Interest rates
aren't the problem, asset prices are the problem and I suggest they need to
reset much further for real affordability to come into play again and allow
consumers to purchase these assets while maintaining appropriate ratios of debt
and equity relative to income.
I haven't heard anyone or read anywhere that anyone is
predicting unemployment to decrease anytime soon. Most expect it to climb throughout the
remainder of this year, stabilize in 2010 and begin to recover in 2011. If this is true, most ABS are going to see
default rates continue to rise at horrific rates. Banks are preparing for this inevitability by
increasing their loan loss reserves, but are they reserving enough? Probably not.
Mohamed El-Erian refers to our evolving situation as "The New
Normal". Is it, or are we striving for
more of the same? I agree that we will
eventually get there, but in the interim, we have stimulus. People are calling for more recapitalization,
more bailouts, more MBS purchases, more treasury purchases, more stimulus, more
of "something that rouses or incites to activity" in an effort to recapture the
"old-normal", which we all loved too much and by all means, was
unsustainable.
I understand the alternative is not pretty but I suggest
that it will eventually become a reality.
I agree that we need to revert to the "old normal", but it's the really old
"old normal" that I'm referring to. Purchase what we can afford and purchase it with the appropriate mixture of
debt and equity relative to our income.
We also take business cycles into account because we will forever continue to have good times
and bad.
As the old saying goes, "you
hope for the best but prepare for the worst."
This doesn't mean that when good times go bad, you look for the Fed to
bail you out. It means you do the best you
can and take your lumps; it means you reap what you sew.