The triple threat to real estate
August 26, 2005

One of the disadvantages of a weekly commentary is that I inevitably end up commenting on short-term changes in the gold price that I would otherwise not be the least bit interested in. Short-term volatility is a distraction; it is noise that can obscure more fundamental changes and trends that are far more important.

The big money is made identifying major dislocations in capital and markets that inevitably have to be corrected. That is primarily what I am interested in and what I pursue in my own investment business. It requires more patience but ultimately I believe I have a better chance of getting the big picture right than trying to outguess professional traders. Besides, the latter is far more stressful.

During the past week the gold price declined $10 an ounce, or just more than 2%. The dollar did strengthen, but not nearly enough to account for the decline in the gold price. The dollar rose 0.23% against the yen, 0.30% against the pound and 0.74% against the euro.

Even though the rise in the dollar cannot account for the magnitude of the decline in the gold price, the drop in the gold price was nonetheless due to the dollar. As the relationship between currency exchange rates and the gold price is becoming better understood more and more traders are using gold as a way to play anticipated changes in the dollar exchange rate.

The gold price rose 2.3% three weeks ago as traders bought gold futures in anticipation of a decline in the dollar -- the Open Interest in gold futures and options increased by 18% from August 9 to August 16. However, instead of declining, the dollar went up and while I have not seen the Open Interest Report for August 23 (it is due tomorrow, August 26) I suspect we will see a decline in Open Interest when it is released. If I am right, and there was a significant decline in Open Interest this week, then it will explain why the gold price declined more than expected.

Futures prices and spot prices are linked because an arbitrage opportunity that traders can profit from arises when the difference between spot and futures prices is greater than what current interest rates and volatility would dictate. So even though it might not always be possible to correlate the magnitude of changes in the US dollar-gold price to the magnitude of changes in the US dollar exchange rate, the two remain linked.

In the long run the US dollar-gold price depends on the US dollar exchange rate and the dollar in turn depends on the (real or perceived) well being of the US economy and US interest rates. Right now the US economy is indisputably dependent on the US real estate market, which brings us to today’s topic: the triple threat to real estate.

Due to fierce competition, banks are under tremendous pressure to lower their mortgage lending standards. If they don’t, they will quickly lose market share in the mortgage business and that means lower earnings and falling stock prices (for the banks), which they don’t want. The banks don’t mind easing the lending requirements for new mortgages because after writing up a new mortgage they turn around and sell it to an investment bank that packages similar mortgages into securities (called mortgage backed assets) that are then sold to pension funds, hedge funds and other investors. As interest rates on government and corporate bonds declined the demand for mortgage backed assets has increased, thereby supplying more capital to fuel the real estate boom. But during all this the systemic risk has increased dramatically.

When interest rates decline it becomes very difficult for fund managers to maintain high returns on the capital they invest, so they end up buying riskier investments in an attempt to increase their profits. Mortgage backed assets started taking off in the 1980s and by the first quarter of this year there were $4.6 trillion worth outstanding. The Mortgage Bankers Association estimates that almost $2.25 trillion mortgage backed assets could be created this year alone. Assuming that one quarter of that is already accounted for in the first quarter numbers, we could see somewhere between 30% and 35% growth in mortgage backed assets this year.

The problem is not with the growth in mortgage backed assets, but with the decline in the quality of the mortgages. Mortgage backed assets comprised of mortgages whose interest rates are fixed only in the early years (3 to 7 years) are currently rated triple-A -- investment grade. But what would those mortgage backed assets be rated once the underlying mortgages revert to variable rate mortgages if, for example, interest rates were to go up?

Investors deem mortgage backed assets to be safe, or at least some of the safest income products currently available and because mortgage backed assets typically have higher yields than government issued bonds the demand is soaring. So here is the triple threat:

One -- Credit Quality: The credit quality of new mortgages in the US has declined dramatically in recent months. The value of subprime loans included in mortgage backed assets doubled in the past two years and according to the Wall Street Journal, loans without full documentation of the borrower’s income and assets (the most risky type of loan) accounted for 70% of mortgage securities rated by Standards and Poor’s in the first half of this year.

Two -- Rising Mortgage Rates: As the credit quality continues to decline investors might start asking for higher returns to compensate for the increase in risk and that would push up mortgage interest rates. But the surge in variable rate mortgages means that the US real estate market is now very sensitive to a rise in mortgage rates.

Three -- Reduced Investor Demand: If mortgage rates rise, borrowers may find that they are unable to make their mortgage payments on variable rate loans. Higher mortgage rates will very likely also mean lower real estate prices, and so there is a reasonable probability that borrowers in trouble will not be able to sell their homes for enough to cover their mortgages. Real estate taxes and broker commissions mean that even if real estate prices do not decline, a seller needs to sell his home for about 10% more than what he purchased it for just to break even.

The prevalence of homeowners who have mortgages equal to, or exceeding 100% of the current market value of their homes is where the problem lies. These are typically also the same borrowers who have adjustable rate or interest only mortgages. When they cannot pay their mortgages any longer and are unable to sell their homes for more than their mortgage debt they will merely hand the keys to banks.

Defaults on mortgages could cause a downgrade in the credit rating of mortgage backed assets and reduce investor demand for such products while simultaneously increasing the interest rates investors require as compensation for the increased risk. As investor demand for mortgage backed assets wanes the banks will tighten the credit quality and write less mortgages. That means less eligible buyers, which means lower real estate prices and lower real estate prices will cause even more defaults by stuck homeowners who are unable to sell their homes to cover their mortgages. And, higher interest rates on mortgage backed assets will translate directly to higher mortgage rates.

A slowdown in the real estate market can have dire consequences for the US economy and the US dollar. The question is only how soon it will happen.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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