The housing market is arguably the sector by which the health of the U.S. economy is gauged; that it has been in the doldrums over the past several years is not in dispute, but it’s clear that there has been improvement in recent months and that the outlook is turning brighter. However, to understand why there is such optimism you have to first understand what drives U.S. mortgages. The three most important factors which control mortgage rate direction and subsequently housing demand are these; banking capital, interest rates, growth and confidence.
The goal of all major banks, and especially the major U.S. banks, such as Bank of America, JP Morgan Chase and Citigroup, is to preserve their capital base, at any and all costs. That means that when a bank loses capital as a result of bad investments, they have less spare capital; and less spare capital means less funding for mortgages.
Bad investments have been a major problem in recent years, directly resulting in the credit squeeze that has traumatized investors worldwide. Though home-grown loans played a significant part in the banking industry’s downturn, bad sovereign-debt loans originating out of the Eurozone are equally to blame. It is the U.S. banks’ exposure to higher risk debt from the Eurozone, primarily Greece’s sovereign bonds but also (and more worrying) to Spain’s and Italy’s, which have affected exactly how much capital is available to lend. Because these countries have less money to lend for mortgages, it essentially quashes housing demand which results then in a drop in housing prices. Though it’s doubtful that housing prices will collapse in an environment such as this the problem is that they also won’t rise.
It would make sense that a rise in interest rates would have a negative effect on housing demand, while a drop in interest rates would have the opposite effect. But that’s not entirely accurate. When the Federal Reserve Bank raises interest rates, longer term (such as 30-year) Treasury-bond yields fall on expectations that inflation will fall and given that, long term rates begin to fall, as well. And because 30-year mortgage rates are linked to 30-year U.S. Treasury yields, the Fed’s hike in interest rates is actually a good thing. In fact, that is the essence of the Fed’s Operation Twist program. With an improvement in the U.S. economy, housing demand should also improve, and while 30-year rates might rise, they will do so steadily, not sharply.
Growth is the most obvious link of the U.S. housing market to the rest of the world. The growth of the U.S. economy is very closely correlated to growth in the Eurozone and Asia, especially China which is the second largest economy after the U.S. If global growth is stable, then banks worldwide feel more confident in their lending, laying the groundwork for a positive Catch-22 scenario. The U.S. banking system is very closely linked to the European banking system, with the bond especially tight between the U.S., the U.K. and Germany. As a result, any escalation of the crisis in the Eurozone will eventually filter into the U.S. banking sector, hitting American banks hard and detrimentally affecting mortgage lending.
U.S. economic growth will also take a hit and when growth falters, consumer confidence deteriorates and then, hand-in-glove, so does demand for housing. Mortgage rates won’t necessarily fall as quickly, either, also putting pressure on the demand side, because banks won’t be willing to lend during an environment they perceive as risky, and will attempt to preserve their returns by ensuring that their risk (of lending during a period of slow growth) is suitably rewarded (through higher mortgage rates).
Eurozone defaults and the U.S. market
Currently, the U.S. banking sectors’ biggest worry is what is going on in the Eurozone, with the largest risks they are facing coming from Spain and Italy. Spain, especially, could ignite a banking crisis there that will affect the U.S. There has, of course, been speculation that either of them (or Greece, for that matter) might default on their existing debt burden and be forced out of the Eurozone. Though the probability that any of the Eurozone members will be forced out of the Eurozone is remote, but the risk does exist nonetheless and U.S. banks must steel themselves, capital-wise, for just such an event, unlikely as it may be.
According to the Bank for International Settlements, as of March 2012, U.S. banks’ exposure to Eurozone debt, specifically from Greece, Italy, Spain, Portugal and Ireland (also known as the PIIGS countries), totaled $770 billion or 7.5 percent of banks’ total direct and other potential exposures. That figure isn’t cast in stone as the data doesn’t reflect any collateral or hedges the U.S. banks might have put in place to lower their exposure, nor does it capture a U.S. banks’ secondary exposure, i.e. exposure to a German bank which is in turn exposed to a Greek bank, etc.
One analysis suggests that the five top U.S. banks, which have a combined exposure of $80 billion to the Eurozone’s banks, have put into place $30 billion in Credit Default Swaps intended to offset a potential loss, making their net exposure $50 billion. The three major credit ratings agencies, namely Standard & Poor’s, Moody’s and Fitch, concur that the largest U.S. banks have been aggressively working to reduce their direct exposure to the those highly indebted Eurozone nations. Earlier this year, the Federal Reserve conducted stress tests among the largest U.S. banks which showed that the majority of them would meet capital adequacy requirements even despite large potential losses.
Though the U.S. banks’ exposure to the crisis over in Europe isn’t as great as that of those banks which are directly within the Eurozone, they are not entirely isolated. Nor are U.S. banks immune from the possibility of default of state and municipal bonds that they hold; any default or bankruptcy will squeeze U.S. banks’ lending capacity and compel them to lend less which is negative for mortgages. Last but not least, given the deterioration of the U.S. economy, it was no wonder that U.S. banks were overwhelmed by defaults on mortgage loans. The delinquency rates for the banking sector as a whole over the past 12 quarters has ranged between 10.14 percent and 11.25 percent which tends to validate banks’ reluctance to lend, however over the last quarter fewer consumers defaulted on their mortgage loans than at any time in the past five years.
Over the past several months, housing sector data has been gratifyingly upbeat, with home prices, housing starts and builder confidence all on an uptrend. The Federal Reserve’s commitment to low interest rates and their implementation of Operation Twist to support the housing market are obvious drivers of that trend. For the last quarter, mortgage originations rose to $471 billion from $395 billion in the second quarter, an increase of 19.24 percent.
Analysts anticipate that the housing sector will continue to improve. A recent news release from Fannie Mae’s Economic & Strategic Research Group said that fiscal uncertainty continued to pose challenges to the economic outlook but they were encouraged by an increase in consumer spending which has fed into the U.S. housing market, in particular in home sales and housing starts. Housing has been a drag on the economy over the last few years but they expect that this year the sector will contribute to economic growth and GDP, with still more improvement likely next year.
The bottom line is that since the 2008-2009 financial crisis the U.S. banking sector has become increasingly conservative. As a result, the banks’ ability to manage their capital and even to maintain extra capital specifically intended for mortgage lending has substantially improved. Couple that with a systematic reduction in the U.S. banks’ exposure to the risky assets in general, and specifically the possible escalation of crisis events in Europe and that means that mortgage markets are likely to remain on firm ground for the foreseeable future.
Barbara Zigah is a lead analyst at DailyForex.com, a Web site that offers daily market analysis, Forex broker reviews and other timely market information. She may be reached by e-mail at [email protected]