Red Sky At Night
by Brian Pretti CFA, Contrary Investor. March 19, 2010
Just about every time one clicks on a news story these days concerning residential real estate, it’s not a fun read. Of course this comment refers to factual stories as opposed to the hope and hype put out by the National Association of Realtors, the Mortgage Bankers Association and other real estate industry groups. To be honest, even the NAR has toned it down in a big way after trying unsuccessfully for about four years to call a bottom in the housing market. The bottom will come, count on it, when even the NAR is skeptical. I’ve been guilty of this pessimism myself, although the personal negativity began half a decade ago, and it seems like only yesterday. Just where does the time go? In a little bit of an about face, it’s high time something positive is said about what is going on in the mortgage markets when everyone else is still looking for doom and gloom. And to be honest, there is indeed some factual information to back up a bit of good cheer for right now. Heaven knows we need it. No kidding, this is really positive news, although I’m not so sure it’s a wonderful set of events for the greater goal of macro US economic recovery.
It has been more than a year since I have written about the Freddie Mac refi data. Don’t get me wrong, I’ve been checking in diligently and regularly alright, there just has not been a heck of a lot to say until now. Although this may sound melodramatic, I was a bit stunned as I perused the fourth quarter report that hit the tape a month or so back. Stunned and personally gratified, to be honest. Records were set in the fourth quarter of last year. And what happened absolutely and concretely validated for me the personal theme of deleveraging at the household level having only just begun. A process that will certainly not be fun, but one that is sorely needed. The American public is “getting it” and acting very responsibly. To the point, only 27% of the residential refinancing undertaken in 4Q of last year involved cash out activity. This is down from 85% about two short years ago. Talk about a radical change of events, the 27% cash out level in 4Q of last year was the lowest cash out level in the history of the refi data stretching back a quarter century now. The top clip of the chart below details the total history of the data.
But of course the real shocker lies in the bottom clip of the graph. Yes, your eyes are not deceiving you, one in three refinancings in 4Q involved additional cash being brought to the table by the homeowner taking out the new loan. Can we now call them “cash-in” refi’s? Absolutely unbelievable as nothing like this has ever been seen before. Talk about fiscal prudence, this set of facts takes the cake. But the key issue is, if this is not the very definition of household deleveraging, then what is it? This is just one reason why I have been banging the drum so loudly now for so long about deleveraging being a primary economic and financial market theme. Have no worries, you have not missed a thing as households are just getting started on this wonderful little adventure.
I’ll stop the end zone victory dance for just a second and point out a few facts. First, we’re just going to have to see if this is the beginning of a trend. One quarter of data does not a trend make. Secondly, according to the Freddie Mac data, conventional 30-year mortgage rates “officially” fell below 5% for the first time in the history of the data in 4Q. So households were being treated to the lowest mortgage rates of a lifetime. As I have discussed extensively this year, and is more than common knowledge, the Fed is set to end the print money and buy mortgage backed securities game in March. The 4Q refi character experience may be a one off one hit wonder if mortgage rates begin to climb. For what it’s worth, my bet is that the Fed will not be able to stop without some other type of mortgage rate subsidization program being enacted, or they simply continue QE after a very brief respite. To be honest, THE overriding issue here is the Fed cannot and will not tolerate a contraction in the money supply. The end of March nears by the day, so we’ll know soon whether this little assumption is anywhere near the money or not. The other fact is that the record low in cash out refi’s may not be 100% voluntary by any means. Mortgage money is scarce as the asset-backed markets are essentially out of the game. The players still left in the mortgage market are few and mortgage underwriting standards are pretty darn tight. In fact bordering on as tight as anything seen in the last two to three decades. So that says a lot about the drop in cash outs. But the real news is the cash-in’s so clearly seen in the bottom clip of the above chart. To be honest, I really never thought I’d see the day.
A few more fun facts and we’ll push forward. The average age of refied property in 4Q was very much in line with what we have seen in recent quarters, about 3.6 years. No new news here. But the bottom clip of the next chart shows us that again for the first time in the history of the data, the median price appreciation of refied properties in 4Q relative to the last mortgage financing of these properties actually witnessed price declines. Never seen before. And, again, remember one third of all refis that occurred in a price decline environment saw those refiing bring cash into the transaction.
One last noteworthy data point from the most recent refi report that again reflects the theme of the importance of credit cycle dynamics in the current environment to real economic outcomes and the fact that for households/consumers the environment has changed markedly. With the drop in cash out activity, nominal dollar cash extracted in the refi process dropped to a level in 4Q of last year not seen in nine years. The top clip of the chart below details over a decade and one half of quarterly cash extraction in the combination of the refi process and home equity line drawdowns. It was only four years back that we were running close to $400 billion annually in “extractions”. You can see that cash out activity kicked into high gear in 2001 and really only began to wind down significantly in 2008. From 2001 through 2007, US cash extracted from residential real estate “values” totaled $1.75 trillion dollars. What is that equivalent to? Almost the entire stimulus package of last year plus total Fed buying of mortgage back securities in 2009. A lot of money? You better believe it. The important message is it will not be repeated in the next eight years. Not a chance.
The bottom clip of the chart above shows us just how meaningful this was in terms of the level of cash outs and HELOC’s relative to like period levels of total personal consumption. And, of course, this ratio has come full circle, retracing over a decade of acceleration and contribution to household financial “well being“. Did this influence the ratio of change in personal consumption over time? In part the answer is yes. As you can see in the chart below the annual rate of change peak in PCE in 1999 corresponds to the mini peak in cash outs seen above. There is also a directional linkage from 2002 through the peak in 2007-08.
Certainly current period change is not the end of the world or the destruction of domestic consumption as we know it, it will probably be decades before home equity is again viewed as a source of funds by households. At the margin, it’s a negative for forward consumption, not that there are not plenty of other negatives already.
In quick summation, the change in the character of refi activity in 4Q of last year was pretty striking. Again, although a quarter does not a trend make, what we see plain and simple in the trends over the last few years and current numbers is household deleveraging. I’ll keep you up on what happens ahead, but when I try to “count the cards” the deleveraging anecdotes just continue to add up. From consumer credit record contraction, to actual net mortgages outstanding falling (mostly the hard way of course), and now to the refi data, the summation sign under all of the recent data is household deleveraging - a key macro theme. I can’t emphasize it enough.
Brian Pretti
© 2010 Brian Pretti
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Brian Pretti CFA | Editor and Publisher, Contrary Investor
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