My brother and I go back and forth in our discussions about the dynamics of the housing industry. He is good on the fundamentals, and I substitute my weakness on the fundamentals with technical analysis, sentiment analysis, and the information I can glean from earnings calls. Today, he wrote out his latest case for the timing of a housing bottom that I think is a must-read. I am not just a biased bear because his view now extends out the timing of a bottom from April, 2010 to as late as April, 2013 in a worst case scenario. I appreciate this latest missive because it seems so thorough and convincing.
OK, enough promotion. One key point that I have harped on over and over again on these pages: the Federal Reserve will remain loathe to raise interest rates as long as unemployment remains highs. It will choose high inflation over weak economic activity, especially now. My brother makes the related point that the Fed will be loathe to raise rates as long as the housing market remains so sickly. Of course, the unemployment rate and the housing market are inescapably intertwined, and this missive makes some good connections between the two.
One more key point related to social unrest. My brother now thinks it much less likely, but I continue to be on the look-out for social upheavals related to the on-going economic crisis. Even as everyone declares the recession over, the amount of pain being experienced by everyday Americans continues to mount, from lost jobs to lost wages to shattered dreams. Combine the increased level of need in society with the explosive nature of anti-government folks who want to keep more of what they have, and we get the potential for some very serious discord across the political spectrum. Stay tuned on that one – America has not experienced this kind of thing in a very long time, and I fear we may be unprepared for what is yet to come (especially given many of us are now too busy celebrating a stock market that is inflating on automatic).
You may also want to consider a 3-minute video from Schaeffer’s “Casual Contrarian” who makes the case for continued price appreciation in the shares of homebuilder Lennar (LEN). Last week, I made the case for avoiding Toll Brothers (TOL) based on massive insider selling.
Now, on to our regularly scheduled program. Again, the following words are not mine, but those of my brother (I did do some minor editing). However, I do fully agree with and endorse this analysis.
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Employment Perspective
Several months ago, I looked at monthly employment rates and home prices in San Diego in the early 1990s recession to see where they bottomed. Home prices bottomed 18 months after unemployment reached a high. At first I was surprised by this lag, but it makes sense since a lot of people are rehired at lower paying jobs and ultimately still have to sell their houses quickly. If you assume that in the current cycle, unemployment peaks in mid-2010, then the best we can hope for is an April 2011 bottom, but more likely an April 2012 bottom. The biggest problem with extrapolating San Diego in the 1990s to the current national situation is that in the current national cycle, home prices and sales started crashing well before the economy, so a lot of the marginal folks have already exited the homeowner system.
Mortgage Delinquency Perspective
The current 6% mortgage delinquency rate (based on 60 days delinquent) is unreal and even scarier is that the mortgage delinquencies graphs are still shooting upwards with no sign of flattening. Let us assume a worst case scenario where 15% of current mortgages default and end up in foreclosure. With 50 million homes with mortgages, that amounts to 7.5 million foreclosures. Spread the resale of these foreclosures out over three years and you get 2.5 million REOs (real estate owned) per year that will need to get sold.
Compare this with the 5 million in annual home sales where we seem to be stabilizing, and we will have REOs at 50% of total sales for 2010, 2011, and 2012. At 50% of the total market, REOs would continue to push home prices lower for three years as buyers will correctly perceive having the upper hand and will submit lowball offers to banks. This dynamic implies an April 2013 bottom. The mitigating factors here are that mortgage delinquencies may top out closer to 10% and loan modifications may get up to 25% success rates. If these two things happened, then you would have closer to 4 million foreclosures over the next three years which would not be enough to overwhelm the 15 million home sales over that period. This would make a April 2010 bottom possible, but deliver flat nominal prices through 2013, at which point they may start rising (except considering interest rates – see below). Note: I am using 3 years because foreclosures will keep chugging for a couple of years after unemployment peaks in mid-2010.
Underwater Perspective
I think that this is the weakest argument for why housing will be bad. Looking back at the 1990s recession again, a study found that in Boston only 7% of underwater homeowners ended up foreclosing. I expect similar results in the current national recession. At the worst, 50% of people will be underwater. If 7% of those people walk away, we are talking about 3.5% of the 50 million homes or about 1.5 million walk-aways over the next couple of years.
Note that annual existing home sales are running at about 5 million. The voluntary walk-aways make for great anecdotal stories, but they are not going to heavily impact the market the way some people fear. There are a host of reasons why a homeowner either cannot or would not walk away unless they absolutely had to. Concerns over walk-aways are more of a distraction than predictive.
Civilian revolt
As wacky as it sounds now, if mortgage delinquencies get to 15% and banks are still slow to modify loans, then we could get to a point where there is a “Tea Party” style revolt against paying mortgages, and we get massive defaults even from people that can pay. The irony is starting to sink in people’s minds that America has a financial system that is being bailed out by the general public, but then these same beneficiaries of taxpayer dollars refuse to help the public when they cannot pay their mortgages. This Tea Party could easily overwhelm the capacity for banks, courts, and governments to respond. Obviously, all bets are off at that point and anything can happen. (Note: I first wrote this a few weeks ago. A Tea Party revolt doesn’t seem as wacky anymore, but as of now anger has been directed at Obama and not the banks).
Interest rates perspective
The scary thing about considering a bottom as far out as 2013 is that the Fed rate is unlikely to remain 0% that long. If the Fed is forced to raise its rate even to 2% at some point before 2013, it could devastate the housing market. I think the Fed would rather face inflation than deal with another downturn in housing caused by higher interest rates. This argues for a 2010 bottom, since the Fed is likely to be accommodative for a long time.
Behavioral economics perspective #1 (Investors)
I recently had a colleague ask me if now is a good time to buy real estate for an investment. Most investors and would-be investors still perceive the current situation as a buying opportunity rather than a flushing out of the market. There are still lots of people (and builders, banks, landlords, related companies, etc) holding on for dear life and until these people let go, it is hard to imagine a bottom occurring. We still have not had the real estate industry mocked the way a pets.com was in the post-dotcom bubble days.
Sentiment does not feel like a bottom yet from investors. It seems that one more leg down in prices is needed for this to happen. This may occur during the upcoming fall/winter cycle. With two more legs down, the sentiment will be sure to turn downward. This argues for a 2010 or 2011 bottom.
Behavioral economics perspective #2 (Owner-Occupied)
This is part speculation and part stereotype, but here it goes…Most houses are bought by couples with one spouse saying “we need a (bigger) house,” and the other spouse saying “let’s wait a year until we can save more money and get more financially stable.” In the bubble years, the financially conservative spouse would look more and more stupid every month as prices rose much faster than the couple’s income and savings. Eventually, the financially conservative spouse would give in to the other spouse and the couple would go ahead and buy, thereby reinforcing the bubble.
For a couple having the same conversation now, the financially conservative spouse looks smarter every month with prices continuing to decline, especially since at least one of the spouses has likely either been laid off or has had a salary reduction or is worried that either blow is coming soon. Sometime around when employment bottoms out (in terms of size of workforce not percentage rates), the financially conservative spouse will start to lose this battle again and the other spouse will say “Ok. We’ve been saving for three years, it’s time to buy now.” This actually favors a 2010 bottom, since employment (in terms of size of workforce) will bottom some time late this year or early next year.
So what are my conclusions? Many of these overlap, so be patient…
- We have not bottomed yet in terms of prices. They will fall through the fall and winter. There are too many headwinds in terms of unemployment, delinquencies, oversupply, and buyer sentiment.
- I am going to stick with my housing price bottom in April 2010. However, I recognize a worse case scenario based on delinquencies turning into foreclosures that overwhelm the housing market that would push the housing price bottom out to April 2013. But even in this worst case scenario, prices will not fall anymore than 10% beyond wherever prices are in 2010, because most of the damage will have been done.
In the best case scenario, the bottom in 2010 will be followed by three years of slow price growth (say around 2%) until at least 2013. More likely, nominal prices will bottom in 2010 and nominal prices will remain relatively flat through 2013 and then start to increase again. I realize that this still equates to a decline in real terms, but at least over this three year period, most homeowners will be building equity and also most homeowners think in nominal not real terms when it comes to the price of their house. - When will home prices get back to their 2005/2006 peak? That is like asking, when will the NASDAQ hit 5,000 again. Don’t hold your breath! 2020 at the absolute earliest in nominal prices, but probably more like 2025. No point in making forecasts that far out.
- The Fed will be under enormous pressure to keep interest rates as low as possible through at least 2013, because of housing alone. This will be true even if prices start to rise in the rest of the economy. It is hard to imagine any situation other than serious inflation by 2013.
- We ain’t seen nothing yet in terms of foreclosures. This is just getting started. My best case scenario has 4 million foreclosures in 2010, 2011, and 2012. The historical data are not good on this, but we could get more foreclosures than we had in the preceding 20 years combined. I am declaring 2010 to be the “Year of the Foreclosure” as loan modifications will certainly be slow to clean up the delinquencies that are already in the pipeline. But with midterm elections in the same year, expect a lot of public anger, political rhetoric, and a bunch of legislative actions to try to stop foreclosures. Obviously, it is unclear how this will impact things, but I am guessing not much based on recent history.
- I have no insight on whether or not banks are intentionally slowing the progression of homes from delinquency to REO. The banks would not admit to it, even if they were. The gap between delinquencies and REOs is notably large, but it is unclear why. More importantly, I do not think I have a problem with banks holding back REOs. I would definitely rather have them focus their resources on loan modifications rather than dumping more houses on the market.
Ideally, they will keep inventories high enough to scare off the builders from adding new supply (10 months of supply, which is where we are now, is enough to do that), but not so high that home prices fall through the floor again (anything over 12 months will lead to more serious declines). If you believe that banks are intentionally holding back supply, then you would also believe that prices will stay flat between 2010 and 2013. This is as quickly as all the foreclosures can be processed without further damaging housing prices beyond where they will end up in Spring 2010. This actually tends to favor the Spring 2010 bottom scenario and the flat through 2013 scenario.
- There will be no need to build any significant number of new houses until at least 2014…sorry Toll Brothers (TOL). New home sales (not prices) may have bottomed, but they definitely will not increase anytime soon. The “newish” inventory from homes built from 2005 to 2007 are coming back on the market and will be a suitable replacement for the new home market.
- The numbers to watch are mortgage delinquencies (tracked well) and loan modification success rates (not tracked well). If 60-day mortgage delinquencies look like they are going to crack 12%, get worried and take another look at the situation. And we need to keep hunting for reliable and credible loan modification data.
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Now back to Dr. Duru’s words:
Be careful out there!
Full disclosure: long puts on TOL and XHB.
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