Risk Spread

By Michael Douville - Real Estate Market

Visit the front pages of Wall Street Greek and Market Moving News to see our current coverage of economic reports and financial markets.

Risk perception has held mortgage rate spreads stubbornly wide, and for good reason, but the government is taking steps to close that gap. As that occurs, a great oppportunity should open up for accumulators of real estate.

(Article interests: AMEX: DIA, AMEX: SPY, Nasdaq: QQQQ, NYSE: NYX, AMEX: DOG, AMEX: SDS, AMEX: QLD, AMEX: XLF, AMEX: IWM, AMEX: TWM, AMEX: IWD, AMEX: SDK, Nasdaq: DPRRX, NYSE: AIV, NYSE: TOL, NYSE: HOV, NYSE: BZH, NYSE: LEN, NYSE: PHM, NYSE: NVR, NYSE: GFA, NYSE: MDC, NYSE: CTX, NYSE: KBH, NYSE: RYL, NYSE: MTH, NYSE: XIN, NYSE: BHS, NYSE: SPF, NYSE: MHO, NYSE: OHB, NYSE: WCI)

Benchmarks are used to set rates throughout the world. The Federal Reserve has traditionally affected the shorter duration lending instruments through the use of the Discount Rate or Fed Funds Rate. Prime Rate loans and many credit card rates, as well as commercial paper rates are set using a contracted margin over the Federal Rates. As loans are reset, the payments adjust to the changed index. Lowering or raising the index obviously affects the pace of the economy. This has been the traditional manner in which the Federal Reserve administers monetary policy. Unfortunately, most mortgage rates in the US are tied to a much longer benchmark, the Ten-Year Treasury Bill.

The Problem

The United States has been the envy of the developed world, in part due to the affordability and availability of home ownership. For decades the goal of both Presidential Administrations and Congress has been to achieve as broad a spectrum of home ownership as possible. Financing has been one of the key components driving this goal. In recent years, loose financing has been abused and the result has been the "Housing Crisis" the US is currently experiencing.

Every investor is aware of the problems associated with providing loans to unqualified and non-creditworthy borrowers with terms that could adjust an affordable payment to an incredibly unaffordable payment, and indeed in some cases a punitive payment. As all are aware, this has resulted in turmoil across all strata of our economy. Asset prices in real estate are not only affecting the borrower in jeopardy of losing their homes, but also the mortgage companies who packaged the loan, the primary lender who underwrote the loan, and the investor who bought the loan and it's payment stream.

The fallout goes beyond the immediate participants in the transaction: to neighbors whose property values have declined due to the foreclosures and forced selling; to the local businesses affected by the drop in consumer spending, due in part to a loss in the "Wealth Effect" factor; and has permeated now to national manufacturers and financial institutions; and indeed has even destabilized nations like Iceland, which derive the bulk of their economy from overlevered entities ultimately tied to these same borrowers. What was meant as a very positive policy has had unintended results. The bottom of the lending pyramid has been, and still remains, the borrower; many whom purchased in the time frame of 2005-2007.

These unfortunate recent buyers comprise a huge segment of mortgages outstanding. Most home loans have an average duration of only 7 years. Therefore, most home loans encumber property bought after 2001. Appreciation in the US has been consistent and in the growth MSAs of California, Nevada, Arizona, and Florida, that rate has been 4-7%. The manic years of 2004, 2005, and 2006 saw price increases of as much as 40-50% per year. This rapid price escalation resulted in borrowers and lenders investing in properties that have ultimately devastated those involved. Historic times require action only available from governments. Have the Treasury and the Federal Reserve attempted a solution?

The 30-year fixed rate mortgage has traditionally carried a "risk premium" of 1.3-1.6% over the 10-Year Treasury. Therefore in an environment of 5% Treasuries, the fixed rate loans would be priced 6.3-6.6% for 30 years, depending on the investor's need to place funds. Until very recently, the risk premium had expanded to over 2.5%. Indeed, as 10-Year Treasury rates dropped, 30-year mortgage rates remained stubbornly in place at around 6%.

The Fix

The Treasury and the Federal Reserve have announced the purchasing of up to $600 billion in mortgages. The program will add a huge amount of liquidity to the system, replacing lost capital; and with the availability of huge sums of mortgage money guaranteed by the US Government, the rates have fallen to under 5%.

"A policy to drive down long-term rates would enhance ownership and dramatically raise asset prices."

Will the historic margin of approximately 1.5% over 10-Year Treasuries be restored? The rate would be unbelievably under 4.5% fixed for 30-years. A policy to drive down long-term rates would enhance ownership and dramatically raise asset prices. Struggling borrowers could refinance into much more affordable payments, and old loans would be retired, thus healing the downstream entities. Lower rates would support higher prices, and the healing process could begin.

The pool of money available for mortgages is enormous. The additional liquidity will replace the lost capital, and as financial institutions regain their reserves and their viability is assured, lending will resume. As the additional liquidity pumped throughout the system starts to disseminate, lenders will find they have excess capital and will begin worrying about return on investment (not the return of the investment).

The Flaw

In my view, the amount of liquidity added to the money supply will invariably lead to inflation. Everyone should initially benefit from the rise of asset prices. Those that make the transition from a disinflationary environment to an inflationary one would reap huge rewards, in my view. Those positioned in safe Treasury Bonds would suffer huge losses, as a "bubble in Treasuries" is forming. This bubble is being generated to a great degree by the Federal Reserve and the Treasury. An Inverse ETF could be used when rates start to rise; however, with such powerful entities involved, rates could stay down an appreciable time.

The Opportunity

As part of a long-term portfolio, real estate will diversify asset classes. Real estate does very well in an inflationary economy, and unlike other inflation hedges such as gold, it has a cash flow component. My outlook for the return of inflation is still 2-3 years away. Prices for property are still depressed, and opportunity abounds. As in any accumulation phase, properties can be selectively assembled over the next 24 months. However, the window of lower rates will remain open only for a short while. Those with an investment horizon longer than 5 years need to strongly consider fixed rate loans. My forecast is for sharply higher rates to combat inflation in the 2014 time frame and a deteriorating global economy. In my opinion, investors should study the costs of refinancing, and consider their time horizon. These rates may not be seen again for a very, very long time.



Please see our disclosures at the Wall Street Greek website and author bio pages found there.