Wednesday, July 30, 2008

Covered Bonds to the Housing Rescue

Last week, Hank Paulson, the Bank of America, Citibank, JP Morgan-Chase and Wells Fargo kicked off a new home mortgage financing plan. More than two hundred years ago, the USA and Europe followed different forks in the mortgage market road. The US went the route of having banks sell million dollar packages of mortgages. Banks issued mortgages and then got rid of them. They may or may not have kept a servicing contract. Under this plan, homeowners send their payment to the servicer, who takes a small fee and sends the balance to the owner of the mortgage. Fannie Mae and Freddie Mac, quasi-government companies have purchased about half of all US mortgages. Under such a plan, the very large pools of mortgages are sliced and diced in many ways to make pieces that can then be resold to mutual funds and other investors.

Under the European plan, the banks hold the mortgages they issue. The customers deal with one bank while making the loan and while paying the loan. If a customer is having difficulty making the payment, he has the ear of his local banker to bend.

To finance mortgages, banks may issue "covered bonds". These bonds are backed by mortgages but, the bond buyers get a straight forward product that is not directly dependent on timely payments. Furthermore the buyers do not own a complicated investment. While the holder of a mortgage receives a stream of payments of ever changing amounts of interest and principle, the holder of a bond receives interest payments only and his principle balance remains constant until paid back. The complications of mortgage payment cash flows are properly left for the banks to handle.

Under the rules laid out by Paulson, only 80% loan to value, standard mortgages will be used as collateral. The banks will pay the interest on the bonds out of total cash flow. The grade of each bond will be determined by the health of the individual bank. Should the bank fail, the bond holder will most likely recover 100% as they will have a senior claim on the banks assets, including the mortgages that support the bonds.

I like the plan. The European covered bond market is a 3.2 trillion dollar market. The system works well. One of the consequences is a change in the relationship of customers to banks. Many a customer will like dealing with their local banker when they get their loan but also when they buy longer dated fixed income investments. The banks are not required to match bond maturities to mortgage maturities. Banks might use 30 year mortgages as the collateral for 5 and 10 year notes. It takes an actuary with a high speed computer to track and manage the cash flows but that is the business banks are in.

The Housing Turn

Housing sales typically turn up well before the "national bottom" in the housing market. Even well before the national bottom in housing starts. In this particular cycle, Michigan and Nevada show how certain markets can distort national averages. Michigan is the rust belt state of the rust belt. The price of the average home in Detroit has fallen from $97,800 in 2003 to $19,400 in May of 2008! The price of second homes in Las Vegas soared to incredible heights by 2005 but have since collapsed by more than 50%. The housing market in many communities is soft but nothing at all like Detroit or Las Vegas.

Using the 1973-1974 downturn, housing sales turned in January of 1974. The national average price of homes did not begin to appreciate until a year later. During the early 1980's downturn, the peak price of oil and the bottom of housing sales both occurred in March of 1980. House prices did not start to rise until January of 1982. The people that bought bargains from 1974 to 1975 made extremely high returns because they were able to scoop fully leveraged assets. Many a $100,000 house with a $100,000 mortgage bounced to a $120,000 house with a $100,000 mortgage in just a year or two. Those who paid a dollar to assume the payments turned a dollar into $20,000.

During this cycle, the turn in oil prices was delayed by conflicts in the Middle East and by the failure of congress to encourage energy production. One result is that country after country is slamming on the economic brake. The following are the recent increases in short term interest rates, India .5%, Pakistan 1%, Columbia .5% to 7 year high, South Africa 6 increases in 1 year, Russia 1%, Israel .25%, Philippine .5%, Brazil .75%. This slamming of the brakes is bringing down demand for oil, bringing down the demand for money, bringing down the demand for housing, bringing down inflation. Lower bond rates will result from lower inflation. Lower bond rates will lead to lower mortgage rates and increase demand for houses.

Covered Bonds to the Rescue

In the USA, short term money market investments have reached record levels. There are about 6 trillion dollars sitting in low-rate short-term accounts. Most of these money market investments are not held by local banks. Under the new plan, many a bank customer will be easily convinced to move funds from a 1.5% money market account to a 5% 7-year covered bond. In recent months, the bank that made a 6.5% mortgage loan had to "have the cash" to make the loan. With the frozen-up mortgage market, he was stuck with the loans he made and had no safe way to finance more. Please note that the 20% safety margin is put up by the home buyer. The bank does not deplete its capital by making mortgage loans the ratio of bonds to mortgage is 1 to 1. One hundred percent of the loans can be used as collateral.

Should banks move 20% of the money market funds over the next 5 years, they will have freed up more than a trillion dollars for the mortgage market. Houses are once again very affordable. The payment on a 6.5% mortgage is within the means of many potential buyers. Should tight short term rates bring down inflation, the mortgage rates could reach 50 year lows. The rebound in the housing market could be quite strong.

The housing market is not turning on a dime but it is turning. Of the 20 cities in the latest Case-Schiller Survey, 7 markets showed price increases. Hank Paulson has won a major victory for free enterprise; the big banks will no longer face so much competition from the government backed enterprises. Unfortunately, Fannie and Freddie were only crippled, not put out of business. Theoretically Paulson holds the power to put them out within the next 18 months but these government backed corporations do serve another political purpose. Politicians from both sides of the isle like keeping a few "goodies" in reserve and these government corporations are ideal for patronage job placements.

When Frederic Bastiat wrote The Petition of the Candle Maker (I think in the early 1800's), he wrote about the silliness of trade protection. Still, I think it appropriate to mention his petition in regard to the mortgage market. Bastiat suggested that all shutters, blinds, curtains, skylights, holes and chinks be closed because the Sun was causing harm to local candle stick makers. Democrats would renegotiate trade deals because China sells stuff to cheap. Democrats would block the Sun if it was in the best interest of their lobbies. It is appropriate that the government stay out of the mortgage market. The government, like the Sun, is just too powerful.