Doug Duncan of Fannie Mae Joins Bruce Norris on the Real Estate Radio Show #557

Norris Bruce

Bruce Norris is an active investor, hard money lender, and real estate educator with over 30 years experience. Bruce has been involved in over 2,000 real estate transactions as a buyer, seller, builder and money partner.

Norris Bruce
September 21, 2017

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On Friday, September 22, the Norris Group proudly presents its 10th annual award-winning black tie event I Survived Real Estate. An incredible lineup of industry experts will join Bruce Norris to discuss perplexing industry trends, head-scratching legislation, and opportunities emerging for real estate professionals. All proceeds from the event benefit Make a Wish and St. Jude Children’s Research Hospital. This event would not be possible without the generous help of the following platinum partners: HousingWire, Coach Fullerton, Coldwell Banker Town and Country, PropertyRadar, the Apartment Owners Association, the San Diego Creative Real Estate Investors Association, InvestClub, Las Brisas Escrow, MVT Productions, Inland Empire Real Estate Investment Club, Realty411, and White House Catering. Visit www.isurvivedrealestate.com for event information and tickets.

Episode Highlights

- What should we expect to see with GDP growth for the rest of the year?
- Why have we seen a growth stint in GDP when unemployment is under 4.5%?
- What is the likelihood of the Fed aggressively raising rates?
- What effects to demographics have on GDP growth and inflation?
- Could we see more millennials migrating out of states due to not being able to afford a home?
- Are wages rising fast enough to keep up with expenses for the average American worker?
- What factors could fuel the next recession?
- What could the Fed do with their mortgage-backed securities?

Episode Notes

Bruce Norris is joined this week by Doug Duncan. He is Fannie Mae’s Senior Vice President and Chief Economist. He is responsible for providing all forecasts and analyses of the economy and housing and mortgage markets for Fannie Mae. He also oversees corporate strategy and is responsible for strategic research regarding external factors and their impact on the company and housing industry. He serves as the Chair of the Fannie Mae corporate house price forecast committee. Named one of Bloomberg Businessweek’s 50 most powerful people in real estate, Duncan is Fannie Mae’s source for information and analysis on the external business and economic environment, the implications of change in the economic environment to the company’s strategy and execution, and forecasting for housing activity, demographics, overall economic activity, and mortgage market activity.

Doug said his job involves a much broader span of responsibilities than most Chief Economists, so it is a privilege. The word “external factors could encompass a lot of things. Bruce asked about the United States in general and what we should expect to see with GDP growth for the remained of 2017 as well as what we did in the first half. Doug said they have not really changed their forecast much for a couple years. The central forecast is 2% growth, and they have actually bumped their forecast up a little bit to 2.2%. This is partly because the second quarter came in a little stronger than they thought, and it would take a big downturn to get it back to the 2%. However, we are talking about a decimal point here.

There is not really much acceleration, although they are seeing some in income. However, what they are not seeing is an acceleration in spending, so people are still being quite conservative post-crisis despite this being the third-largest extension we have ever had. People are still being relatively conservative in their financial behavior, which is not necessarily bad. Bruce asked if one of these behaviors is not pulling equity out of their home. Doug said they have seen a little bit of this, but it is nothing like what they saw in the boom. It seems as though the purposes of the equity extraction are not vacations, but more of investment. This includes putting it back into the house or paying for the kids’ college education. It is nowhere near anything they saw in the boom.

At a 2% growth rate, Bruce asked what the likelihood is for the Fed aggressively raising the rate. Doug said aggressively is unlikely, and they are actually having a significant debate. If you read the minutes of the last Fed report, there is a debate among the governors about how to think about inflation. There is no support for their classic model-driven view. A couple board members who asked have been more aligned with the Philip’s curve approach to things backing off of that. While it is still in their forecast that the Fed will raise rates in December and starting the runoff of their portfolio this month, the probabilities of that December raise have declined somewhat. There are still several months of data before that, and they will act depending on the data. However, it does not look like the inflation data will be a cause for them to aggressively raise rates. However, this does not mean they will not do it.

Bruce asked if they do it aggressively, will it be in their mind that they have to get it up to a certain level and if they need to take it back during a recession. Doug said that effects both their thinking on their portfolio and on the future. As he mentioned, this is the third-longest economic expansion ever, and at some point they all ended. You could argue that ten of the last thirteen ended by the Fed raising rates when things were starting to slow. All those things will be part of their considerations. When people say they have ammunition, it means they have enough room to cut rates significantly to spur economic activity since they do not have much room at the moment. However, it depends on what you think the real sustainable growth rate of the economy is. If they believe it is only 1.8-2% annually in real terms, then rates are not that far from where they would need to be to have the ammunition.

Doug thinks the economy can grow upwards of 3% with the right policies in place. This would suggest a higher rate of interest in the future as the Fed could go farther. However, we are not there now, and he has not seen any policy changes that would enable that. They probably do not have that much farther to go unless they revert to the purely model-driven perspective that seems to be behind their thinking.

We have an unemployment rate under 4 ½ and a 2% GDP growth. Those numbers normally don’t go together, so Bruce wondered why there has been a lack of GDP growth during this entire upside. Doug said there are a couple clues out there. While the Administration has not been successful in healthcare or tax reform, they have been successful in regulatory reform. There has been significant deregulation, especially in the energy sector. Doug and Bruce have discussed before about the pickup in business investment; and if you segment it by sector, it’s clear this is taking place in the energy sector. One of the clues is that regulation is related to the level of real economic activity. There was a tremendous increase in regulation during the last Administration, which has imposed costs and reduced opportunities in the business sector. This is made evident by the deregulation that has been seen and the rise in investment in the energy sector.

This is one of the reasons growth has been stinted. For the parts nearest the center, there is clear consensus that there needs to be fundamental tax reform. There is a lot of argument about how this gets done and what it should contain. There is a broad consensus in Washington that tax reform would be beneficial to growth. There is no perfect solution to the healthcare issue because there are lots of aspects of the world of healthcare that are not amenable to the free market thinking that can dominate in the business sector. People make choices and decisions sometimes, but there is a relationship between what is being done in healthcare and what can be done in tax reform. This is a discussion that will continue for some time and has a bearing on the pace the economy can grow. The level of healthcare expenditures is quite significant within all economic activity and is likely to grow significantly given the aging of the boomers.

Bruce asked next about demographics and their effect on GDP growth and inflation. Doug said last year the leading household edge of the boomers turned 70. That is the year in which, if you delay Social Security receipts, you can maximize your Social Security returns. You are now seeing the full retirement benefit draw of the boomers going forward. The boomers are also the group who, in the early stages of the recovery from the recession, saw the most significant increase in workforce participation. This suggested that they are not going back to work to spend the money, but rather they are worried about their retirement. This continues to remain true as they are saving for retirement.

Primary rates have slowed recently because asset valuations in stock portfolios and homes have risen back to levels they were at the end of the boom. However, consumption has not picked up from there, which suggests those households are not going to consume out of the expectation that wealth was sustainable. This was a mistake they made prior to the meltdown. They expect what this means is the millennials need to step in, and they clearly are. If you look at the housing data, surveys of millennials show they eventually want to own a home, but they need a job. In turn, this job needs a sustainable income. Then, they will get married and have kids, then buy a house. They had some data where they tracked specific millennials, and they are doing exactly what they said. They are now the driver in the home purchase area.

The problem was that a lot of the initial jobs for millennials were in markets where you simply could not build single-family homes. Now we have a supply problem because boomers are aging in place. The job growth for millennials has been in a lot of the same places, so there is a low level of turnover of existing homes and a low level of construction of new homes. One of the drivers of inflation is the housing component, which is the largest component of the CPI measurement. This has been growing significantly faster than the rest of the core. It seems to be driven by the supply problem; which is why when Fannie Mae talked to the Fed over the last several years, the consistent question from the leadership was what was wrong with the housing supply function. This told Doug that their thinking was that housing’s contribution was possibly overstated in the way the CPI measures it because it is actually a market structure question and not price level. This may keep them a little more patient on raising rates than otherwise.

Bruce wondered if it is becoming more common for millennials to migrate to a different states due to not being able to afford a home. Doug said yes and that businesses recognize this. Given the prices they can charge for their products and the amount of labor that is required, the price of labor is too high. Because of the affordability of housing combined with this, they will move their business. You started to see businesses migrate out of high class markets and into lower class markets. This is part of the reason you can see the millennials starting to actively drive the demand curve. However, it is much broader geographically than it was initially because businesses are relocating so they can afford the labor force to allow them to produce and sell their products properly.

Although they predicted this, they did not predict particular markets because different kinds of businesses have different directions they may want to go geographically based on the kinds of products they produce. The expectation was that you would start to see migration of businesses, particularly where they do not have high fixed costs, into markets where they can afford the labor that could then afford houses to live there.

Bruce asked about the average American worker and if wages are rising fast enough to keep up with the expenses. Doug said in the most recent couple of years, that has started to be true in part because inflation is so low. In the last couple years, household incomes have performed reasonably well. This was not the case for the first seven years of this recovery. Recently, this has started to be true.

Doug said they have tried to think through an answer to the question their CEO asked them. The question is whether it is reasonable to expect that a recession will emerge just because the expansion is old. They think the answer is no, but they all end. How could they craft a reasonable story saying this will go on for a while? If you think about the origins of the bubble burst, what happened coming out of the .com meltdown in 2000 was households moved to investment in real estate more strongly, which started an upward movement in house prices in real terms that was above historical norms. If the household observed that rising value of their home, believed it was sustainable, and started to increase consumption by borrowing with cash-out refis, then that expenditure became sale with products and services to businesses, which increased their profitability and increased their ability to invest in equipment and plants, thus improving compensation to the workforce. This caused a rise in wages. If that was all based on the assumption that the real estate valuation was stable and consistent, then that turned out to not be true.

They fell significantly, and Bruce was one of the people crashing on that front. If you think about that, to restore normal relationships you have to reverse that process. The question is how long it takes to reverse that process in order to get the alignment of wages, asset valuations, and consumptions all back to normal levels. They had speculated back in 2011 and 2012 that it might be a ten-year process. If you target the end of the bubble or start of the downturn at the end of 2006. We are at the end of that ten-year time period now, and that has not all worked out empirically, but it seems to be a reasonable way to think about the business reversal on some of those excesses, which worked their way through the system before some more normal relationships emerge.

Bruce asked Doug what he feels fuels the next recession. Doug said typically there are 2 or 3 causes of recession. One is excessive Fed tightening. A second is financial sector excesses. A third is imbalances in production and consumption. It does not look like it is an imbalance in production and consumption since inventory seems reasonably normal. Time will tell whether the Fed acts appropriately or not. However, it is still true that domestically and globally we have the highest level of debt to GDP we have ever had. Whether that can be worked off without some economic downturn is an open question. For the United States Fed, it gets to the question of whether they will let their portfolio run off. Doug believes this will happen before the end of the year.

They have amassed a large funding of debt and have about $4.5 trillion of assets on their balance sheets. $1.8 trillion of this is mortgage-related assets. What they are doing today is as the Treasury security or mortgage-backed security matures, it takes the principal that matures and reinvests in another Treasury or mortgage-backed security. It depends on which one matured. When they say they are going to let it run off, it means that they simply will not repurchase another security when the existing matures. They are very programmatic in describing it. Once they know what to do, they will set limits on what to run off over what time period and how they plan to change the pace of it. They suggested it will be like watching paint dry, although he is skeptical of this. He wrote a piece not long ago in National Mortgage News asking the question of whether it was prudent to consider some potential disruptions in that space.

The expectation is that they will most likely let all of the mortgage-backed securities run off of their portfolio over time, although they may save some small increments since they built that tool for the conduct of monetary policy. They may hold some in portfolio just to keep the mechanics alive, although he does not know if that is true. To the extent they want to make additional investments in their portfolio, that will go back to the traditional investments, which is Treasury securities. People are speculating about how small their portfolio will get. One of the things that they sometimes forget or are unaware of is that the Fed’s portfolio has to be the size of the cash outstanding globally.

Right now that is around $2 ½ trillion, and it will grow as the global economy expands and the demand for dollars expands. It is not going to get smaller than the amount of currency outstanding. They will also want some kind of liquidity reserve to manage the structure of the Treasuries they hold, which could be half a billion dollars. They have a Treasury trading account that they hold as well. Their thought is that they may go from that $4 ½ trillion down to $3 trillion roughly. This seems reasonable considering the things they have to do and the things they would probably want to do.

Bruce closed by asking about the impact on short-term interest rates and when they do this. Doug said in the short-run it is not much since the pace is going to be slow. Over time, you would expect the shift away from mortgage securities. The Treasuries will increase the spreads between Treasuries and mortgages and push mortgage rates up between 25 and 40 basis points

Doug Duncan will be one of the featured speakers on the panel at I Survived Real Estate. The Norris Group would like to thank its gold sponsors for supporting I Survived Real Estate: First Lending Solutions, Guaranteed Rate and Nathan Chabolla, In A Day Development, Inland Valley Association of Realtors, Jennifer Buys Houses, Keller Williams Corona, Keystone CPA, LA South REIA, Michael Ryan, New Western, North San Diego Real Estate Investors, Northern California Real Estate Investors Association, Orange County Investment Club, Pacific Premiere Bank, Pasadena FIBI, Pilot Limousine, RealWealth Network, Rick and LeeAnne Rossiter, the San Jose Real Estate Investors Association, San Francisco Bay Real Estate Networking Summit, Sonoca Corporation, South Orange County Real Estate Club, Spinnaker Loans, Think Realty, uDirect IRA Services, Westin South Coast Plaza, Wilson Investment Properties, Inc. See www.isurvivedrealestate.com for event information.