Good to the Last Drop?
by Brian Pretti CFA, Contrary Investor. March 28, 2008
Well, apparently good to the last drop is indeed the case when it applies to US households still "extracting" equity from residential real estate. I want to quickly roll over the recent refi stats as of year-end 2007. And this is important why? Because although many Street pundits are trying to claim that the worst is behind us in the financial markets (the bottom is in, remember?), the Fed has once again saved the world (at least for a month or two, maybe, in terms of providing just enough liquidity that has essentially forestalled financial institutions from potentially having to try to monetize the very bad paper they are holding as an alternative to currently being handed free money from the Fed), and that better days lie ahead for the economy now that the "Fed gets it," that fact is that what lies ahead is a US consumer that has not yet weaned itself off of real estate equity as a source of household funds. At least not as of the end of the fourth quarter of 2007. Very important in terms of the forward character of US consumption. Mortgage equity withdrawal is just about to take on an entirely new meaning, trust me. And like any addict, withdrawal can be quite the painful experience. US households are about to find out just how kicking the habit feels. Let's get right to it.
Let's quickly walk through the current residential refi data character as it also has very meaningful implications for the broader economy. I will not belabor the point as I've been through this too many times in recent years. Mortgage equity extraction has been a huge boost to household cash flows and consumer spending actions. As the nature of the convenience of taking equity out of residential real estate contracts ahead, this necessarily has important implications for broad economy wide tone and rhythm. Probably the most important data of the entire report is contained in the first three charts below. Home equity cashed out in 2007, according to the folks at Freddie Mac, was approximately $250 billion. Please remember, this is refi cash out only, not inclusive of home equity lines or actual sales of real estate for cash. Although not wildly overwhelming, this number represents about 1.8% of current nominal US GDP. At the margin, not inconsequential.
When this number is looked at as a percentage of the year over year change in household disposable personal income, it takes on a much more meaningful impact. The year over year change in nominal dollar US disposable personal income during 2007 was $565 billion. Without question, cash out refi activity referenced above continued to be quite meaningful to US households broadly last year. Let's put it this way, and without actively searching out pessimism, the fallout from the potential decline in cash out refi activity hasn't even begun to be felt as of yet. As you can see below, refi cash outs this decade have occurred in amounts very meaningful relative to the year over year change in disposable personal income. Even in the late 1990's as the credit cycle was still accelerating, 5-10% cash outs relative to disposable income at the outside was the norm. We've simply left that in the dust in the current decade. Of course the important question remains, do we ultimately revert back to levels seen in the 1990's? For the sake of US consumption, the US retailing community, and those foreign economies dependent on US consumer goods imports, let's hope not.
Finally, and it simply continues to amaze me to be honest, cash out dollars as a percentage of new refied loans in 2007 stood just shy of 26.5%. At least as of the totality of last year, the continued leveraging of US residential real estate was in full bloom. As per all anecdotes of the moment, 2008 should begin the 180 degree process as far as these trends are concerned. We'll just have to take it one quarter at a time as the cycle continues to play out.
A few remaining data points with accompanying charts cover the rest of the important refi data waterfront for last year. The average age of a refied loan as of 4Q 2007 was just under four years. What this tells us is that, on average, loans made over the 2004-2007 period may indeed be having a much tougher time being refied. Remember, the adjustable mortgage rate resets now exploding on household balance sheets and P&L's are largely of the vintage of the last four plus or minus years. The loans made in 2005 and 2006 especially are in many cases in desperate need of restructure. But this data is telling us that on average, these are not the loans being refied. Not a good thing in terms of the potential further foreclosure activity. Lastly, although this is a relatively generic comment, we're now in the area as per this data when the cycle has peaked for refis. Will it be so again? I believe that's a very good bet.
Without dragging you through another chart, the ratio of the new mortgage interest rate relative to the old loan rate now being refied remains above 100%, telling us the new interest rate is higher. This has been the character of refis for eight consecutive quarters now. There has been virtually no cost of capital advantage to homeowners walking through the refi process. In fact, cost of mortgage capital has gone up consistently. We're now in the longest period on record (the last two plus decades) where refied loans are witnessing higher mortgage rates with the new loan. Quite the anomaly relative to historical experience. But of course the latest housing cycle itself has been quite the anomaly relative to historical experience. What is clear is that about the only advantage in the refi process of the last few years has been exchanging a variable stream of future payments for a fixed stream. Don't get me wrong, as per current circumstances, this is surely benefit enough. But in dollars and cents terms, current circumstances of aggregate refi character is doing nothing to help households lower monthly housing costs during a period of meaningfully rising personal inflation (energy, food, etc.).
During 4Q of last year, over 80% of refi activity involved a cash out component. And you already saw the average 25%+ cash out for all of 2007 in one of the prior historical data charts.
Point blank, I continue to believe the character of residential real estate will continue to have a very meaningful impact on real economy, credit market and broader financial market outcomes ahead. I have a very hard time seeing it any other way or believing that "all the bad news has already been priced in." I hope you too can see that the demise of extracting equity from residential real estate in this country has not even started in earnest as of the close of last year. This lies directly ahead of us. With 80% cash out activity on refis up until now, how could it be otherwise? And you saw that relative to disposable income, cash out refi activity decade to date has no precedent in terms of importance to overall household cash flow, and I use that term loosely.
What lies ahead? We're going to enter a period, which has not yet begun, when cash out activity in the refi process drops dramatically. If there is clearly one constant truism in the refi data above, it’s that it is cyclical in nature. That character has not been repealed. It lies ahead of us, not behind, as many a pundit would like you to believe. Can the Fed wave their magic monetary wand and change the inevitable decline in cash out refis to come? Can Freddie Mac and Fannie being allowed to drop capital ratios from 3-1/2% to 3% (below the former Bear Stearns capital ratio when it was laid to rest) change an inevitable cyclical downturn in refi cash out activity?
As I look at Fed actions of the moment, it is clear the Fed is providing liquidity to those financial firms certainly unwilling (in terms of setting price precedent), and literally unable in many cases, to monetize their CDO, SIV, etc. type assets which are underpinned by the collateral called residential real estate. But these actions do nothing to forestall ultimate balance sheet reconciliation except to buy time. Unfortunately as this process plays out, so does the one you see below.
This does nothing but deepen the asset value problem at the major financial institutions and ultimately leave US households with less and less to "refi" vis-à-vis the cash out mechanism with each passing month. Oh well, like a good cup of coffee, cash out refis are being enjoyed right down to the last drop, in residential real estate values that is. Just a touch more bitter to the average US household taste bud, no?
© 2008 Brian Pretti