The Efficient Market Has Spoken: This Is A Mistake

In the early days of the real estate crisis, you will recall the infamous statement of Federal Reserve Chairman Bernanke, that the trouble would remain isolated to the housing sector. The statement was later drowned out and faded by a series of game saving actions by our fearless leader. But this week’s discovery that Our Economic Emperor Has No Clothes reminds us of his imperfection. It shows the Fed, despite all its great achievements and accomplishments, has a self-destructive nature with regard to real estate and the economy. However, the efficient markets in real estate and securities classes served notice this week to the Federal Reserve and to us. They said, "This is a mistake!"

The Federal Reserve has gone to great lengths to revive the all-critical and economic central real estate sector. When it could lower interest rates no further, and with the housing market showing not even a faint sign of life, the Fed invented a way to cut mortgage rates to record low levels. Quantitative easing became a term on the tip of every American tongue, though most had no idea what it meant. What they knew was that even though it felt dirty, it was an invention of necessity, and it worked.

Combined with a series of legislated incentives specific to homebuyers and homeowners, it gave housing a heartbeat again. A handful of surviving homebuilders, including the likes of leading homebuilder PulteGroup (PHM) slopped up market share and put together fantastic stock performances. And after losing all credibility, the mortgage-backed securities market regained the respect of investors, who migrated into high-yielding mortgage REITs like Annaly Capital (NLY). Meanwhile, financial institutions like Bank of America (BAC), which had gobbled up major mortgage lenders on their last legs and found themselves burdened with huge and questionable mortgage portfolios, were nursed back to life. The whole of the securities market, which in the winter of 2009 seemed doomed to disappear, instead recovered and thrived, as evidenced by the performance of the S&P 500 Index from its ominous intraday bottom of $ 666 on March 6, 2009 to its close this Friday at $ 1,592.

Like many a great man who achieves everything that he sets out to and overcomes every challenge presented to him, the Fed’s worst enemy would seem to be itself. The reaction of the efficient market to the announcement of the FOMC this past week presents a clear message: This is a mistake! Furthermore, the reaction of potential homebuyers to rising mortgage rates presents a clear message: This is a mistake!

Halting the purchases of mortgage-backed securities is obviously premature, as evidenced by weeks of rising mortgage rates and commensurate drops in mortgage activity. I heard a Wall Street talking head Friday suggest that rising rates would not impact the housing recovery, because he had financed his home at a much higher cost (9%+ mortgage rate) than the current rate. What that gentleman failed to recognize was that the time he financed his home was very different than current times, and that his personal financial circumstances are far different than the average American citizen getting by paycheck to paycheck. Indeed, this nascent housing recovery is still very vulnerable and highly dependent on mortgage rates.

I also took note of another comment on business television regarding mortgage rates and their importance in the home purchase equation. The individual referenced indicated that he thought mortgage rates were not the most important factor. I beg to differ, and suggest that mortgage costs are at least as important as the home price to the average American. I believe this is so because people will buy what they can afford on a monthly basis, not on an overall accounting. Obviously, the home price is critical, but at any price, a rising mortgage rate is going to swing an affordable home out of reach.

Another talking head said that home purchases financed with mortgages came into play for just two-thirds of the total home purchases today, with 33% of existing home sales in May paid for in cash. She suggested that this meant increases in mortgage rates would not seriously impact the housing recovery. Again, I beg to differ. The fact that a great number of home purchases today are made with cash simply reflects the participation of well-financed investors finding arbitrage opportunity in the flooded pool of distressed properties. The fact that there are still not enough regular, normal home buyers in the market simply says this market is not healthy yet. Therefore, it still needs medicine of the sort the Fed has been providing it.


6/18 to 6/21




Bank of America


Annaly Capital




Stocks collapsed since the Fed Chairman’s press conference Wednesday, within which he confirmed that the Fed would be tapering away its asset purchase program starting this year. There is a message being conveyed here by the efficient market, and it is, "This is an economic mistake!" I think the Fed had better take heed of the message of the efficient mortgage market and of the stock market, before irreparable damage is done to the economy. I understand that synthetic supports cannot be sustained forever, nor should they be, but premature removal of those supports will result in the collapse of the economy and the real estate market, as evidenced by the collapse of securities markets last week.

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