MBS OP-ED: FASB, Quarter End, Dying Mortgage Products
Before beginning, I’ll point out that everything in this column is true and accurate; I’m not a fan of playing tricks on loyal readers. However, I think it’s appropriate to share one of my favorite aphorisms for the day, a quote from Murphy’s Third Law: “Nothing is ever Foolproof, because Fools are so ingenious.”
MBS investorsspent a lot of time last week debating the relative merits of the Treasury Department’s latest stab at propping up the banking system, the Public-Private Investment Fund (PPIFs). The program is designed to create investment pools funded by a combination of public and private capital and, in many cases, also be eligible for funding through the TALF program (a Fed initiative designed to fund purchases of asset-backed securities.)
However, the Financial Accounting Standards Board (FASB) is also considering a number of changes to mark-to-market rules which, if implemented, will reduce bank managements’ need to write down the value of many assets now on their books. With these changes, it’s unclear that banks will feel the need to sell a lot of the “legacy assets” held in portfolio; they will have a lot more flexibility in deciding both whether to mark down asset values and what those values should be. There’s talk that a lot of private capital is looking to get involved in the program, but I don’t believe that many senior managers at banks will feel the need to sell assets at anywhere near current prices given the revised accounting treatment.
It is true that the PPIF is designed to boost the prices of the legacy assetsthrough the injection of public and private capital into the process, as well as the prospect of allowing investors to lever themselves through Fed financing. While increased investor interest will certainly improve the pricing of assets, it won’t happen immediately. Moreover, trying to help the financial system recover from its overleveraged condition by offering government-subsidized financing is akin to a hangover remedy that starts with a breakfast beer. Put simply, I don’t expect the selling of securities into the program will be large enough to substantially impact the banks’ financial health. MORE COMMENTARY ON PROPOSED FASB CHANGES
With respect to the market, this quarter-end is the first one in quite a while that hasn’t appeared resulted in distorted financial conditions. Quarter-ends typically present challenging funding conditions. Both investors and financial firms like to put cash on their balance sheets for reporting purposes, creating additional demand for cash and pushing funding rates higher. Since the end of 2006, quarter-ends have been extremely ugly for the markets; it’s not a coincidence that Bear Stearns and Lehman both failed a few weeks from the end of a quarter. However, financing conditions are currently as tame as they’ve been at quarter-end for years. LIBOR spreads remain in line with Treasury and repo rates, and MBS dollar rolls are also trading fairly well. This is a positive sign for the financials, as the funding markets are the financial system’s coal mine canaries.
A recent posting in the Forums led me to ponder the future of the mortgage industry. While someone could write a dissertation on the topic, I’ll briefly address a few interesting issues. I think that ARM products will be out of favor indefinitely. It is an unfortunate development, as many homebuyers are astute enough to manage their finances and take advantage of the lower rates normally available on adjustable-rate products. (The mortgage yield curve, like most other curves, is normally upward-sloping.)
Unfortunately, the taint from various products’ well-documented performance issues has dovetailed with the traditional reluctance of U.S. homebuyers to finance their home purchases using adjustable-rate liabilities. According to the Mortgage Bankers Association, less than 2% of loan applications taken recently were for ARM loans; for much of the past few years, ARMs comprised 20-30% of the total number of applications, and roughly half of dollar volumes. In part, this reflects the current structure of mortgage rates; the Bankrate.com national average for 5/1 ARMs is only 14 basis points lower than that of fixed-rate loans. I think the ARM/fixed differential would need to be in excess of 75 basis points to get large numbers of borrowers to even consider using the product again.
I also view the “affordability product” as a dying (if not entirely dead) concept. The demise of the affordability product, specifically interest-only products, has had a significant impact on the housing markets, and the degree to which the availability of products such as interest-only loans and option ARMs distorted traditional affordability measures is poorly understood. An examination of the National Association of Realtors (NAR) Affordability Index is interesting. The index is simply a form of a coverage ratio that compares actual median monthly family incomes to the income needed to qualify on a home. The NAR uses national median home prices and assumes a 20% down payment and a 25% qualifying ratio (using principal and interest, but excluding taxes and insurance payments). Importantly, the index calculates payments using a fully-amortizing 30-year loan.
According to the NAR, the current Affordability Index of 173.5 is the highest on record, a combination of lower home prices, low lending rates, and fairly steady family incomes. However, a revised index calculated using an interest-only loan (instead of a fully-amortizing mortgage) would have been in the area of 160-170 in early 2004, due to the lower payment required for the interest-only product.
The point is that the ability to easily take out fixed-rate interest-only loans (and, later, negative-amortization products) gave a massive boost to affordability from late 2003 through early 2007, which in turn supported home prices. By implication, the sudden lack of availability of these products conspired with other factors (including the demise of subprime lending and extremely high jumbo rates) to deepen a cyclical slump in home prices. Instead of being at all-time highs, housing affordability has only recently returned to the levels of 2004 and 2005, if viewed in the proper context.