So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. 😉 )
As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)
David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →