Muni Madness (redux)

If you follow me on twitter, you've seen this and can probably skip it.

In what seems like a yearly event now, with 3 consecutive years of this game, tax-exempt municipal bonds are once again cheap. It could be the overall bond sell-off, it could be the Detroit scandal, it could be bond fund outflows; I don't know what the cause is, but I do know the bonds are cheap.

Frequent readers know we are generally fans of quantitative methods, so expect some numbers.

In the last 5 years, our preferred proxy for the tax-exempt AAA market has disconnected itself the ratio range that was common until the global financial crisis. Due to the tax-exempt nature of muni bonds, benchmark yields were often quoted as a percentage of treasury yields instead of a spread, but this has become an increasingly inaccurate way to look at yields. We consider two options:

1. The market underwent a structural change by which the old measures became invalid. An example of a similar event would be the '87 crash after which options began exhibiting (steeper) volatility smiles. In this case we would consider the structural change to be either a transition from rate-based to an credit-based market, a change in the way liquidity is priced post-GFC or a combination of the two.
2. That the "fair-value" ratio is itself a function of interest rates and tax-exempt bonds exhibit negative convexity as yields approach a floor, a relationship which had not been visible until the introduction of ZIRP brought treasury yields down far enough for the relationship top be visible.

 Although we agree with the assertions that, market-wide, the tax-exempt market has transitioned from rate to credit, we believe the AAA benchmark is exempt from this because of its information insensitive nature (for more on this see Slapped in the Face by the Invisible Hand by Gary Gorton) and while we generally agree about the repricing of liquidity post-GFC, we believe we have the ability to control for that (more later). A review of the data from 2001 to present day as well as our expectation of behavior by participants makes us believe the second option, that the "fair" ratio is dynamic, is the likely explanation.

Although we do not put much weight on the automatically generated regression, we believe it to suffice as evidence that tax-exempt bonds tend to exhibit negative convexity, possibly from an absolute rate floor. Below you can observe 2001-present and June 2009-present time series with accompanying overlaid histograms showing ratio changes over time and the distribution of values within those time periods. Please notice the increase in ratios as yields fell to new lows as the adoption of forward guidance and quantitative policy by the Fed lowered 10y rates to new post-WWII lows and the apparent reversion of this trend after the secular low was printed in June 2012.

Continuing this general line of thinking, we explore a linear relationship between the AAA 10y tax-exempt yield and the 10y treasury yield and find strong evidence of a nearly constant  sensitivity of municipal yields to treasury yields of 0.587. 

 

We expand this simple example into a multiple regression incorporating the MOVE index and the VIX index as a measure of treasury-implied volatility and a proxy for CDX.IG respectively. This allows us to internalize other credit-insensitive spread products into the model, namely MBS (for more information read about MBS replication) and high-grade corporate bonds. 

To test for structural changes pre- and post GFC-, we slice the data into 4 time periods:

• pre-GFC:  prior to January 1st, 2008
• GFC: January 1st, 2008 - June 1st, 2009
• post-GFC: subsequent to June 1st, 2009
• Complete: all data

The results are reproduced below:

PRE-CRISIS DATA

Residuals:
      Min        1Q    Median        3Q       Max 
-0.260117 -0.066022 -0.004478  0.067822  0.227960 

Coefficients:
                          Estimate Std. Error t value Pr(>|t|)    
(Intercept)              0.8584473  0.0255899   33.55   <2e-16 ***
pre_crisis_data$USGG10YR 0.6018459  0.0049374  121.89   <2e-16 ***
pre_crisis_data$MOVE     0.0019368  0.0001343   14.42   <2e-16 ***
pre_crisis_data$VIX      0.0064424  0.0004559   14.13   <2e-16 ***
---
Signif. codes:  0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1 

Residual standard error: 0.09118 on 1719 degrees of freedom
Multiple R-squared: 0.9001, Adjusted R-squared:   0.9 
F-statistic:  5165 on 3 and 1719 DF,  p-value: < 2.2e-16 

CRISIS DATA:

 
Residuals:
     Min       1Q   Median       3Q      Max 
-0.66890 -0.17289  0.05204  0.15769  0.59407 

Coefficients:
                     Estimate Std. Error t value Pr(>|t|)    
(Intercept)          1.770108   0.113410  15.608   <2e-16 ***
crisis_data$USGG10YR 0.294021   0.027904  10.537   <2e-16 ***
crisis_data$MOVE     0.005621   0.000594   9.462   <2e-16 ***
crisis_data$VIX      0.003370   0.001531   2.201   0.0284 *  
---
Signif. codes:  0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1 

Residual standard error: 0.2308 on 349 degrees of freedom
Multiple R-squared: 0.517, Adjusted R-squared: 0.5128

Residuals:
     Min       1Q   Median       3Q      Max 
-0.30228 -0.08212 -0.00518  0.06629  0.47018 

POST CRISIS DATA:

Coefficients:
                          Estimate Std. Error t value Pr(>|t|)    
(Intercept)               0.981564   0.016827  58.331   <2e-16 ***
post_crisis_data$USGG10YR 0.519255   0.006456  80.426   <2e-16 ***
post_crisis_data$MOVE     0.002171   0.000249   8.718   <2e-16 ***
post_crisis_data$VIX      0.006691   0.000766   8.735   <2e-16 ***
---
Signif. codes:  0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1 

Residual standard error: 0.1195 on 1034 degrees of freedom
Multiple R-squared: 0.9322, Adjusted R-squared: 0.932 
F-statistic:  4736 on 3 and 1034 DF,  p-value: < 2.2e-16 
F-statistic: 124.5 on 3 and 349 DF,  p-value: < 2.2e-16

COMPLETE SAMPLE:

Residuals:
     Min       1Q   Median       3Q      Max 
-0.43382 -0.06802 -0.00074  0.07707  0.38103 

Coefficients:
                   Estimate Std. Error t value Pr(>|t|)    
(Intercept)       0.8175504  0.0107706   75.91   <2e-16 ***
all_data$USGG10YR 0.6160607  0.0021784  282.81   <2e-16 ***
all_data$MOVE     0.0014400  0.0001251   11.51   <2e-16 ***
all_data$VIX      0.0068161  0.0004370   15.60   <2e-16 ***
---
Signif. codes:  0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1 

Residual standard error: 0.1128 on 2757 degrees of freedom
Multiple R-squared: 0.9726, Adjusted R-squared: 0.9726 
F-statistic: 3.268e+04 on 3 and 2757 DF,  p-value: < 2.2e-16 

As you can see, outside the GFC-period, all of the variables are statistically significant, and the models exhibit high R^2s. Although there is mild colinearity between VIX and MOVE, the correlation is limited and the results are not invalidated. A test for heteroskadicity reveals no significant skerodasticity outside the November, 2008 credit meltdown.

The following table displays the correlation matrix between the residuals of various estimation methods:

               all   pre-gfc  post-gfc   non-gfc
all      1.0000000 0.9957032 0.8588698 1.0000000
pre-gfc  0.9957032 1.0000000 0.8949263 0.9957032
post-gfc 0.8588698 0.8949263 1.0000000 0.8588698
non-gfc  1.0000000 0.9957032 0.8588698 1.0000000 

Based on the very high correlations as well as a review of the residual time series, we don't believe there was a significant structural change after the GFC and believe the benefits of using a strictly post-GFC distribution are outweighed by the lower sample size. For the following illustrations, we use the model regressed from the full sample. A higher residual value represents a lower than predicted yield for the MMA 10y benchmark and a lower value represents a "cheaper" MMA 10y. The first chart illustrates the last year, where the "basis" is the residual of the regression, in percentage points. The second is a time series of residuals over the entire sample.

Conclusion

We think high-grade tax-exempt bonds are cheap. The yields we are seeing right now are usually associated with higher rate and/or higher volatility periods. Additionally, given the apparent turn in interest rates, we see the lower rate-sensitivity and accompanying negative convexity as fundamentally attractive features in a rising-rate environment. The loss in "upside" from the negative-convexity is more than compensated, in our opinion, by higher pre- and post-tax yields, and there remains significant price-upside if yields normalize to predicted levels in a sideways-rates market. We believe ample liquidity and accomodative monetary policy limits the risks of a 2008-like tail scenario, despite what a certain blonde talking-head (who, incidentally, triggered the last sell-off of a similar magnitude in early 2011) with no P&L to speak-of may be saying on TV.  Depending on how much zerohedge you read, your mileage may vary.

Tomorrow we will attempt to revisit the topic from a different angle, comparing tax-exempt credit to corporate credit to illustrate the difference in priced-in losses and then, sometime this weekend, we hope to touch on some vehicles the average investor can use to express a view on the sector.

xoxo,

groditi

Housekeeping note

My last 3 longer pieces have all been posted at Kevin Ferry's excellent site, The Contrarian Corner. It is likely that most of my more serious posts will be published there in the future. You can find all my contributions to it at the following address:

The Contrarian Corner - Author Archives - groditi

The last 3 pieces have been:

• Too much money, not enough paper, redux 
• How Leveraged Money Becomes Less Leveraged (and less money) 
• The Low Return of High Yield

 

ARSUSD Blue Chip Swap Rate (BCS)

Quick post since I've been approached multiple times in the last few weeks about the calculation of the Blue Chip Swap Rate (BCS), a popular unofficial measure of the market-driven price of ARSUSD (NDFs settle against the official ARSUSD cross, which is tightly controlled by the central bank). As you can see, the current BCS for USDARS is ~6.86 vs the official rate at 4.77, representing a large premium on USDs by the Argentine population. With inflation persisting and Banco Central de la Republica Argentina (BCRA) keeping peso depreciation under the rate of actual inflation (and equal to the official inflation measure) the Argentine peso becomes more overvalued every day that passes, making exports increasingly uncompetitive in the global markets (reducing supply of USDs by reducing the current account balance), depressing the local economy and exacerbating capital flight despite a plethora of capital controls introduced over the last 14 months. The most likely ending for this situation is a sudden and violent devaluation similar to the Mexican devaluation of December 1994 once BCRA loses its grip on the exchange rate.

OtherRelated Readings:
Argentina surprised by Germany, which voted against granting a loan at the IDB
Argentine bonds fall following “selective default”
Argentina demands 1-for-1 on imports/exports (video)

Marginal purchases will continue until real term structure steepens

Note: for those unfamiliar with terminology of TIPS, please see Give me a Break (even) for some basic discussion

 

Last night, I finally came up with a concise way of expressing my Fed policy view: "Marginal purchases will continue until real term structure steepens."

Real term structure flattening means that "too much money, not enough paper" is still valid, and marginal Fed LSAPs are reducing the supply of available financial assets enough to lower rates by increasing supply of reserves and reducing supply of risk-free assets. Bear steepening of the real term structure would mean that either marginal asset-buyers have decided other assets offer better prospective returns (flight-to-safety has ended), private credit is growing at a faster pace than the Fed is reducing supply of assets (deleveraging has ended) or, more likely, a combination of both. A side effect of rising and steepening real rates would be that the discount rate (ex-effect from break-evens) used to discount future private cash-flows would rise and therefore, all else equal, that would mean lower asset prices across the board for cash-flow generating assets. I use the real term-structure for this mental exercise because expected returns of non-risk free assets are affected by inflation expectations both in variable-rate instruments (loans, FRNs, some ABS, equities) through rate expectations and fixed-rate instruments as well through expected default rates and recovery expectations. Not to worry, though, falling asset prices due to higher real rates are an eventual inevitability of the Fed's exceptionally accommodating monetary policy and must be accepted as such. All it will mean is buying the same assets at higher expected returns, and should be welcome news for anyone with more financial assets than liabilities.

Too much money, not enough paper

If you follow me on twitter, you are by now very well acquainted with the title of this post. What it refers to is the fact that the Fed's LSAPs are creating a surplus of liquidity and scarcity of product in capital markets, which has driven prices up in any financial asset that generates yield (and many that don't). During this yield chase--or, as I like to call it, The Great Incredible Paper Chase--debt issuers have done what any rational party would have done when there is more demand than supply of a good they can produce, they've stepped up production. As long as the Fed is expanding their balance sheet, the market will have the capacity to absorb new issuance, but it is important to remember that the Fed's balance sheet expansion will not continue forever and that, at some point, they will halt expansion and/or mop-up reserves. At that point, if the issuance of new paper and the capacity of the market to absorb it are in equilibrium, the equilibrium will be upset and, like anyone who has taken an economics 101 course can tell you, prices will reflect it.

So, before getting into a fist-fight over the last tootsie roll left in the mud after the yield piñata, remember that the eventual draining of reserves by the Fed will have full-size snickers raining from the skies and no amount of tootsie rolls will be a fair trade for even a bite-sized milky way.

Y u hate capital so much?!

The following text was originally posted as a comment to David Schawel's Economic Musings blog on April 19th, but it seems relevant to bring it back given the freebase scenario making the rounds. My official position is that it's going to be an adverse reality unless we stop hating capital. It's a little off-the-cuff so don't get caught up in precision and just try to to suck up the main point, which is, without new capital, the banks are decimating the private sector in order to fund the deficit (aka support the government) AKA NO BUENO

From "How Spain pays the piper",

Given that we are starting with a capital-constrained banking system (even before write-downs or 2013 EBA recommendations), we know this, holding capital levels stable, any government deficit must be matched by foreign capital or by reduced lending to the private sector to maintain leverage ratios stable--of course, due to 0%-RW on SPGBs, the EUR amt need not match centavo for centavo. Now, retained earnings (new capital) are not zero, so banks can either maintain their balance sheet size and increase their capital ratio (delever), or increase balance sheet size (fund the deficit) and maintain their capital ratio, or--most likely--something in between, where purchases of new sovereign bonds against increases in capital and levered via LTRO produce large amounts of carry.
This gives us the illusion that banks may very well be able to earn their way out of this mess (see also: LTRO), however, this all changes if we change the risk weight on SPGBs to something other than its current level of zero. Which is were we ask ourselves: In a country where almost 3/4 of private household wealth (ex expected benefits from government pensions, etc) is held as housing equity which has been borrowed against, what happens to the sovereign if that # is cut in half? After all, the sovereign's creditworthiness is just the aggregate of the households. Its credit backed by its ability to tax and/or confiscate private wealth to pay back creditors. If the households are, collectively, broke, then what is left for the government to take? Which is where I--finally--get to my point. If the government represents the collective households and the collective households are overburdened, then how will they be able to back their sovereign's increasing promises as the banks decimate the private sector through loan attrition? Or, in simpler terms, Is there any difference between extending-and-pretending with the households' mortgages and extending-and-pretending with the sovereign's obligations?
As we continue on our march to binary outcomes, I believe it becomes important to ask ourselves, why do we hate capital so much? What is so wrong about recapitalizing the banks and arresting this self-feedback loop? Is it about crystallizing losses by raising equity at prices below book? If so, why the big deal? If equity were really so under-priced, current shareholders would surely rush to a private offering before letting outsiders dilute them, no?
As a final comment, I think there is a 4th possible solution: Capital injections from the core banks and sovereigns.
Maybe this should actually be 3c, but given that we know there is no way except for "more capital" to resolve this and whether it be through debt-to-equity swaps or lower than normal real rates, Core private savings will ultimately pay for this. It might be nice to skip the whole near-financial-meltdown part that ends in core households recapitalizing their own banks after the D2E swaps and just get it over with so 25% of the worlds 12th largest economy could, you know, get back to work.

A tale of two spreads (laughing all the way to the bank)

top: spread between mortgage rates and MBS yield
bottom: spread between CC MBS and 7-year US treasury note

On the heels of the Fed announcing it's latest round of LSAPs, we are suddenly seeing a flurry of media attention around the fact that, despite rocketing MBS prices, mortgage rates are simply not budging. Of course, regular readers are not surprised, as on September 9th I highlighted this very likely possibility in, The twist (redux), A point that David Schawel originally brought up on August 6th (and whose post title I shamelessly stole).

...there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! Proponents of the MBS Twist insist that the Fed can put pressure on the "primary-secondary" spread and push savings to borrowers by increasing (more in a second) their purchases of current coupons, but to me it is clear that the problem lies in the demand, not supply, side of loans. This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price.

Since Chairman Bernanke announced the latest round of open-ended LSAPs, current-coupon MBS has tightened 56bp to Treasuries while the primary-secondary spread widened 31bp to all-time record highs despite 7y Treasury notes trading 10bp wider than pre-FOMC. Meanwhile, earlier today, MBS traded flat to 10y swaps.  It is clear who's keeping the windfall for now.

Give me a break (even)

Top: TIPS  & UST curves; Bottom: break-evens

Some market participants have described the mechanism through which quantitative monetary policy (read: LSAPs) works or is intended to work to be centered around inflation expectations. The line of thinking is that the Fed is trying to stoke inflation expectations to incentivise purchase of goods today by increasing the rate at which people expect the price level to increase while holding down rates, increasing the gap between yields and expectations of inflation, commonly referred to as the "real rate" and observed in the market for Treasury Inflation Protected Securities (TIPS).

From the TIPS and US Treasury Notes and Bonds curves we can derive what we call "break-evens," or the level of future inflation at which payoffs of both TIPS and regular Treasuries are the same. There's some idiosyncrasies here because there is optionality in TIPS as and a right skew to inflation, and so it is possible (and in my opinion true) that this option is reflected in yields and TIPS holders are willing to pay an additional premium (which is constantly changing) for the embedded option which is ultimately reflected in break-evens, which are often interpreted as "inflation expectations."

5-year, 10-year, and 5-year forward 5-year break-evens (rhs)
YoY All Urban Consumers CPI (lhs)

It is hard to ignore the sudden rise in break-evens coinciding with anticipation for Fed LSAPs (QE), and I am choosing to interpret this reaction as representative of market participant "animal spirits." The sudden rise in break-evens (71bp for 5y!!) means that a level of inflation above the Fed's symmetrical target is now "priced-in" for US Treasuries. Which leaves us with the question, "Will incremental asset purchases by the Fed increase the compounded annual rate of inflation by 0.70% over the next five years?" My opinion is that they will not and break-evens are showing us that there is either panic over what additional LSAPs mean for near-term inflation or there the option embedded in TIPS is being aggressively bought and the rise in break-evens reflects the rising premium of this hypothetical call option.

With both core and headline YoY CPI comparisons below the 2% symmetrical target, core YoY CPI displaying a negative 1st derivative and YoY comparisons getting easier (CPI rate of change peaked last year around August) it looks to me like break-evens are excessively ebullient given the evidence of quantitative policy effects on the general price level over the last 3+ years in the US. It is my belief that quantitative monetary policy alone during a period of deleveraging can not generate the necessary credit growth to drive meaningful price inflation other than through whatever transitory effect a weaker currency has on commodity inputs (which represent a small % of final price).  As I mentioned in The Twist, redux,

While borrowers continue to deleverage, any impact from lower rates will be limited and as mortgage debt outstanding continues to fall, the marginal stimulative power of monetary policy, unfortunately, diminishes.

Additionally,there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! (see lower left). ... This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price. 

YoY % change in average hourly and weekly earnings
of private sector employees. (source)

That is why, unless the Fed's continuing LSAPs are paired with fiscal stimulus (hopefully in the form of an extension of the HARP program) I have a hard time believing current break-evens will be achieved. Additionally, I have chosen to interpret the Fed FOMC's decision to embark in another round of LSAPs as confirmation the economy remains fragile and the growth outlook has not improved and, with gasoline prices flirting with $5/gal, and real wages still falling, it is hard to see how marginal purchases of mortgage securities (that have marginally diminishing impact) will manage to stoke aggregate demand to a level that drives meaningful inflation in the short term. Keeping mortgage rates low provides an increase in discretionary income for homeowners able to refinance at a lower rate but, if real wages don't grow and gasoline price increases are taking a significant portion of those savings, the beneficiaries are basically just treading water. And, if I had to guess, I would guess that a non-trivial portion of savings from any mortgage refinancing will go towards paying down revolving credit.

That's why, against every piece of folksy advice* I've gotten from veteran traders, I am very much bullish on the 10-year Treasury Note. I bought exposure to this tenor because I think, in no uncertain terms, that inflation expectations have a harsh reality check coming, the embedded call in TIPS is grossly overpriced and--due to their healthy roll, favorable 2s10s steepness and high exposure to inflation expectations--the ten year note is the ideal way to play this thesis. As such, I will continue to buy weakness in the note and concentrate my duration exposure around this particular tenor. The market has become entirely too intoxicated with the promises of QE and has forgotten that monetary base expansion is not inflationary without both credit and wage growth.

The you go, that is my thesis for buying dimes. In the words of my friend Kevin Ferry, "book it, time-stamp it, laminate it, decoupage it, roll it up and smoke it!"

* "Don't fight the Fed," "Don't fight the tape," "Don't get married to a position," "There's old traders and bold trades but no old bold traders"

Shorter Monetary Policy

Home prices and interest rates

With mortgage rates near record lows, due both to low inflation and negative real rates, the leveraged purchasing power of real wages is near historic maximums. Additionally, for the most part, it looks like the bottom is in for housing price declines. Does this make it a good time to buy leveraged real-estate to capture future price appreciation while financing it at low rates? I do not think it's as clear as many people think it is. Below we'll explore why.

Purchasing power of a $1,000 monthly payment on a
30-year fixed-rate mortgage assuming 15% down-payment.

The purchasing power of a fixed monthly payment is dependent on two things, the number of periods, and the interest rate. If we maintain the the number of payments constant and put interest rates on the x axis and purchasing power on the y axis, you can see how purchasing power declines at a declining rate as rates increasing. In other words,  it is an inverse exponential function, the first derivative of purchasing power with respect to rates is negative while the second derivative is positive.

"primary-secondary" spread

To keep this exercise simple, we will consider the interest rate on a mortgage to be a function of a risk-free rate and a spread. For the sake of simplicity we will consider this spread as compensation the lender receives for taking-on various risks and duties (credit and prepayment risks as well as compensate the the servicer of the loan). The two accompanying screenshots illustrate the "primary-secondary" spread, or the spread between mortgage rates and the yield on mortgage-backed securities, and the spread between the yield of a 30-year current coupon MBS and the 10-year US Treasury Note. The sum of these two spreads roughly represents the aggregate spread between risk-free rates and the national average average mortgage rate.

Fannie Mae current coupon, 10-year US Treasury Note spread

As previously discussed, this is one of the main channels in which the Fed has been supporting the property market. By lowering the Fed funds target and through LSAPs (Large Scale Asset Purchases, colloquially known as QE or Quantitative Easing) they increased the purchasing power of payments by lowering the spread of MBS trade at to treasuries and lowered interest rates. Later on, by buying US Treasury notes and bonds, in what is sometimes called QE2, they lowered interest rates. And, finally, with 2011s "Operation Twist," they helped flatten the yield curve and bring down longer-term interest rates. By buying Treasuries and Agency MBS, the Fed pushed underlying risk-free rates down and and helped put downward pressure on the spread by pushing down the value of the embedded option in the securities (lowering implied volatility of the embedded option).

Finally, we need to recognize that the risk-free rate is also a function of two factors, the real rate of interest and future inflation expectations. The real rate of interest + inflation expectations equal the nominal rate of interest. We can observe the real rate of interest through Treasury Inflation Protected Securities (TIPS) and can compute inflation expectations by comparing that to the yield on regular treasuries, this is called the break-even rate. Therefore we now see that the purchasing power of a monthly payment is dependent on the mortgage spread, the level of real rates, and the market's expectation of future inflation.

You're probably thinking, "gee, thanks for the lesson, but what does this have to do with home prices?" Well, everything. As you can see from the charts above, both the spread on MBS and the level of real rates (how much return lenders expect to earn after inflation) are both at historical lows and the primary-secondary spread is refusing to fall despite record-tight spreads to treasuries. Increases in either real rates or MBS spreads would, unless accompanied by falling inflation expectations or lower primary-secondary spread, cause a fall in purchasing power. In fact, an increase from present mortgage rates of just 0.50% would lower the purchasing power of a payment by almost 6%!

Historical % of median household income required to buy
 a median-price existing home at prevailing mortgage rates

Until now we have worked through this exercise assuming the payment is fixed but, historically, we find that home prices tend to roughly follow wages. As you can see from the chart to the right, the payment required to buy a median price existing-home using the national average of mortgage rates mostly oscillates between 25% and 35% of median household income (mean is 30%). In other words, housing prices are constrained by purchasing, which is a function of wages and and interest rates. Which, finally, leads me to the reason I do not believe increases in home prices are as sure a bet as many think.

Purchasing power of various payments at a 3.5% interest rate

For home prices to sustainably exceed inflation, wage gains have to outpace inflation by more than the increase in rates over that same time period. We saw in the first chart that purchasing power increases at an increasing rate as rates decline. Here, we can see that see that, at a fixed interest rate, purchasing power increases at a stable rate with payment. This means that for home prices to sustainably increase, growth in wages not only has to outpace inflation, but it has to outpace it by a margin wide enough to compensate for losses in purchasing power from any changes in the mortgage rate during that same period.

The Federal reserve is taking extraordinary actions to keep interest rates, risk-spreads and implied volatility low in order to stimulate the economy and achieve their 2% inflation-rate target. Remember Chairman Bernanke publicly stated, "[the 2 percent target is] not a ceiling, it’s a symmetric objective." While this leaves the door open for future easing in the near-term, we need to remember that, at some point, the easing cycle will stop and drop in real rates will stop, even if it seems unthinkable now.

My good friend David Schawel and I like to joke around that the Fed was nice enough to allow us to recognize all the future income of our bonds early. And, in a way, this is exactly what the Fed is trying to achieve with housing. By inflating purchasing power through lower real rates and compressed spreads, the Fed has allowed home-owners to recognize the future appreciation of their property at an accelerated pace. In the future, as real growth returns and, with it, real rates rise, the purchasing power of a payment will drop and rising home prices will require either households to devote a larger % of household income to housing and/or wages to increase at a rate faster than inflation. Remember, a 0.5% increase in mortgage rates from current levels would reduce purchasing power by about 5.94% if we maintained payment unchanged. At the same time, the increase in payment for a stable loan price if rates rose 0.50% would be 6.32%. In other words, to maintain prices stable, monthly outlays need to increase at a faster rate than pricing power decreases due to any change in rate moves.

Depressed real estate prices and low financing rates are leading many to see the current climate as a golden opportunity to buy leveraged real-estate, but price increases are not guaranteed, and the pay-out on a leveraged bet on housing is dependent many different factors. While affordability remains high and payments as % of income are near historic lows due to the Fed's extremely accommodating policy, an economic recovery can put an end to Fed accommodation and suspension of the Fed's MBS reinvestment program would be reflected on both, the risk-free interest rate and the spread at which MBS trade, turning a tailwind into a headwind for price appreciation. Leveraged buyers also run the risk of near-term price declines or inflation rates below the rate priced in by nominal rates. Leveraged real estate requires price appreciation and/or profits from rents to outpace the rate of inflation built-in to interest rates, which as we already saw, is not near lows.

I don't have an opinion on whether residential real-estate is a good or bad investment, it's not my line of work, but I think many investors are failing to see that a leveraged bet on real-estate price appreciation is, indirectly, a bet on inflation exceeding current inflation expectations and future wages increasing at a rate faster than inflation. Under an inflationary environment, increases in the real price level of real estate would require a mix of an increase in the % of income spent on housing and real wages in order to allow growth in outlays to outpace the loss in purchasing power created by any increase in real-rates, inflation expectations, or mortgage spreads.