Friday, August 20, 2010

Why Deflation?

This is why!

REFI BOOM|related|story|text|&par=yahoo

Refi's of existing mortgages are deflationary.

The reason the Fed is ape crazy over deflation is that they own $1.25T in mortgages, mostly of the higher coupon variety. Most of these are trading well above par.  As many complete refi's, the underlying mortgages get paid off, which in turn erodes the PV of the MBS.

Many MBS investors will be hurt two ways.

1-Capital loss on existing MBS that is trading above par
2-They are forced to reinvest at much lower coupon levels.

Most of the mortgage activity has been the refi variety.

From the article:

"To summarize, refinance applications are way up, up 17 percent, while purchase applications are on life support, down 3.4 percent from the previous week and down nearly 39 percent from a year ago. Refis now make up a full 81.4 percent of all mortgage applications, up from 78.1 percent the previous week, and at their highest level since January of 2009."

Why are consumers not signing on the bottom line for a new home? Let's see:

1-Housing is artificially being propped up by the government in favor of the financial sector, thus there is zero price discovery. Many are simply worried and or confused to where home prices are headed. The direction is clearly down when looking at foreclosure rates.

2-The labor markets are dreadful. People who are fortunate to even have employment are in no mood to add to their indebtedness.

3-Existing homeowners who are already below the water level on their homes will be forced to sit on then probably for the next 5-10 years. Why buy a new home that is overpriced more than the one they live in?

4-Many consumers have tattered balance sheets. They can't qualify for a mortgage or doing so they will have to pay a higher rate.

5-Many have stopped "Living" the "American Dream". They are more worried about the real purpose of America, which is to find gainful employment. Many are worried that they don't have enough money for retirement, why would they put a considerable amount of money into an obvious money pit?

Again, housing needs to further correct some 20-25% across the board. This will allow normal everyday Americans to purchase a home that is not going to bury them. Who cares if interest rates are low? Housing is still 20-25% overvalued in many markets.

Ask yourself this:

Would you rather buy a home for say 400K when rates are at 4.5% or buy the same home for 300K at 7%?

With the government meddling in the housing market, rates are artificially low. I suggest anyone who is in the money on their homes to refinance immediately to a 15Y mortgage. These rates won't last forever and one should always take advantage of stupidity.

What is happening at the moment is the government is propping up the housing market. They are not allowing the natural forces of supply and demand to do what they do. The market has no clue what price discovery is at the moment. Fannie, Freddie and FHA need to be completely wound down. This will cause great strain to bank balance sheets and cause our economy to contract but there really is no other logical or reasonable way to fix the 2nd biggest strain on our economy. The biggest strain obviously is jobs and that is a structural secular problem that will take some time to figure out. Its ludicrous that renters are subsidizing irresponsible homeowners. Its preposterous that the taxpayer is subsidizing the financial sector.

How do you not expect deflation with all of these headwinds? The government will always understate deflation as well as inflation. Have you heard of the Boskin Commission? You can't judge these simple metrics from what the government tells you. We are going thru the 2nd decade of Japanese policy makers lies about what is going on in that island. The official deflation numbers were -1.5%, the real figures were closer to -4% a year. In this realm, the best investment in Japan was Surprise! Surprise! 10Y JGB's. So the best investment in the US in a deflationary environment? Surprise! Surprise! 10Y US Treasuries.

Going back to government intervention:
This is what they do. Government policy makers and central bankers, all do what people who cheat on their spouses do...They LIE! After they get caught? They LIE some more. When LIE's are not feasible and you are caught with the goods? They rationalize. What generally leads up to all of this is that when the truth becomes unpalatable, it seeks being the truth. Lies only remain.

The big lie at the moment is Fannie and Freddie and the lack of price discovery in the housing market.

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