Despite positive factors, growth is not guaranteed
by Ron D’Vari & Zareh Baghdassarian, NewOakNewOak is an independent financial services advisory firm built for today’s global markets. Led by a team of experienced market and legal practitioners, NewOak provides a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators, including financial advisory and dispute resolution, valuation, credit and compliance, risk management, stress testing, model validation and financial technology solutions. We have analyzed or advised on more than $4.5 trillion in assets to date. Visit newoak.com
The U.S. housing market’s performance is inherently intertwined with a multitude of macro factors such as interest rates, GDP, the job market, consumer confidence, housing finance regulation, credit availability and the public’s view of homeownership. To further complicate matters, the housing market itself is a key driver of the U.S. economy as well as the availability of mortgage credit.
The global economic and geopolitical environment also plays a influential role in the direction of the overall U.S. economy, fiscal and monetary policies and housing demand both in the short and intermediate terms.
Despite many positive forces, housing market growth is not guaranteed and remains fraught with uncertainty. While there are many factors in play, two overarching dynamics stand out as keys to the recovery of the economy overall and the housing market in particular: the Federal policy and housing finance regulations.
Uncertainty looms as QE ends
The uncertainty of interest rates in the next one to two years has taken on enormous significance as the Fed is nearing the end of its quantitative easing and markets can expect an imminent rise in interest rates. There is a good chance the Fed will signal that it plans to raise interest rates sooner rather than later. This could become a real test of the economy’s vulnerability and housing market fragility.
Strict adherence to the Consumer Financial Protection Bureau’s ability-to-repay/qualified mortgage (ATR/QM) rules that went into effect in January is a significant concern for many lenders and has constrained mortgage origination to some extent. As a result, many otherwise qualified home buyers are failing the QM/ATR rules.
Another risk is the bleak GDP numbers in the Eurozone, with France and Italy of special concern. This has raised fear of “Japanomics” in Europe. Healthy growth in Spain, Greece and Ireland, as well as open talks of quantitative easing in Europe, mitigates some of the fear. Eurozone economic woes and little to no inflation can be a risk as well as a positive for the U.S. housing market and finance if it helps to moderate a rise in rates. The increasing emphasis on more flexible and growth-oriented fiscal policies in the U.S., Europe and Japan will be a positive driver of GDP growth if it comes to pass.
We remain cautiously optimistic that the Fed will take into account all these factors along with global conditions and labor and housing market fragility. We also think troubles in the Eurozone and emerging markets will be gradually addressed. This could help keep global inflation under control, hence giving Fed policy makers more leeway and time to normalize interest rates.
Banks in Munis: The Fight to Quality
After nearly a year of deliberation, this September the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency officially adopted a new rule – the Liquidity Coverage Ratio (LCR) rule. Its goal is to help ensure banks have enough high quality liquid assets (HQLA) during periods of financial stress. At issue is the exclusion of municipals from the pool of securities applicable to the LCR calculation. However, market participants must realize that the current environment is a point of disequilibrium; deterring banks from chasing supply may be just what the majority of municipal investors desire.
George Friedlander, chief muni strategist at Citigroup, claims the proposed exclusion of municipals will have an “exacerbating effect” on the broader municipal market, heightened especially at times of stress. But, will it really?
While it is clear that the exclusion presents one less reason for banks to buy municipal bonds, a drop in demand may fail to materialize. For example, JP Morgan, one of the largest holders of municipal debt among U.S. banks ($44 billion as of 2Q 2014) will likely be unaffected. The bank already planned to exclude the securities from the assets it will use to satisfy the LCR requirement according to a recent Bloomberg article. In the unlikely assumption they are alone in that decision, demand from banks would be constrained and yields would likely rise to some degree. However, even this would not be a point of contagion as many predict. Rather, it would be a market returning to equilibrium from abnormally low yields.
Further, over the period from December 2010 to March 2014, the muni market shrunk by nearly 3%, or $110 billion, while banks increased municipal holdings to $425 billion, by $171 billion, totaling 11.6% of outstanding muni debt. Proponents of municipals as HQLA defend that banks have picked up the market slack during stressful times. Impressive but, of all bank-held municipals, roughly 27% are in the form of loans, not bonds, according to a July 28 research note by Friedlander; thus outside of the pool of HQLA contending debt.
Ultimately, the market’s standards of quality must rise: not due to what Washington regulators deem to be high quality, but rather in an effort to advance market participants past the antiquated municipal analyst. To do so, we must worry less about regulatory pressures that will likely impact only a miniscule faction, and instead focus on demonstrating to regulators the soundness of our fundamental assessments of creditworthiness.