Ravengate
Partners - Stock market, economic and political commentary by Patricia Chadwick

Archive for September, 2010

To Buy or Not to Buy (A House) – Redux

Monday, September 27th, 2010

In last week’s blog, I asked that question and then provided the issues facing a buyer, without supplying a firm answer. So let me directly answer my own question this week.

YES, I say emphatically, now is indeed an excellent time to buy a house in this country. Seldom in the last fifty years has a potential homebuyer been given the opportunity to take advantage simultaneously of both low prices in houses and low mortgage rates.

Under “normal” conditions, when housing prices are weak, it is generally during periods of high interest rates. This is logical because the mortgage interest rate is the key variable in determining the monthly mortgage payment. As interest rates rise, a buyer is forced to “trade down” i.e. find a less expensive house because of the cost of financing. The other side of that coin is true also – during periods of low interest rates, the buyers of houses can afford to pay up somewhat because the cost of financing is advantageous.

However, as I noted last week, these are not “normal” times. The glut of housing is keeping prices exceptionally low despite the extremely favorable interest rates that mortgage seekers can obtain.

But fair warning – interest rates will not stay at this level forever. In fact, I believe it would actually benefit the economy to have rates rise somewhat. (But that’s a discussion for another blog.) That won’t happen just yet, but the process of finding the right house and getting the paperwork done to get a mortgage can take months and months. The sweet spot for homebuyers is now and it may not last that long.

Getting one’s foot in the door (pun intended) of home ownership is still a worthwhile long term goal. The unfortunate experience of too many homeowners over the last several years is the exception, not the rule. Owning one’s own home is still a legitimate part of the American dream, and the equity built up over twenty to thirty to forty years can be of great value in retirement.

Even if the home available today is not one’s dream house, it can still be a good investment. The “average” home is sold every seven years – we are a country on the move, scaling up and scaling back, depending on our circumstances. In that way, we are different from many other cultures. We are a mobile country. And under normal conditions, and normal conditions will come back again, selling a house is not a difficult transaction.

There is always the “caveat emptor” aspect. Do your homework! Some real estate markets may be so overbuilt that prices are still too high. Shop around and don’t be forced into anything. But get out there and hoof it; drive and walk and talk. Put energy into a search. You are making a long term investment that should serve you well.

Monday, September 27th, 2010


To Buy or Not to Buy (A House)

Monday, September 20th, 2010

That is the question for many potential homebuyers. (Apologies to William Shakespeare) But it is complicated by two other questions that must be answered by two other related parties – (1) the seller: To sell (at a distressed price) or not to sell (and wait till the market improves) and (2) the bank: To finance or not to finance.

In “normal” times (i.e. such as existed for most of the last half century) when interest rates were low, it was an opportune time for eager homebuyers to fulfill their dreams. In “normal” times, prevailing mortgage interest rates are the critical element in determining the price a buyer is willing to pay, because the interest rate is the fulcrum in the transaction.

In “normal” times, low interest rates give house prices an upward boost that sellers are happy to meet and that buyers know they can afford. In “normal” times, banks’ mortgage business thrives when interest rates are low and the arithmetic for approving a mortgage is straightforward and logical.

But we are not living in normal times. Interest rates are as low as they have ever been in the lifetime of this country’s baby-boomers. Even most of our parents never had a mortgage at rates as low as can be realized today. So why isn’t the mortgage business booming? Why is there still such a glut of housing inventory aching to be bought and hoping to be sold? Why does it take a Federal Government tax credit to move the inventory?

I have been pondering those questions for some months and not coming up with a truly intelligent conclusion in my own mind. But a very recent encounter with refinancing a mortgage myself has opened my eyes. Getting a mortgage has now become hugely complex and banks have been maneuvered into making it difficult.

The old rule of “monthly take-home pay of three times your mortgage payment” is no longer applicable. The old rule of providing statements proving the value of all your financial assets to the bank is no longer sufficient to satisfy the mortgage lenders. Now that statement is given a 30% haircut by the bank as it tallies up your assets. Given the volatility in the stock market, I can understand that application to a portfolio of stocks. But triple AAA rated bonds, yes, even Federal Government bonds, are being given the same 30% haircut. Who made that edict – the Federal Government itself or the banks? In either case, it says something about the state of fear in lending. Banks appear unwilling to take any risk at all – two earners are deemed no more secure than one earner (or so it seems).

“Houses, houses, everywhere, Nor any one to buy.” (Apologies – this time to Samuel Taylor Coleridge) So what can be done to end this logjam?

As a machinery analyst for years, I watched the inventories at major capital goods manufacturers. When they got too high, there was only one thing to do – give incentives to potential buyers to get rid of the inventory. The same is true every January in the retail industry. And today, that is what is needed in the glutted housing industry – a major incentive to get rid of the inventory. Without that, there will be no new housing built, and the industry will remain endlessly morbid.

My solution may sound like blasphemy to fiscal conservatives (of whom I consider myself one) but I would bring back the Federal Government’s tax credit for first time home-buyers and keep it in place until the inventory of housing is down to a level that will allow for new homebuilding. Like extending unemployment benefits, this is a temporary solution that will have benefits for the private sector and ultimately for the government.

A tax credit may give the buyer that extra edge to accept a slightly higher bid, and coax the seller into parting with an illiquid asset. Financing will still be a problem, but one can only hope that if the demand for mortgages starts to pick up, the banks will see green (there is no doubt that they make nice money in the process) and will figure that the odds of every new mortgagee defaulting are mighty slim.

The Government will really not be out money in the long run because the increased economic activity will ultimately generate revenues – something it dearly needs to count on. It is a bit of a supply side argument – and I don’t mind that at all.

A Sad Labor Day for Workers

Tuesday, September 7th, 2010

With unemployment standing at 9.6%, it has been anything but a joyous Labor Day for workers in the U.S.

Economists, pundits and market watchers are making much of the desultory job creation in this (to date) lackluster economic recovery.

Numerous factors are at work, hindering new job creation, including (1) continued inventory reduction in the housing sector (2) ongoing deleveraging of consumers’ balance sheets (3) shrinking tax receipts and growing unfunded pension and other liabilities of Government – Federal, State and local, forcing spending cutbacks (4) the reluctance of the banking system to lend to worthy customers because of their own concern about existing loans on their balance sheets and, perhaps the most worrisome of all (5) the high cost of labor relative to capital.

Recessions almost always result from correcting excess inventory in the economy. During the last recession, about a decade ago, the glut was focused largely in the technology and telecommunications industries. The recession that we are now having such difficulty exiting was fomented largely by an excess in consumer debt levels. Much of that excess leverage on the consumers’ balance sheets represented mortgage debt, which created a secondary bubble in residential housing. Thus, we have experienced a major double whammy, resulting in a deep recession simultaneously in two very large sectors of the U.S. economy – finance and housing.

Many of the jobs created to support the expansion of those two industries during the ‘good times’ have now been lost permanently, or a least far enough into the future to seem permanent. Three years after the start of the recession, there is still far too much housing stock for sale and too few buyers willing or able to absorb it. In the world of finance, as financial institutions have reduced their own levels of debt, they have shed jobs that will not likely return for another decade.

The shortfall in tax revenues created by the recession has thrown Governments, most particularly many State and municipal governments which cannot simply print money, into their own recessions. Their fortunes will not turn until economic growth has rebounded significantly from current levels. In the meantime, they have no option but to cut spending, which means to lay off employees. It is a vicious cycle.

In the world of economics, the two main factors of production are capital (i.e. equipment) and labor (i.e. manpower). How those two are combined to generate output is a function of their cost. If the cost of capital is high relative to the cost of labor, management will choose to buy labor, and the converse is true as well. When capital is cheap versus the cost of labor, investment in equipment will increase to replace costly manpower.

Today, the cost of capital is far lower, and therefore relatively more attractive, than the cost of labor. With interest rates near zero percent, capital is as cheap as it was fifty years ago. The same cannot be said for labor, despite the high unemployment rate which logically should act as a catalyst to lower its cost.

We know why the cost of capital is cheap – the Federal Reserve is attempting to stimulate economic growth and is thus pushing money into the system, in the hopes that cheap money will be incentive enough for investment and spending. As companies take advantage of low interest rates and invest in capital equipment at the expense of hiring more people, they are enhancing productivity, and thus reinforcing the rationale for replacing labor with capital.

So why is the cost of labor so high? In part it is because, relative to a cost of near zero for capital, it is hard for labor to compete. So despite the fact that hourly wage rates received by workers have barely grown at all over the last several years, compared to the price of capital which has fallen dramatically, labor is in an unfavorable competitive position. In addition, the cost of labor is rising in real terms because of the growth in non-wage costs – those costs associated with health care, retirement funding and increased government regulation. When weighing the costs and benefits of spending money on capital or labor, it is little surprise that managements are choosing capital in favor of labor. It is cheaper and there are no hidden or unknown costs.

A generation ago, many economists subscribed to the Phillips Curve theory, which espoused the notion that there was a direct link between employment and inflation. Specifically, it stated that if unemployment fell too much, the cost of labor would soar leading to inflation. The ‘danger rate’ of employment was deemed to be 7.5%. That theory was almost universally discarded when during the 1990s unemployment in the U.S. fell below 4% without any negative impact on inflation. What the economists seemed to have overlooked was the beneficial impact of productivity gains which allowed wages to increase without impacting inflation.

So what will it take to get back to 7% unemployment? Will we ever see the ‘good old days’ of 4% unemployment again? Or will the U.S. be stuck with chronic high levels of unemployment such as seem to have become a part of the economic fabric of Europe today?

Despite the painfully slow decline in our domestic unemployment rate, I believe that the U.S. economic system still provides the raw ingredients for dynamic growth. Notwithstanding the rising costs imposed on the private sector by Government, the spirit and drive of entrepreneurism remains unabated in this country. There is a magnetic appeal in our way of life that lures aspiring entrepreneurs and capitalists from around the world. The opportunity and the freedom to follow one’s own dreams are still an integral part of the structure of our economy.

Unfortunately, it will take more time this go round to get back on our feet because restructuring the balance sheet of the consumer is a long and arduous task.