Geithner Outlines Accomplishments, Future of Financial Reform

Treasury Secretary Timothy Geithner told
the Financial Stability Oversight Council that the financial system is getting
stronger and safer and that much of the excess risk-taking and careless
financial practices that caused so much damage has been forced out.  However, he said, “These gains will erode
over time if we are not able to put our full reforms into place.”

He outlined the basic framework has been
laid, with new global agreements to limit leverage, rules for managing the
failure of a large firm and the new Consumer Financial Protection Bureau (CFPB)
up and running, and the majority of the new safeguards for derivatives markets proposed.  Geithner ticked off the major accomplishments
of reform.

First, banks now face much
tougher limits on risk which are critical to reducing the risk of large
financial failures and limiting the damage such failures can cause.  The focus in 2012 will be “on defining the
new liquidity standards and on making sure that capital risk-weights are
applied consistently.”

 The new rules are tougher on
the largest banks that pose the greatest risk and are being complemented by
other limits on risk-taking such as the Volcker Rules and limits on the size of
firms and concentration of the financial systems.  These will not apply only to banks but to
other large financial institutions that could pose a threat to financial system
stability and this year the Risk Council will make the first of these
designations.

Second, the derivatives market will,
for the first time, be required to meet a comprehensive set of transparency
requirements, margin rules and other safeguards.  These reforms are designed to move
standardized contracts to clearing houses and trading platforms and will be
complemented with more conservative safeguards for the more complex and
specialized products less amenable to central clearing and electronic
trading.  These reforms, the balance of
which will be outlined this year, will lower costs for those who use the
products, allow parties to hedge against risk, but limit the potential for
abuse, the Secretary said. 

Third, is a carefully designed set
of safeguards against risk outside the banking system and enhanced protections
for the basic infrastructure of the financial markets: 

  • Money market funds will have new
    requirements designed to limit “runs.”
  • Important funding markets like the
    tri-party repo market are now more conservatively structured.
  • International trade repositories are
    being developed for derivatives, including credit default swaps.
  • Designated financial market utilities
    will have oversight and requirements for stronger financial reserves;

Fourth; there will be a stronger set
of protections in place against “too big to fail” institutions.  The key elements are:

  • Capital and liquidity rules with
    tough limits on leverage to both reduce the probability of failure and prevent
    a domino effect;
  • New protections for derivatives,
    funding markets, and for the market infrastructure to limit contagion across
    the financial system;
  • Tougher limits on institutional size;
  • A bankruptcy-type framework to
    manage the failure of large financial firms.
    This “resolution authority” will prohibit bailouts for private
    investors, protect taxpayers, and force the financial system to bear the costs
    of future crisis.

Fifth, significantly stronger
protections for investors and consumers are being put in place including the
CFPB which is working to improve disclosures for mortgages and credit cards and
developing new standards for qualified mortgages.  New authorities are being used to strengthen protections
for investors and to give shareholders greater voice on issues like executive
compensation.

Geithner pointed to the failure of
account segregation rules to protect customers in the MF Global disaster as proof
of the need for more protections and said that the Council will work with the
SEC and the Commodity Futures Trading Council on this problem.   

Moving forward, reforms must be
structured to endure as the market evolves and to work not just in isolation
but to interact appropriately with each other and the broader economy.  “We
want to be careful to get the balance right-building a more stable financial
system, with better protections for consumers and investors, that allows for
financial innovation in support of economic growth.” 

First, he said, we have to make sure
we have a level playing field at home; that financial firms engaged in similar
activity and financial instruments that have similar characteristics are
treated roughly the same because small differences can have powerful effects in
shifting risk to where the rules are softer. 
A level field globally is also important, particularly with reforms that
toughen rules on capital, margin, liquidity, and leverage, as well as in the
global derivatives markets.  “In these areas we are working to discourage
other nations from applying softer rules to their institutions and to try to
attract financial activity away from the U.S. market and U.S. institutions.” 

It is necessary to align the
developing derivatives regimes around the world; preventing attempts to soften
application of capital rules, limiting the discretion available to supervisors
in enforcing rules on risk-weights for capital and designing rules for
resolution of large global institutions.  Also, because some U.S. reforms are different
or tougher from rules in other markets, there needs to be a sensible way to
apply those rules to the foreign operations of U.S. firms and the U.S.
operation of foreign firms.

 The U.S. also needs to move
forward with reforms to the mortgage market including a path to winding down
the government sponsored enterprises (GSEs.) 
The Administration has already outlined a broad strategy, Geithner said,
and expects to lay out more detail in the spring.  The immediate concern is to repair the damage
to homeowners, the housing market, and neighborhoods.  The President spoke this week about the range
of tools he plans to use.  Our ultimate goals
are to wind down the GSEs, bring private capital back into the market, reduce
the government’s direct role, and better target support toward first-time
homebuyers and low- and moderate-income Americans.

Geithner said the new system must
foster affordable rentals options, have stronger, clearer consumer protections,
and create a level playing field for all institutions participating in the
system.  For this to happen without
hurting the broader economy and adding further damage to those areas that have
been hardest hit, banks and private investors must come back into the market on
a larger scale and they want more clarity on the rules that will apply. 

Credit availability is still a problem
and there is a broad array of programs in place to improve access to credit and
capital for small businesses.  As
conditions improve, it is important that we remain focused on making sure that
small businesses, a crucial engine of job growth, have continued access to
equity capital and credit.

Many Americans trying to buy a home
or refinance their mortgage are also finding it hard to access credit, even for
FHA- or GSE-backed mortgages.  The Administration has been working closely
with the FHA and FHFA to encourage them to take additional measures to remove
unnecessary barriers and they are making progress.  They will probably outline additional reforms
in the coming weeks.

Bank supervisors, in the normal
conduct of bank exams and supervision, as well as in the design of new rules to
limit risk taking and abuse, must be careful not to overdo it with actions that
cause undue damage to the availability of credit or liquidity to markets.

Geithner said the U.S. financial
system is getting stronger
, and is now significantly stronger than it was
before the crisis.  Among the achievements:

  • Banks have increased common equity
    by more than $350 billion since 2009.
  • Banks and other financial
    institutions with more than $5 trillion in assets at the end of 2007 have been
    shut down, acquired, or restructured.
  • The asset-backed commercial paper
    market has shrunk by 70 percent since its peak in 2007, and the tri-party repo
    market and prime money market funds have shrunk by 40 percent and 33 percent
    respectively since their 2008 peaks.
  • The financial assistance we provided
    to banks through TARP, for example, will result in taxpayer gains of
    approximately $20 billion.

The Secretary said the strength of
the banks is helping to support broader economic growth, including the more
than 3 million private sector jobs created over 22 straight months, and the 30
percent increase in private investment in equipment and software.  
Broadly, the cost of credit has fallen significantly since late 2008 and early
2009.  Banks are lending more, with commercial and industrial loans to
businesses up by an annual rate of more than 10 percent over the past six
months.  

He concluded by saying that no
financial system is invulnerable to crisis, and there is a lot of unfinished
business on the path of reform.  The reforms are tough where they need to
be tough.  “But they will leave our financial system safer, better able to
help businesses raise capital, and better able to help families finance safely
the purchase of a house or a car, to borrow to invest in a college education,
or to save for retirement.  And they will protect the taxpayer from having
to pay the price of future crisis.”

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SEC Names Ex-Credit Suisse Employees in Subprime Fraud Scheme

Four
former investment bankers and traders from the Credit Suisse Group were charged
by the Securities and Exchange Commission (SEC) Wednesday violating multiple
sections of the Securities Exchange Act of 1934 while trading in subprime
mortgage bonds
.  The indictments allege
the four engaged in a complex scheme to fraudulently overstate the prices of $3
billion of the bonds during the height of the subprime credit crisis. 

The
four are Kareem Serageldin, the group’s former global head of structured credit
trading; David Higgs, former head of hedge trading; and two traders, Faisal Siddiqui and Salmaan
Siddiqui.  According to the complaint
filed in U.S. District Court for the Southern District of New York, Serageldin
oversaw a significant portion of Credit Suisse’s structured products and
mortgage-related businesses. The traders reported to Higgs and Serageldin.

The SEC charges that the four
deliberately ignored specific market information showing that prices of the
subject bonds were declining sharply, pricing them instead in a way that
allowed Credit Suisse to achieve fictional profits, and, through the traders,
changing bond prices in order to hit daily and monthly profit target and cover
losses.  The scheme was driven in part by
the prospect of lavish year-end bonuses and promotions.  The scheme hit its peak at the end of 2007.

“The
stunning scale of the illegal mismarking in this case was surpassed only by the
greed of the senior bankers behind the scheme,” said Robert Khuzami, Director
of the SEC’s Division of Enforcement and a Co-Chair of the newly formed Residential
Mortgage-Backed Securities Working Group
, “At precisely the moment investors
and market participants were urgently seeking accurate information about
financial institutions’ exposure to the subprime market, the senior bankers
falsely and selfishly inflated the value of more than $3 billion in
asset-backed securities in order to protect their bonuses and, in one case,
protect a highly coveted promotion.”  

SEC
explained that it was not charging Credit Suisse in the scheme because the
wrongdoing was isolated; Credit Suisse reported the violations to the SEC,
voluntarily terminated the four, implemented internal controls to prevent
additional misconduct, and cooperated with SEC in the investigation.  The SEC said that the four named in the
complaint also cooperated in the investigation and that assistance was provided
by the FBI, the U.S. Attorney’s Office for the Southern District of New York
and the United Kingdom Financial Services Authority.

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FHFA Answers Conflict of Interest Charges against Freddie Mac

The
Federal Housing Finance Agency (FHFA) issued a statement late Monday refuting a
story
from ProPublic and NPR
that a complicated investment strategy utilized by Freddie Mac had influenced
it to discourage refinancing of some of its mortgages.  FHFA confirmed that the investments using
Collateralized Mortgage Obligations (CMOs) exist but said they did not impact
refinancing decisions and that their use has ended. (the NPR Story)

Freddie Mac’s charter calls for
it to make home loans more accessible, both to purchase and refinance their
homes but the ProPublica story, written by Jesse
Eisinger (ProPublica) and Chris Arnold (NPR) charged that the CMO trades “give Freddie a powerful incentive to do
the opposite
, highlighting a conflict of interest at the heart of the company.
In addition to being an instrument of government policy dedicated to making
home loans more accessible, Freddie also has giant investment portfolios and
could lose substantial amounts of money if too many borrowers refinance.”

Here,
in a nutshell, is what the story (we are quoting from an “updated” version)
says Freddie has been doing.  

Freddie
creates a security (MBS) backed by mortgages it guarantees which was divided
into two parts.  The larger portion, backed
by principal, was fairly low risk, paid a low return and was sold to investors.  The smaller portion, backed by interest
payments on the mortgages, was riskier, and paid a higher return determined by
the interest rates on the underlying loans. 
This portion, called an inverse floater, was retained by Freddie Mac.

In
2010 and 2011 Freddie Mac’s purchase (retention) of these inverse floaters rose
dramatically, from a total of 12 purchased in 2008 and 2009 to 29.  Most of the mortgages backing these floaters had
interest rates of 6.5 to 7 percent.

In
structuring these transactions, Freddie Mac sells off most of the value of the
MBS but does not reduce its risk because it still guarantees the underlying
mortgages and must pay the entire value in the case of default.  The floaters, stripped of the real value of
the underlying principal, are also now harder and possibly more expensive to
sell, and as Freddie gets paid the difference between the interest rates on the
loans and the current interest rate, if rates rise, the value of the floaters
falls. 

While
Freddie, under its agreement with the Treasury Department, has reduced the size
of its portfolio by 6 percent between 2010 and 2011, “that $43 billion drop in
the portfolio overstates the risk reduction because the company retained risk
through the inverse floaters
.”

Since
the real value of the floater is the high rate of interest being paid by the
mortgagee, if large numbers pay off their loans the floater loses value.  Thus, the article charges, Freddie has tried
to deter prospective refinancers by tightening its underwriting guidelines and
raising prices.  It cites, as its sole
example of tightened standards that in October 2010 the company changed a rule
that had prohibited financing for persons who had engaged in some short sales
to prohibiting financing for persons who had engaged in any short sale, but it
also quotes critics who charge that the Home Affordable Refinance Program
(HARP) could be reaching “millions more people if Fannie (Mae) and Freddie
implemented the program more effectively.”

It
has discouraged refinancing by raising fees. 
During Thanksgiving week in 2010, the article contends, Freddie quietly
announced it was raising post-settlement delivery fees.  In November 2011, FHFA announced that the
GSEs were eliminating or reducing some fees but the Federal Reserve said that “more
might be done.”

If
Freddie Mac has limited refinancing, the article says, it also affected the whole
economy which might benefit from billions of dollars of discretionary income generated
through lower mortgage payments.  Refinancing
might also reduce foreclosures and limit the losses the GSEs suffer through defaults
of their guaranteed loans.

The
authors say there is no evidence that decisions about trades and decisions
about refinancing were coordinated.  “The
company is a key gatekeeper for home loans but says its traders are “walled
off” from the officials who have restricted homeowners from taking advantage of
historically low interest rates by imposing higher fees and new rules.”

ProPublica/NPR says that the
floater trades “raise questions about the FHFA’s oversight of Fannie and
Freddie” as a regulator but, as conservator it also acts as the board of
directors and shareholders and has emphasized that its main goal is to limit
taxpayer losses.  This has frustrated the
administration because FHFA has made preserving the companies’ assets a
priority over helping homeowners.  The
President tried to replace acting director Edward J. DeMarco, but Congress
refused to confirm his nominee. 

The
authors conclude by saying that FHFA knew about the inverse floater trades
before they were approached about the story but officials declined to comment on whether the
FHFA knew about them as Freddie was conducting them or whether the FHFA had
explicitly approved them.”

The
FHFA statement
said that Freddie Mac has historically used CMOs as a tool to
manage its retained portfolio and to address issues associated with security
performance.  The inverse floaters were
used to finance mortgages sold to Freddie through its cash window and to sell
mortgages out of its portfolio “in response to market demand and to shrink its
own portfolio.”  The inverse floater
essentially leaves Freddie with a portion of the risk exposure it would have
had if it had kept the entire mortgage on its balance sheet and also results in
a more complex financing structure that requires specialized risk management
processes.  (Full FHFA Statement)

The
agency said that for several reasons Freddie’s retention of inverse floaters ended in
2011 and only $5 billion is held in the company’s $650 billion retained
portfolio.  Later that year FHFA staff
identified concerns about the floaters and the company agreed that these
transactions would not resume pending completing of the agency examination.

These
investments FHFA said did not have any impact on the recent changes to
HARP.  In evaluating changes, FHFA
specifically directed both Freddie and Fannie not to consider changes in their
own investment income in the HARP evaluation process and now that the HARP
changes are in place the refinance process is between borrowers and loan
originators and servicers, not Freddie Mac.

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Correspondent Investors: News, Volumes and Rumors; Government Turns Focus to HEMP

Sorry, did
I hit the incorrect letter? The Administration announced important enhancements
to the Making Home Affordable Program, including the Home Affordable Modification Program (HAMP) late last week. The
expanded program is expected to be available by May, but we should keep a few
things in mind. First, this is not the mortgage refinancing program that
President Obama mentioned in the SOTU speech (that referred to helping current
borrowers refinance into a lower rate). The HAMP update is a focus on debt
forgiveness modifications, and arguably impacts investors more than originators
and Realtors – the implications for
agency MBS investors seem limited but are very meaningful for non-agency
investors
. (Removing the 31% DTI constraint for HAMP eligible borrowers
could embrace about 800,000 potential borrowers, and the program will be
extended through 2013.)

Analysts suggest that the effect on
agency MBS prepayment speeds should be minimal
, since the vast majority of debt
forgiveness will be on delinquent loans, which are typically already bought out
of the agency MBS trust (if they are more than 120 days delinquent). The only
effect could be if underwater borrowers in agency MBS pools start going
delinquent on purpose to qualify for debt forgiveness, speeds will obviously
rise – hopefully unlikely. And only pools of loans originated before 2009
qualify for this program. FHFA Acting Director Edward DeMarco released a press
statement stating that “principal forgiveness did not provide benefits
that were greater than principal forbearance as a loss mitigation tool”.
Further, the press release noted that “FHFA’s assessment of the investor
incentives now being offered will follow its previous analysis, including
consideration of the eligible universe, operational costs to implement such
changes, and potential borrower incentive effects.” This suggests that
Fannie Mae and Freddie Mac may not adopt this program. The incentive to
investors for principal reduction in HAMP has been tripled (the range of 6-18
cent payout on debt reduction goes up to 18-63 cents) – a significant change
for various reasons and should result in higher modification rates. It is
important to note that the incentives for servicers are not any different now
than before (servicer strip dependence on the balance).

The President’s State of the Union address
suggested a new government effort to refinance borrowers but at this point most
expect it will be aimed at non-agency loans
, but more details should emerge in the near term. Total
borrower savings from such a refi effort would be at most $5-6 billion per year,
but in reality would be a small fraction of that amount. The program may
involve non-agencies refinancing into FHA loans and so expect the impact on the
agency MBS market to be modest, however. Total throughput of the program should
be low, given the challenges witnessed in agency HARP, lack of servicer
incentives, and rep/warrant hurdles. Recently a speech by HUD Secretary Donovan
sparked fears of a Ginnie refi program and while this program is likely
targeted at non-agencies investors continue to fear event risk in Ginnies,
possibly via a restructuring of MIPs at some point.

And while
we’re talking about residential MBS’s, agency (Fannie, Ginnie, Freddie) MBS prices have had a great run since
mid-December compared to Treasury prices
. Some now expect agency MBS
spreads to remain tight so long as the 10-year Treasury stays at current
levels.  Should the 10-year yield hit 2.5%, however, they would see those
spreads widen significantly. These projections are due in part to the Fed’s
announcement that they will likely keep short-term rates low until late 2014,
which both creates an ideal scenario for banks to buy up agency MBS and for
implied volatilities to decline, and to the fact that the Treasury has been
selling about $10 billion agency MBS monthly but that this should be drawing to
a close, leaving only $15 billion.  Additionally, the MBS sector is
attractively priced
compared to investment grade corporate bonds right now, so
the long-term “supply-demand technical” look good. In the event that the
10-year yield reached 2.5%, though, spreads would widen, a prediction assuming
that a selloff is caused by improving fundamentals of the economy, which
reduces the probability that the Fed’s QE3 involving agency MBS would diminish
significantly in a rates backup scenario.  Such a shift in rates would
also indicate that volatility had increased, which would likely lead to a
sudden increase in agency MBS, which of course skews that nice supply-demand
projection. There’s your dose of daily technical talk.

There is a lot of chatter about
investors out there, some of it factual, some of it rumored
. The most recent big move was from
Citibank, which, due to liquidity and market risk concerns, became the latest
major bank to stop the purchase of “medium” and “high risk” mortgage loans from
its correspondent originators. No one wants buyback requests appearing in their
mailbox, and Citi is no exception. And we know that these, if they can’t be
fought, are passed on to the company that sold the loan to the investor. So Citi is attempting to improve the quality
of the mortgages it buys
, a good thing, and told correspondent lenders
“to withdraw medium/high risk loans,” saying the bank could not
predict time frames for when the loans would be reviewed “if we are able
to review them at all.” Perhaps Citi’s pre-purchase review process (begun
in 2010) is still letting some potentially defective loans slip through.

While this
is a good goal, and should be done, for correspondent
clients it is more tough news since it comes on the heels of Bank of America
and MetLife’s exit from correspondent lending. Ally/GMAC has scaled back. And
rumors surfaced last week, and I repeat – rumors, that SunTrust will be
combining its wholesale and correspondent channels, and that PHH is also
contemplating scaling back operations.
(Of course wholesale reps love
calling on larger correspondent clients, but it doesn’t work the other way –
correspondent reps rarely want the opportunity to call on brokers. Certainly
the rep and warrants are different.) On the positive side, we have Wells Fargo being featured on the
Forbes cover
and recent results from Flagstar
showing that mortgage banking operations had strong revenues in the fourth
quarter. (Flagstar’s gain on loan sale income increased from Q3 totals to
$106.9 million, with a margin of 102 basis points. The firm reported
residential first mortgage loan originations of $10.2 billion in Q4, an
increase of $3.3 billion, or 47.1 percent, from third quarter totals.)

We’re
pretty much done with much of the earnings reports from the big
banks/servicers. Things don’t look too peachy as most took charges for
repurchasing soured loans, complying with federal mortgage servicing standards,
paying for an upcoming settlement with state attorneys general and resolving
significant foreclosure and litigation costs. Wells Fargo posted the strongest
fourth-quarter mortgage results but still had $300 million in costs related to
mortgage servicing and foreclosures. U.S.
Bancorp and PNC Financial Services both took charges in the quarter related to
the pending settlement agreement
with state attorneys general and to the
cost of complying with federal consent orders for past mortgage servicing
failures ($164 million and $240 million, respectively). Most lenders would
agree that mortgage banking profits are up and origination volume increased in
the fourth quarter, things are slower than a year ago. BofA’s mortgage origination volume dropped 77% from a year ago and
Wells saw a 6.2% decline from a year earlier in fourth-quarter mortgage
originations (to $120 billion). Chase’s mortgage origination volume dropped 24%
from a year earlier, and Citigroup’s fell 3%.
One investment bank noted,
“Solid organic loan growth is very difficult to achieve when consumers and
corporations are deleveraging (cutting back on debt in their lives) and
economic growth is moderate.”

MGIC (which injected $200 million into a subsidiary last
month to keep writing policies) announced that it posted its sixth straight
quarterly loss. MGIC said its risk-to-capital ratio will probably exceed the
maximum 25-to-1 allowed by some state regulators in the second half of this
year. The ratio was 20.3-to-1 on Dec. 31 compared with 22.2-to-1 on Sept. 30.

Friday saw our share of bank closures. In Florida First Guaranty Bank and
Trust Company of Jacksonville was enveloped by CenterState Bank of Florida, with
the help of the FDIC. Up in Tennessee, Tennessee Commerce Bank became part of
Kentucky’s Republic Bank & Trust Company and BankEast in Knoxville is now
part of U.S. Bank National Association of Ohio. And up in Minnesota Patriot
Bank Minnesota is now part of First Resource Bank of Savage, Minnesota.

Friday
also had news that the U.S. economy expanded less than forecast in the fourth
quarter as consumers curbed spending and government agencies cut back,
validating the Federal Reserve’s decision to keep interest rates low for a
longer period. GDP disappointed analysts. Remember – jobs and housing, housing
and jobs. “We’re going into 2012 with less momentum than people were thinking,”
said Michael Hanson, a senior U.S. economist at Bank of America. This week’s
Fed announcement that they would hold rates near zero for years was a stunning
admission that monetary policy has failed to stimulate the economy to anywhere
near the extent anticipated. And fiscal policy has had the same impact. So what
does the government have up its sleeve? Not much.

If that’s
the case, then we’re in for a weak 1st quarter here in the United
States, and we’re going to have to face the prospect that European debt needs
to be written off. At this point it is arguable how much of Europe’s coming
recession spills into the United States, but it will indeed have an impact.
And, more often than not, a slowing U.S.
economy leads to lower rates
(since there is less demand for capital) – unfortunately
for LO’s the lower rates have to be balanced against the higher fees,
documentation hurdles, and appraisal problems.

Our 10-yr
T-note closed Friday with a yield of 1.90%. One headline I saw this morning
noted that, “US stocks are poised to open lower Monday after the weekend came
and went without Greek leaders reaching an agreement on a debt-relief deal.” Is
that a surprise to anyone? In this country this morning we’ve already had Personal
Income +.5%, Personal Consumption was unchanged, the savings rate went to 4%,
and the Core PCE Price Index was +.2%. For the remainder of the week, the big
excitement will be Friday’s employment data. But rates continue to drop, and we find the 10-yr down to 1.83% and MBS
prices
are about .250 better.

An old man walks into the barbershop for a shave and a haircut, but he tells
the barber he can’t get all his whiskers off because his cheeks are wrinkled
from age.
The barber gets a little wooden ball from a cup on the shelf and tells him to
put it inside his cheek to spread out the skin.
When he’s finished, the old man tells the barber that was the cleanest shave
he’s had in years. But he wanted to know what would have happened if he had
swallowed that little ball.
The barber replied: “You’d just bring it back tomorrow like everyone else
does”.

If you’re
interested, visit my twice-a-month blog at the STRATMOR Group web site located
at www.stratmorgroup.com. The current blog discusses
residential lending and mortgage programs around the world. If you have both
the time and inclination, make a comment on what I have written, or on
other comments so that folks can learn what’s going on out there from the other
readers.

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Supply Shortfall Persists for Apartments

Little new apartment construction and surging demand has created a shortfall of 2.5 million units, the largest the nation has seen in more than a half-century, according to research from Nareit, a trade group for real-estate investment trusts.

As we’ve reported, apartment landlords are seeing vacancy rates decline as more Americans rent by choice or necessity. In the fourth quarter, apartment vacancy fell to the lowest rate since late 2001, with the national rate dropping to 5.2% from 6.6% a year earlier, according to Reis Inc. The vacancy rate had risen as high as 8% in 2009.

Pent-up demand could pull that rate even lower. According to Nareit, the normal rate of household formation is about 1.2% annually. But, with the sour economy in the last four years, the rate plunged to about 0.5%, as people delayed moving out and opted to live with roommates and parents longer.

This has created an unmet demand of about 2 million households, “about three times what it has been in previous business cycles,” says Calvin Schnure, vice president of research and industry information at Nareit. He expects many of these people to eventually turn to the rental market.

This comes as construction of new apartments slowed dramatically after the financial crisis. Building of multifamily units fell to a 20-year low during the recession and the units under construction remain at nearly 60% below the long-term average. Apartment construction is slowly picking up, though it will be a year or two before many projects are finished.

As the economy heals and hiring picks up, many of these households will seek their own place and that’s expected to be rentals, Mr. Schnure says. Once those doubling up “have an income that they can make their own rent payment, they’re going to rent on their own,” he said.

Keep in mind that Nareit’s members include publicly held apartment owners. The seemingly red-hot sector could weaken if the housing market recovers and more people buy homes.

Another risk is overdevelopment, which could create competition that forces landlords to cut rents. There’s also the chance of the economy weakening further, keeping all that pent-up demand, well, pent up.

Mr. Schnure remains bullish. “The fun is just about to begin,” he says. “It’s going to take some time for these households to move up. It’s a question of when it’s going to be realized. Even if you take a fairly conservative assumption,” it could be several years.

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