Real estate is about to get real bad: Welshcake

By Welshcake

The extent of disconnect between real estate and what other markets have been experiencing is enough to convince me a whole other layer of economic mayhem is on the way. But investors in credit, for all their current pain, could still end up shining if they are prepared.

You know I’m hardly one to jump on a bandwagon of doom. And never let anyone insinuate I’m writing this take-down out of saltiness at Creditflux for not inviting me to join them at the Global ABS 2022 conference in Barcelona.

“But I need to soak up the last-days-of-Rome vibes!” I pleaded down the phone.

“And that’s exactly why you’re not coming.”

To hell with them, my record stands for itself. I have been a big advocate for CLOs as a stabilising force in leveraged markets. And I will back credit derivatives at every turn, such is my support for that most versatile product. Just try saying “murky cabal” or “the Isda Determinations Panel” in the pub and I’ll spark you out.

But as trauma builds in credit, equity, commodities, crypto and other risk assets, the real estate market’s gratingly glib sounding of good times has required an ever-greater suspension of disbelief. Big investment managers still have it as a core pick.

I’m genuinely interested to hear from readers about this, because its nigh on impossible for anyone invested in that space to admit there is a major problem. Anyone who does probably ends up like the Google engineer who got laid off this week for saying the company’s AI chatbot had become sentient.

There is enough of an overlap between firms that do CLOs and real estate that you guys really should have a nosey about over there.

This isn’t some preamble to a joke about a Welsh subprime CLO crisis – I wish it were. But Wales did recently give me a useful insight into cognitive dissonance. Our national football team’s victory over Ukraine to qualify for the World Cup in Qatar was bittersweet since it had meant so much to our opponents to deliver their people a moment of hope. But Ukraine is also a way better team. There, I’ve said it.

Cue talk of Welsh glory and how manager Rob Page is a tactical mastermind. Some folks assume we’ve already got one hand on the trophy. The reality is Wales is tactically very naïve. Which other team at international level would continuously punt the ball up-field into no-man’s land to lose possession when trying to protect a 1-0 lead? Wales will struggle to progress from the competition’s group stage – and that hurts when we’re up against England and the USA.  

But Welsh passions are nothing compared to the cognitive dissonance of global real estate, an asset class that has been bid up vastly beyond realistic appraisals and whose inflated self-worth in this time of economic disruption derives from a rear-mirror perspective. When something is this on fire it needs to know when the fuel is used up – and what exactly it has been burning.

I have come up with 10 myths the market has been telling itself, all of which will contribute to impending crisis as they fall away. This list is by no means exhaustive.  

Myth number one: high inflation will be transitory. This is an easy one because we already know it not to be true. US treasury secretary Janet Yellen has admitted, finally, she got this wrong last year. But what’s scariest is that most of the developments that could bring inflation back into line are out of central banks’ hands – and that’s before even considering how long it typically takes for policy to have an effect. Or whether central banks globally can mount a coordinated rear-guard.

Myth number two: the consumer price index number is a true reflection of inflation. As bad as the US economy’s 40-year high CPI reading of 8.6% in May was, it gets much worse when you break it down into constituent parts and how those affect the average consumer. Spiralling food, fuel and utility costs are eating into their bottom lines, with the US savings rate already cut to 4.4%, its lowest level since 2007/8, and consumer sentiment worse than before the 2008 crash. Even if you hold store in the CPI number, it has now been above wage growth for a year.    

Myth number three: central banks won’t jeopardise asset stability by moving too fast on rates. This may have been the case until now, particularly regarding the ECB and Bank of England. But in this week’s Federal Reserve meeting, credibility is on the line. The FOMC has no choice but to deliver bad news in the form of a decisive hike if markets are to believe inflation can be contained. And a revised GDP forecast must acknowledge the shortening odds of a recession. Either money or reality are leaving the system and it’s hard to see a win for risk assets.

Myth number four: housing will continue to benefit from an imbalance of unmet demand versus thin supply. This might be true for now if you’re talking about places like the US east coast or London. But more westerly and southern US metro areas can be very different, with inventory starting to rise and a growing number of house sales that require lower price offers.

Rear-view thinking overlooked that the post-pandemic buying surge would run its course, that housebuilding delayed by the pandemic would proceed to completion, and that foreclosures staved off by government intervention would subsequently resume. Purchasing power and affordability is heading ever lower, with the US 30-year fixed mortgage rate having spiked up to 6% and the Mortgage Purchase Application index down from a high of 348 in 2021 to 2016 levels at around 208. Tech and start-up driven bubbles like the Bay Area have even more demand reduction to fear as hiring patterns and stock earnings shift into reverse.

Myth number five: the housing market is more resilient than stocks or bonds. To be fair, this is normally a reasonable assumption. Real estate is a behemoth that usually takes a very long time to move. But in 2006/7 it was the canary that corporate credit professionals ignored at their peril. This time around the disconnect is working – or rather not working – the other way. But just as then, the potential energy building up in the elastic band will fly with force when let go. Or there’s gathering nervousness in a herd that will stick fast together until the moment it bolts as one.

However you view it, the stats present a picture of inevitable mean reversion. US house prices, adjusted for inflation, are 50% above their long-run historical average, according to the Case Shiller house price index. And the price of housing in many metro areas relative to earnings is at way higher multiples then their historical average. It took over a decade to build this bubble, so getting out will be painful.

Myth number six: central banks and governments will step in to prop up house buyers. This is almost a Pavlov’s Dog mindset by now, but the reason it’s wrong goes to the heart of the credibility question. Printing money and cutting rates to save the day is no longer a viable option – not unless you want even more pain down the line.

For the first time in 30 years, US inflation is above the unemployment rate, which is only 3.6%. A crisis of mass foreclosures is far less likely than in 2008, or at least in the first wave that looks set to be more a mean-reversion of prices. But low unemployment cannot be a given in the equation, when an unstated but self-apparent aim of the Fed will be to pursue tightening this number and inflation coming back into line.

Myth number seven: RMBS will provide an engine for the home mortgage market. It may seem churlish to disparage this component while lauding CLOs as a loan market support. But in truth both have been less able to provide their customary function as issuance slows, with softening investor demand palpable in things like non-disclosure of discount margins. For RMBS, it now feels like the bid may all but evaporate, with strategists having revised down issuance volumes for US agency mortgage deals to half their 2021 tally. And most of that business has already been done, which doesn’t augur well for the rest of 2022.

Myth number eight: we don’t have the structural weaknesses of the great financial crisis. Unquestionably, mortgage underwriting has been much better than back in the early 2000s. Affordability criteria have been much more stringent. There have not been CDOs of ABS, synthetic replications, reverse engineering of quasi-triple A products, complete disintermediation of house buyers from end investors, all that jazz. Banks are under much stricter capital controls and central clearing houses now backstop counterparty risk.

But one gigantic structural weakness we didn’t have back in ’08 is the sheer amount of government borrowing and central bank money printing that has gone on since. Pandemic intervention dwarfed that of the GFC, in large part undertaken through a perverse form of corporate socialism that propped up companies whether they needed it or not – rather than allowing free reign of the survival-of-the-fittest market forces that supposedly underpin capitalism.

Further government intervention is a deus ex-machina we should remove from any foreseeable plot line. What is to come will thus be a huge test of post-GFC systemic risk mitigation apparatus.

Myth number nine: We’ve been here before. There are many in markets outside of real estate willing to accept how big an issue persistent inflation poses, but who see the worst-case scenario to be something like the 1970s. Make no mistake, this itself would be disastrous, and it’s not a way forward any government will countenance if it wants to stay in power. But the current picture looks even bleaker in key regards, since the US personal savings rate was more like 10-15% in the 1970s, with inflation only outstripping this during a spike in 1980.

If you’ve been paying attention, what emerges from this is a perfect storm of tumultuous headwinds – and converging at a terrifying rate on a market that cannot accept it has anything to fear. It is precisely because it is enjoying such heights that it has so far to fall. And this is what sets it apart from you guys in credit, who have already had to adapt and find ways to navigate the turbulence. It’s not a great outlook for the coming months, but one should expect that the deeper and faster this thing heads the quicker credit investors will have an opportunity to buy in on lucrative trades. Something like the spirit of ’09 perhaps.

Which brings us to myth number 10: central banks can engineer a soft landing. It’s amazing that economists and strategists keep holding onto this possibility in their analysis like it’s a caveat with reasonable odds. Historically, central banks have never delivered a soft landing when inflation passed 5%, so how will they manage to do this now when so many of the economy’s marauding monsters are completely off the leash? Possibily those who still countenance a soft landing believe that geopolitical and supply chain disruptions will abate, or simply that inflationary and recessionary narratives cannot co-exist for long. But what if they can? Or if today's inflationary hysteria can give way abruptly to a deflationary crash?

Soft landings seem out of the question as central banks set their tactics to hoofing the rates ball further and further up the pitch. I would rather bet my money on Wales winning the World Cup.   

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