Real estate is a key factor in PIMCO’s overall economic outlook and the firm’s investment strategy for mortgage-backed securities (MBS). We asked Scott Simon, head of PIMCO’s mortgage-backed securities team, for an update on the firm’s outlook for real estate and how this is shaping the overall economic outlook and MBS investment strategy.
Q: PIMCO expects U.S. economic growth to slow in 2005. What role does real estate play in that forecast?
Simon: Real estate has been incredibly helpful to the U.S. economy by keeping consumer spending much healthier than most people, including PIMCO, had forecast. The Federal Reserve, in trying to rehabilitate the corporate sector, created very low interest rates, which led to very low mortgage rates and very high affordability for houses.
The average person does not buy a $350,000 house. The average person typically thinks about houses in terms of the monthly payment. For example, a prospective homebuyer might be willing to pay $2,000 a month. At 8% on a 30-year mortgage, that $2,000 monthly payment gets you a $273,000 mortgage. With a 20% down payment, that buys you a $341,000 house. At 5% on a 30-year mortgage, $2,000 a month gets you a $372,000 mortgage, and with 20% down a $466,000 house. That is one of the main reasons housing went up as much as it did. Affordability-wise, $2,000 a month bought a whole lot more house when interest rates went from the 8% to 9% range down into the 5% to 6% range. And in a lot of cases, even lower rates could be had if you used a shorter mortgage or a hybrid mortgage.
With the rise in housing prices, you’ve had a lot of equity take-out. People have taken out between $100 billion and $200 billion a year for the last four years. That made consumers feel a lot richer and they indeed were a lot richer given that the average consumer’s biggest asset is real estate. So real estate has really helped consumers consume over the last five years.
We think this is going to reverse somewhat because we expect real estate price increases to start to slow down. Mortgage rates are not going down; we think they will go up. This means that some of the additional tailwind that has come from real estate will go away, and that does indeed contribute to our view of slower economic growth in the U.S.
Q: So PIMCO expects housing price appreciation to slow, but does not necessarily expect housing prices to fall?
Simon: To the degree that rates go up in 30-year mortgages and in 15-year mortgages, and now even in five-year and three-year mortgages because the yield curve has flattened so much, you are going to see less fuel for run-ups in housing prices. Real estate prices will probably continue to go up through the beginning of 2005 as people lock in, but we think the reality is that housing appreciation will slow and eventually go to zero. Some of the really high-priced outliers in parts of the country will likely go down, but it is hard to know when.
Q: There has been a noticeable shift toward adjustable rate mortgages (ARMs) as homebuyers sought lower rates, adding to concerns about the potential effect of rising interest rates on the real estate market. Is this shift to ARMs another negative factor in PIMCO’s real estate outlook?
Simon: We think the ARM story is overblown. People are talking about the fact that 45% or 50% of the mortgages being created right now are adjustable, but the percentage of ARMs being created right now is very small relative to the overall mortgage market. In terms of total mortgages outstanding, only 21% are going to adjust in the next five years and only 3% will adjust in the next 12 months.
Adjustables are becoming a bigger portion right now, but historically, ARMs issuance has gone up every time there has been a refinancing wave and an increase in rates. If you look at 1994, it looked exactly like it does right now. When rates go up, people start to say "wait a minute, I wanted a 5% mortgage" and then they look at 30-year fixed rate mortgages and the rate is 5.75% but the rate on an adjustable rate mortgage is 5% so they do that. Historically, that has really been what has caused the move to ARMs any time you’ve had rates go up. So we think the shift to ARMs is very normal from a historical point of view and really doesn’t have a lot of meaning.
Our bigger concern is credit on the margin and the rising number of interest-only loans1 rather than an overall move to adjustables.
Q: Why is PIMCO more concerned about the rise in interest-only loans?
Simon: We think a lot of the interest-only borrowers are people who are close to being entirely maxed out in terms of spending. These borrowers don’t
want lower monthly payments; they
need them. We’re afraid that a lot of those people are going to get really squeezed financially when those loans reset upwards.
Most of these interest-only loans seem to be coming as adjustables at below-market teaser rates. For two years, borrowers get a below-the-market rate and then the loans will reset upward. They are hoping that they can reset and refinance into a teaser rate again two years from now, but if they can’t, their payments will go up by about 40% in a lot of cases, given present short-term rates. We think those people are in serious trouble because a lot of interest-only borrowers have a very high debt-to-income ratio to begin with, and we are very nervous about them from a credit point of view. This also removes fuel for further real estate increases.
Q: Why are mortgage lenders extending these loans to borrowers with such high debt-to-income ratios?
Simon: Mortgage lenders don’t really make the loan. They loan the money but then sell the loan through mortgage-backed securities and people like PIMCO and banks and insurance companies and overseas investors buy the bonds, which essentially means that we’re lending the money to the homebuyer. If investors are willing to buy the bond, the homeowner can get the loan.
Q: How are these factors affecting PIMCO’s investment strategy in mortgage-backed securities? Is PIMCO more cautious because of the potential risks presented by these types of loans?
Simon: We don’t think there is going to be a debacle, but we don’t want to get paid nothing for the possibility that there will be. So we’re being very cautious in terms of non-agency debt-debt not issued by Fannie Mae, Freddie Mac or Ginnie Mae.
I think we at PIMCO are just much more conservative in what we will buy. Maybe we have a more sober view of the economy, but we are nervous about it and it really does affect what we buy and what we won’t buy. We are very nervous about deals that have a high percentage of interest-only loans. In the sub-prime floating rate market, we’re buying very, very short cash flows. We are also buying cash flows that are in the first third of the AAA-rated cash flows. So, literally, if two months were to go by and half the people defaulted and their houses went down 50%, we would still get our money back. We’re giving up spread for structure certainty at this point.
We’re also concerned about appraisals. Appraisers tend to get paid because they give appraisals that get deals done. If anything, appraisals are too high. After a huge run-up in real estate, we don’t want to buy brand new paper at really high appraisals unless it has massive credit support. And we typically require more than a lot of investors.
Q: What explains the continued demand for MBS considering the relatively low compensation for risk in some of these bonds?
Simon: What’s happening is you have a lot of investors who are looking to make carry income. Carry typically comes at the price of duration risk and/or credit risk. When people are starved for carry, they are willing to take more duration risk than they necessarily might want to take and they end up taking more credit risk than they want to take. Overseas investors have bought a lot of mortgages and carry is really what they are looking for. They’re not necessarily thinking about it from a total return point of view, which creates opportunities for us but makes the assets expensive.
We, as total return investors, demand the trade-off between carry and risk, whether it is credit risk or duration risk. If we think a risk is worth 50 basis points, and you’re only getting 30 basis points of compensation, we’re not going to take that risk because if you do that trade over and over you’re going to lose money. There is something to invest in that is better than that.
That’s really what I think people pay us for. Our clients don’t want us to just gamble and give away risk, but to try to make investments where we are over-compensated for the risk as opposed to under-compensated.
Q: Is the U.S. real estate market a bubble waiting to pop?
Simon: We think affordability has really driven the price increases in the U.S., and while real estate looks expensive relative to rents, from an affordability point of view, it’s not bad historically. If you look at Australia and the U.K., they really look like bubbles to us, much more so than the U.S. In the U.S., we have some just grotesque regional markets but their whole nationwide markets are pretty horrible.
Q: Scott, thank you for the update on PIMCO’s outlook for real estate and investment strategy for MBS.