Debt Limits and Downgrades

I was called to the NBC studio last night to provide commentary for the dueling speeches by the President and the Speaker of the House. Stock market futures declined after the President’s speech and declined more after the Speaker’s speech. This morning, all seems forgotten as futures indicate a positive opening for stocks which tells us that this entrenched political strutting and fretting is no surprise to investors. I’m worried by something Admiral Hyman Rickover said in 1957, “Our past history and security have given us the sentimental belief that the things we fear will never really happen – that everything turns out right in the end. But prudent men will reject these tranquilizers and prefer to face the facts so that they can plan intelligently.” I’m deeply concerned that our sentimental optimism may blind us to the consequences and ramifications of losing our AAA rating on US Treasuries.

This should have never gotten to this point. We need a deal with the greatest amount of cuts, and we need to lift the debt limit – NOW. It looks as if our sovereign debt rating will most surely be cut by the ratings agencies. That this has been allowed to happen is a shameful, despicable black mark that should follow each legislator to his or her grave. We need a standard that will force a severe penalty for Congress (and not the American people) if our deficit continues to be allowed to imperil our economic future. It should not be too much to expect from our leaders to be able to compromise and address the long-term structural deficits. It’s not fair that we all have to go through this painful process, but it is necessary if we expect to actually get out of this mess.

I’ve spent some time researching the effects of ratings downgrades. The typical expectations follow Greece’s pattern of lower ratings and higher interest rates. Japan is the exception. Yields on Japanese bonds fell after ratings downgrades. I turned my head-scratching to my friend Dr. Jay Bryson, a brilliant international economist with Wells Fargo. Everything else is not equal in terms of Japan. Yes, they were getting downgraded, but they were also slipping further and further into a modest deflationary spiral, which would tend to bring down nominal yields. The question is how much lower would JGB yields be if Japan was not downgraded? In terms of the United States, I don’t think anybody has a real precise answer of what will happen. Given our political paralysis I think a downgrade is inevitable.

Most people are assuming that a downgrade will have some effect on interest rates. Most people are also assuming that the effects will be limited to 25 basis points or so (on the 10-year Treasury note). Let me first say that I have no idea how the bond market will react. But my guess is that the move will be limited to a short-term and modest spike, followed by a reversal. I believe we will get a reversal for a number of reasons. First, the US dollar and US Treasuries are still the best house in a bad neighborhood, provide the best liquidity, and will look attractive given what is going on in Europe and Japan. Second, I think the underlying fundamentals of the US economy remain weak, with anemic job growth, an over-indebted consumer, and falling housing prices. Third, an eventual deal to lower our deficits and debt will likely result in austerity measures similar to those forced upon the Greeks (although not nearly as onerous). Lower government spending will act as a deterrent to economic growth, which increases the likelihood of a QE3. And finally, weak economic growth and the potential for austerity measures mean that the Fed is likely to keep Fed Funds target at 0-0.25% for longer.

But let me be clear: simply because we are benefiting from being “the best house in a bad neighborhood” right now does not mean we should be risking an incredibly valuable national asset. The dollar’s status as reserve currency and the country’s status as the safest place in the world to invest save us countless billions in funding costs every year. It is unthinkable that we would risk this gift that has been bestowed upon us through the hard work of many generations of Americans. We cannot count on the messes in Europe and Japan to keep our interest rates low forever. The Chinese and others must be dumbfounded at our recklessness. I certainly am.

Having said all that, let’s just assume that rates do rise in response to a downgrade. The implications for the housing market are complicated. Right now we have affordability rates at very high levels, and housing prices are still declining. Given the affordability levels (thanks to ultra-low mortgage rates and a 30% drop in housing prices), one would think there would be more demand. However, buyers are not materializing because 1) unemployment remains stubbornly high and incomes are not growing respectably; 2) prospective buyers think prices are still going lower; and 3) prospective buyers cannot qualify for loans given stricter lending standards from FHA, Freddie Mac and Fannie Mae. In my opinion, this third point is perhaps the key to any potential turnaround in housing. Banks, for the most part, are still only originating loans that can be funneled to Fannie Mac, Freddie Mae, or are backed by FHA. The private label securitization market is closed, for all intents and purposes. Therefore, demand is being held back due to financing issues. It would seem to me that this issue would be the best place to start from a policy standpoint. But I’m getting away from the topic.

So we’ve covered why demand for housing has been weak. But the more important determinant of housing prices over the near- to intermediate term will be on the supply side. There are still over 2 million houses in the foreclosure pipeline. The combination of loans in foreclosure and loans 30 days+ delinquent is nearly 13%. While down from the highs, this is still a huge amount of supply pressure. Mortgage servicers have been exceedingly careful about the process of foreclosure in the wake of the revelations about robo-signing and other improper foreclosure practices. The regulatory scrutiny caused by the robo-signing ordeal has exacerbated the supply problem. Given the backlogs, servicers simply do not have the resources to work through all these foreclosures. Therefore, the pipeline has swelled, foreclosures are taking much longer, and the correction cycle has been extended much longer than should have been the case. The market has not been allowed to clear yet.

In addition, estimates say anywhere from 23% to 30% of total mortgages are underwater (the principal balance of the loan exceeds the home value). My belief is that the loan servicers, in anticipation of more widespread strategic defaults (homeowners simply stop paying their mortgage even though they have the resources to do so), will increasingly call the borrowers and offer to write down their principal balances. It is unclear what effect this will have on homeowner behavior and housing prices. But it is not hard to imagine a scenario whereby a herd mentality takes over and borrowers increasingly try to stick it to the banks.

It is pretty clear to me that the true clearing price for residential real estate in many regions is lower based on a lot of supply and not enough demand. The most likely scenario going forward is that inventories will continue to be slowly cleared, causing additional pressure on prices. Meanwhile, more and more homeowners will find themselves underwater, forcing the banks to be more aggressive about writing balances down. This whole process lead to another meaningful downward adjustment in prices. However, it is more likely that the Fed increases its role in supporting the housing market. I believe the Fed is super-focused on housing, and this is why I believe a QE3 could be coming before long. Housing is just far too important to our economy right now. It affects consumer sentiment, consumer behavior, savings rates, and the job market. And as we all know, consumer spending represents 70% of our economy.

I guess my point is that higher interest rates are only one of a number of factors that could potentially pressure housing prices more in the near future. There are other factors that have been inhibiting demand and increasing supply. For sure, a rise in mortgage rates would not be a welcome development for homeowners, prospective buyers or the Fed. And the Fed’s focus on housing is just another reason why we view sharply higher interest rates as unlikely any time soon.

But lower housing prices, while very important, are just one consequence of higher interest rates (which could be the result of a debt downgrade). There are almost too many to count. A sign at my mechanic’s garage reads, “Poor planning on your part does not require panic on our part.” Unfortunately, my mechanic may not have considered the actions of Congress when composing his sign. Whatever may have happened to this point, let’s heed Admiral Rickover’s admonition for, “…prudent men will reject these tranquilizers and prefer to face the facts so that they can plan intelligently.”

Our portfolios remain defensively positioned.

Hang in there.