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
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
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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