Posted September 13, 2007

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Bonus columns:
· Retirement Vendor Kickbacks
· The St. Louis Pension Bond Debate

Pensions, Housing & Mortgage $$$

Is there a way to help employees in the housing and mortgage markets?

In every crisis, there lies within both danger and opportunity. Most analysts would agree that the Federal Reserve's easy money policies during the last recession set the stage for residential lending practices that had unsustainably low adjustable rate mortgages and lax underwriting standards. "Ninja" loans (No Income, No Job and no Assets) became subprime mortgages and those were securitized into junk paper now held by many banks, hedge funds, and even a few public pension funds.

Given the drift toward riskier investments by public pension funds in the past decade, it's a relief that we haven't seen more subprime mortgages reported in their portfolios during this episode. Most public funds managed to avoid the junk paper, fortunately.

Meanwhile, the Federal Reserve has pumped liquidity into the nation's banking and financial systems by purchasing mortgage securities and cutting the discount rate. Markets now anticipate that the Fed will cut its overnight Fed funds rate twice or more in coming months, as a "neutral rate" is clearly now less than 5 percent as the economy cools. However, the Fed is reluctant to fuel inflation with another big round of easy money just to save builders, mortgage companies, Ninja borrowers, realtors, speculators and hedge funds or to appease TV bigmouths. Central bankers prefer that the market discipline those who borrowed and lent too easily or gambled with too much leverage, especially as the dollar is now at risk.

Which leaves us with a housing construction industry spilling red ink, declining residential property values in many states, and a tight mortgage market. The subprime crisis in starter homes and moderately priced real estate has now spread to the jumbo loan market, which means the weakness is trickling upward. Over two million foreclosures are expected this year and next.

Reportedly, a trillion dollars of securitized low-grade mortgages overhang the markets, and $750 billion of adjustable rate mortgage (ARM) principal will reset over the next year. This means the home construction, residential real estate and mortgage finance industries will suffer for longer than many expected.

Ordinarily, I don't discuss sector investment strategies and oppose industry-specific "bailouts" — and I remain skeptical about legislative efforts to direct pension funds into local economies. Public pension funds cannot themselves solve the housing and mortgage slump. But my investment nose smells a potential opportunity for sound long-term, contrarian investment strategies by some pension funds, and the hedge funds that many public plans have joined as partners. Now is the time for patient capital to plot strategy.

Let's start with the mortgage market, which is less risky than real estate when there's no leverage added. Pension funds have long been investors in mortgage securities. A few plans, like the two California goliaths, CalPERS and CalSTRS, have also offered a residential home loan program to public employees as a deliberate part of their public mission.

When newly built South Florida condos go to auction with no minimum bids, that won't help the local property tax base or the state's economy. One solution may be to offer public employees the chance of a lifetime to buy financially distressed properties at bargain prices. Unlike Ninja loans, their down-payment loans can be secured by the employees' stake in the pension fund.

A complementary approach could be taken with governmental 457, 401 and 403b plan loans as secondary financing sources. Plan sponsors in distressed regions should re-think their standard "prime plus 1 percent" loan rate for residential purposes during this housing recession. Why not the current interest rate on conventional mortgages? Secondary loan money at 6 percent vs 9 percent would be a valuable employee benefit for creditworthy first-time buyers and ARM refugees.

When jumbo mortgage rates started carrying 8 percent yields vs Treasury bonds yielding 4 percent, they became intriguing long-term investments, when underwritten properly. Somebody will soon figure out how to funnel public pension capital into a mortgage marketplace that is now gasping for funds. Public funds with the right partner could become the 'Fannie Mae' of the jumbo market.

Likewise, there will likely be some savvy investors who will put together packages of distressed residential real estate, including washed-out condo properties, for investment by pension funds. As foreclosures peak, opportunities will abound. The legislature doesn't need to mandate such investments by the pension funds if pension administrators and CIOs stay on their toes. If the returns are attractive, pension managers will figure this out themselves.

Even subprime mortgages, now radioactive, will eventually become viable investments once foreclosures subside. Grave-dancing high-yield portfolio managers will figure that one out.

Finally, the publicly traded homebuilders have seen their stock prices collapse in the past two years, and especially last month. Most of them now trade far below book value, although their asset values are likely to decline further. One reported "accounting irregularities" which brought more short selling. In every past cycle, some homebuilders have gone out of business. Some might be consolidated through mergers at a premium to their depressed prices. It's a truly Darwinian industry in which the strong firms buy out the weak ones. The survivors could become ripe targets for private equity buyouts with pension fund capital.

The problem, of course, is timing. Nobody knows how long and how deep this real estate recession will run. Overbuilt housing inventory will take a year or two to be absorbed, as will foreclosures. So there is time for patient money to do the necessary research as these markets bottom out, although I would move quickly in the high-grade mortgage market.

Public pension fund trustees, especially those in hardest-hit states, should meet with industry experts to learn whether they have a viable role as savvy investors, not as philanthropists. CIOs should talk to their mortgage and real estate specialists and private equity firms to explore opportunities. If broader economic weakness compels the Fed to cut interest rates, these sectors should become more attractive, just as they did at the end of the last business cycle — and that requires preparation and agility. Meanwhile, some administrators should revisit their terms of homeownership lending to creditworthy plan participants. A pro-active approach also helps the fund trustees keep a step ahead of their increasingly meddlesome state legislatures.

Disclosure and disclaimer: Mr. Miller's personal portfolio includes interests in homebuilding corporations. His public policy views, general market observations and institutional strategies are his own and should not be construed as investment advice or recommendations concerning specific securities.

Last month:
· Pensions & Potholes
· Rx for Sick Leave
· CIOs Tell It Like It Is

Index of recent columns

Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net.
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