As Joe has discovered, I tend to like a pictorial story. As a start to a series looking at the housing sector, let’s look at what is happening in the macro economy, beginning with the monetary and credit mechanisms.
What happens to a dollar in our system? Dollars are constantly changing hands, but at any point in time there is a measurable amount of these dollars. You may invest in Company X whereby you give them money for stock; that money now exists in Company X’s bank account. Company X then uses the money, in conjunction with a loan, to buy a machine from Acme, now the money exists in Acme’s account and a loan exists on the bank books.
At the other extreme, if you save conservatively, you may bury dollars in an old Folger’s can in your back yard. This money is then unavailable to the broad economy to use for growth; this has some parallels to investing in gold. As money goes from cash in your pocket, to checking, to money markets, to cd’s or savings, to loans, to investment in equity the more discretion you grant the other party for use of this money. This discretion is obviously subject to contracts and laws.
The point is that the amount of money is measureable and the metrics are known as money supply. As money goes from Currency to M1, M2 etc. we increase the discretion or ability to leverage this money, hence the multiplier of money.
In order to look at money and credit in the system we will use MZM(Zero Maturity Money) as it is the closest series to True Austrian Money produced by the Fed. MZM is essentially all money immediately available for use to settle a transaction; immediate here means there are no terms or penalties. The only difference in Austrian money is that it does not include money market accounts; the correlation of the 2 series is close to 90%.
Broad money growth has accelerated to 8.7% but loan growth is struggling, though improving, with non-financial credit growing at 3.8% and the financial sector credit contracting about 4.7% yoy.
A quick look below at the ratio of debt outstanding in the private sectors to MZM shows the leveraging that took place over the past decade and the recent deleveraging that has been occurring since 2007. At the end of the 1990’s we hit 6:1 leverage, thanks in part to entities such as Long Term Capital Management and the “innovations” of the financial industry. The results were an Asian crises followed by a technology market bubble. Leading up to 2007 leverage again breached the 6:1 level and again another crisis, this time in the mortgage and banking industries. We have now come back to 5.1:1 which is below the mean for the last 30 years. The graph looks like the biggest hill on the biggest roller coaster at the park and it has not been such a fun ride the last 3 years. Thanks go out to the banks, hedge funds and speculators as well as the banking lobbyists, regulators, the Fed and our government officials for giving us this thrill.
A look at total loans and leases/demand deposits at commercial banks gives us insight into the conduit for the leveraging of our economy over the past decade. Coincidentally, in 1999 the Gramm-Leach-Bliley Bill repealed a provision of the Glass-Steagall act of 1933. This allowed commercial banks to own investment banks. It essentially allowed the investment banks access to the monetary base of the country, which they proceeded to leverage. The uses of this newly acquired money could be described as pure speculation as we have now seen bubbles in technology stocks, real estate, oil and potentially gold over the course of the last 12 years. Thanks go out to Alan Greenspan and the government officials who opened the flood gates, bank lobbyists for greasing the politicians and the banks for their deployment of our capital. Notice I’m not yelling encore.
So let’s ask some pertinent questions about the health of the mortgage financing sectors to assess whether they will support a recovery in housing. Can the financial sector afford to lend the money? A look at the debt to equity ratio again shows the leverage at the height of the crises. But the banks are healing and with injections like the $5bln Warren Buffet gave BofA this week, we see this healing trend continuing. The risk here is that bank assets drop in value. Potential direct and derivative exposure to the sovereign debt crises in Europe is weighing on banks these past few weeks and to continue their march to meeting Basel III capital requirements, they need the US economy to keep moving forward.
Banks have been reluctant to take on more mortgage exposure, collecting fees only instead of spreads. After tightening their lending standards for the past 4 years, it looks like the banking sector has reached a neutral point on lending to home purchasers. Their willingness to expand their balance sheet with new mortgages will be very positive.
By default, government sponsored entities are the primary lender in the mortgage market, and they are bruised and battered to say the least. GSE’s had a negative net worth from Q3’08 until Q2’09. They had borrowed more money from the capital markets than the combined value of the mortgages they had on their books and the equity capital given to them by the government on our behalf. They currently sit very precariously at 125:1 debt to equity; a 1% loss in the value of their mortgage portfolio would put them under water again. But let’s remember, it’s for the public good to have a bunch of bureaucrats running the only entity in the country currently extending credit to residential real estate purchases. That actually may be true today, but did we need them 5 years ago extending credit to buyers with no income and no job while their CEO, Franklin Raines, was compensated over $90mln from 1999-2006. I don’t know why, but visions of Rodney Dangerfield come to mind. He works for Fannie Mae, is on a golf course, wearing plaid pants, talking on a 1980’s box phone and yelling lend Mortimer lend.
The banks and GSE’s are the main conduit for credit to the housing market. They were severely damaged by the Sub-Prime crisis but at least the banking system is making strides and appears on the brink of re-entering the mortgage market. The environment is still fragile and the exposure they have to Europe, though small, is placing them in precarious circumstances as they strive to meet upcoming Basel III regulation requirements and protect their shareholders. The GSE’s are mandated to lend, but at 125:1 D/E they fail with the smallest of hiccups. The recent government debt ceiling debate, rating’s downgrade and current level of government borrowing come into play here. Banks are still scared though not nearly to the extent they were 2 years ago; this is the reason 90% of the cash they collect from selling monetized treasuries is still sitting at the Fed.
Recent volatility in money market accounts has investors moving toward even more conservative savings vehicles, namely checking deposits (recent media of BNY charging large depositors) and gold. Money supply is growing and there is plenty parked at the fed, so the engine is running and warm for economic activity. The Fed has provided money enough to foster growth and conventional methods merely provide more potential energy, which is a risk for the future but solves nothing today.
My view is that necessary repairs are occurring and the seeds of growth are in place. The government has been borrowing too heavily and needs to back off, but at these low interest rates no real harm has been inflicted. We haven’t quite climbed out of the abyss but we can see the light of day. Patience.
Next week will continue our look into a possible housing market turn around. Specifically we’ll look at the household sector and assess their debt burden and ability to purchase homes. We’ll conclude with a more micro analysis of supply and demand for housing with a look at the 1 and multi-unit single family market, the rental market and commercial properties.