Affordable Housing Institute : US

 

As we watch the US housing and capital markets struggle to find their equilibrium, there’s no question we are experiencing a worldwide phenomenon – and even allowing for the parochial lenses through which Americans receive news of other people’s markets, I think it’s clear that however much disturbance we are facing in the US markets, many other nations are about to fare worse, as illustrated by a recent article from The Economist:

 

STUDENTS of politics (and more than a few politicians) know only too well the old dictum about lies that are repeated often enough becoming truth. Those foolish enough to believe it should take a look at the sorry tale of Northern Rock, a troubled mortgage lender that failed last September when it ran out of cash.

 

The US has the world’s most complex – some might say, ‘overgrown’ — housing ecosystem, and it is replete with creatures absent from other nations, starting with:

 

Something not seen in America since 1932: the run on Northern Rock

 

1.  Deposit insurance.  Ever since 1933, Northern Rock couldn’t happen in the US, not because we’re cleverer about avoiding bank failures (we’re not), but rather because we have deposit insurance.  In the US, all deposit-taking institutions must be backed up by the FDIC – the Federal Deposit Insurance Corporation – and its now-absorbed sibling, the FSLIC. 

 

For almost a year afterwards Alistair Darling, the chancellor of the exchequer, repeated, mantra-like, that this was a sound bank brought low by events from afar, and that taxpayers would get back every one of the billions of pounds they lent it. On August 5th Mr Darling was mugged by reality when Northern Rock came to him, cap in hand, again.

 

They want more money?

 

This time the bank wanted help in shoring up its balance-sheet, which is crumbling thanks to a mortgage book that looks worse by the day. The government, which is still owed some £21 billion ($41 billion) by the hapless bank, has agreed to convert as much as £3 billion of the debt (as well as some £400m in preference shares) into ordinary shares.  This urgent need for capital should make those who still think taxpayers will get all their money back think twice. So should those who dare to hope that Britain’s banks have seen the worst of the credit crisis.

 

While reports over here are sketchy and I’ve had no time to study them, I’m very confident that the Bank of England did the right thing, at least strategically, in covering Northern Rock’s deposits.  However, lacking an established regulatory structure – remember, catastrophe is a precondition to fundamental reform – the Bank has to make up the rules as it goes along.  As we saw in Banking on Value and Anatomy of a Coup, this is high-stakes poker, and very complex:

 

Northern Rock needed more government help because the cushion of capital it holds against bad loans deflated alarmingly in the first half of the year, leaving it dangerously undercapitalised. In the first six months it posted a net loss of £565.5m; without the extra money, similar losses in the second half would have brought it within a hair’s breadth of running out of regulatory capital. This injection has bought it time. But there is little hope that it can stem its losses, most of which arise from bad loans in its mortgage book. And the bank has mainly itself to blame for it.

 

The thinness of Northern Rock’s capitalization highlights another feature of the US:

 

Thinly capitalized?  Moi?

 

2.  The Government-Sponsored Enterprises (GSEs).  The US has a dozen of these – in addition to Fannie Mae and Freddie Mac, about whom I’ve written extensively before, there are the twelve Federal Home Loan Banks.  All of these are Federally-backed sources of continuing liquidity, and while the GSEs may expose us to extensive systemic risk, the last twelve months have made a good case for them

 

For much of this decade it expanded rapidly. All the way up to, and then beyond, the peak of the housing market last summer it helped customers pile on debt, lending buyers who could not scrape together a deposit up to 125% of the value of a property.

 

You’ll end me 25% more than I’m worth?

 

Those numbers are – well, they’re insane.  Nobody in his or her right mind lends over 100% of a property’s value, without any hard equity as mind-concentrating security.  Small wonder they’re rotting at a rapid rate:

 

Such loans account for about a quarter of Northern Rock’s mortgage book and they are going bad fast. Arrears on them have trebled in the past year (from 0.7% to 2.1%) and are now almost double the industry average for all mortgages.

 

Our managing director sees nothing Rotten about our portfolio

 

Northern Rock, as an unregulated and unobserved lender, obviously bought its market share by offering the most generous lending terms – and even now appears to be flailing desperately:

 

Some of the increase in arrears is an illusion caused by a shrinking mortgage book. In order to repay the government its loan (and to avoid falling foul of European rules prohibiting companies that get state aid from competing unfairly), the bank is encouraging existing customers to take their business elsewhere. Its very best ones are doing just that. But those who have already missed payments or who flunk credit tests at other banks are being left behind at Northern Rock.

 

There, children, is a quintessential example of ‘adverse selection.’

 

Selected by others

 

Northern Rock is also unwittingly making an even better case for an under-appreciated part of the US ecosystem:

 

3. The state housing finance agencies.  The nation’s state-level housing finance agencies are independent governmentally-controlled lending bodies that serve multiple roles: they provide long-term mortgage financing, they channel Federal resources (such as tax-exempt bonding authority and Low Income Housing Tax Credits), and they have a mission orientation.  As I previously said, they’re the subprime lender that worked:

 

Amid all the stories about the subprime sector’s troubles, a remarkable finding — a whole group of subprime lenders whose loans have done well — has gone largely and curiously unnoticed.

 

I’m modest about my accomplishments

 

Who are these heroes? As presented in this Standard and Poor’s report — the housing finance agencies:

 

Housing finance agencies (HFAs) also serve borrowers who would be candidates for subprime loans: low- to moderate-income and first-time homebuyers. However, Standard & Poor’s Ratings Services has found that HFAs face little risk from defaults on their loans.

 

When the nation’s largest subprime lender can go insolvent almost overnight (meltdown in a mere six weeks), the HFAs’ stability is thus truly remarkable:

 

We do not expect to see any impact from subprime lending on the ratings of HFA single family indentures – several series of bonds with the same collateral; or their issuer credit ratings (Issuer Credit Ratings), which measure the entities’ general creditworthiness.

 

In term of pursuing the bankability and homeownership frontiers, HFAs are well capitalized, publicly accountable, and publicly supported.  That makes them the right pioneers for this territory.

 

Heading for homeownership

 

If England had a set of mission-oriented regional lenders, the space that Northern Rock foolhardily occupied would have been filled by entities with both political legitimacy and greater financial resources.

 

All banks are now afflicted by a slowing economy and falling house prices, which are driving up arrears and repossessions. On August 7th Barclays joined the queue of banks bearing bad news, with pre-tax profits down 33% and predictions of tough times ahead.  One sign of desperation is that the government may scrap transaction taxes on home sales in a bid to breathe life into the market.

 

Never mind that England’s high transfer taxes (they’re called ’stamp duty’ and over here, them’s fightin’ words) add a gratuitous drag on the home-buying economy and tax one subgroup (homeowners) for burdens that ought to be borne by the nation as a whole.

 

When in doubt, blame the Indians

 

The thinking behind waiving stamp duty indirectly highlights the fourth element of the US housing ecosystem that will continue to cushion our downside:

 

4.  A permanent professional rental sector.  For all that it has done, the subprime phenomenon lifted US homeownership rates no more than three points, from 67% to just under 70%.  The remaining 30% of households, as my AHI advisor and Harvard’s Joint Center for Housing Studies chair Nic Retsinas repeatedly points out, are renters. 

 

A steep rise in bad debts could not come at a worse time for British banks. They are only now getting their heads back above water after raising capital from investors to rebuild balance-sheets battered by write-offs on exotic bonds and derivatives backed by iffy American mortgages. There is a real risk that they will be faced with a fresh wave of write-downs, this time home-grown, and be forced to ask shareholders again for cash—lots of it.

 

When homes are foreclosed, they do not disappear; they either go vacant or they turn into rentals.  As I’ve written about, busted condos can become rental reversions.  In a country with an established professional rental sector, price downturns are opportunities to thicken the stock of permanent professional rental apartments.  The financial markets take the hit – investors lose their money – but the properties remain occupied, and eventually they recover.

 

Professional rental, in other words, is a systemic shock absorber. 

 

You want some rental in your housing undercarriage

 

The UK doesn’t have it.  To begin with, the homeownership rate is well above 80%.  REITs are very new, and have focused on more glamorous property types (shopping centers, office buildings).  Most apartments are buy-to-let properties held by small landlords.

 

A few months ago only the most pessimistic analysts were musing about the impact on banks of a 1990s-style recession. Then, predictions that banks’ loan losses might approach £20 billion were seen as fanciful. Now gloom is a growth industry, and such dire estimates are commonplace. Some reckon that losses may be far higher: consumers are more heavily indebted going into this recession than they were before the last one, and inflation is lower, which means that nominal house prices may fall further. More cash calls from banks seem certain.

 

There are times when nothing but cash will do

 

If the UK had a professional rental market, there would be buyers – at large discounts, to be sure, but capital sources nevertheless.  (We’ve seen this already in the US.)  And that invites the fifth difference:

 

5.  Mission Entrepreneurial Entities, in the form of CDC’s and non-profit owners.  I’ve written about MEE’s before:

 

Unfortunately for them – and for cities around the world – bad nomenclature (NGO v CDC v HA) has obscured fundamental similarities, preventing information exchange.  Regardless of what they are called, all these entities are mission entrepreneurial enterprises:

 

Mission.  They got into the field to make positive change.

Entrepreneur.  They achieve their results via entrepreneurship, as actors in the space, not government, taking risks, persuading established institutions to do things (approve proposals, provide capital).

Enterprise.  However little they pay their staff, they must cover their expenses and make cash profits, else they cannot continue pursuing their mission outcomes.

 

 

Faithful AHI blog readers know that because of my background – thirty-plus years working in affordable housing, but always on the private side, and always in an entrepreneurial environment – I’m predisposed to see their value everywhere.  Still, when I see change being made – in the UK, the US, or increasingly in the global south – the change is coming from the MEEs. 

They’re the ones doing transactions.

They’re the ones turning resources into properties and developments.

They’re the ones organizing slum dwellers into political and economic forces.

They’re the ones whose activity changes the political environment.

 

MEEs are the change agents. 

 

In housing-finance ecosystemic terms, they’re the critters.

 

 

We’re driving the pace of change!

 

Just as ecosystems don’t work without animals, whether acting as the plants’ reproductive system or converting DNA into more DNA (”A hen is only an egg’s device for making another egg” – Samuel Butler), without the critters, the ecosystem doesn’t work.

 

The ecosystem works in Erewhon

 

The UK has some MEEs, as I’ve noted before:

 

In the UK, which has essentially no for-profit permanent professional rental sector, the non-profit Housing Associations (HAs) have grown up with the field to themselves.  With that head start, many of them have become large, diversified, and highly professional, to the point where the whole sector is seen as thoroughly market-competitive.  More than any other group, UK Housing Associations see themselves as MEEs.   

 

If the UK’s Housing Associations don’t step up, and fast, the situations going to get really nasty:

 

Whether shareholders will be willing to dig deep a second time is far less clear.

 

That’s Economist-speak for ‘not bloody likely.’

 

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