Friday, October 26, 2007

On Housing

It seems like a good idea to understand more about the housing market for many reasons. For one, it is a big source of consumer wealth, and some have estimated that we can see a four trillion decline in household real estate wealth by the time the current cycle is over. This would have secondary effects on all sorts of industries. But more importantly for investors, the 52 week low list is flooded with financial, real estate, and homebuilding names, so understanding this industry will be important in making informed investment decisions. Thanks to Calculated Risk for the charts and well, almost everything I've learned.

The housing boom from 2000-2006 saw huge gains in home prices, but it also saw a huge increase in sales activity. On that matter, it is important to understand there are two widely published metrics, new home sales and existing home sales. New home sales are houses being sold for the first time, while existing home are homes that are being re-sold. Both have had big increases during the current boom. (See charts below)

With Existing home sales, what is surprising is how much this sales activity has increased recently. You would naturally expect a certain level of existing home sales as people decide to move to new areas. But people are basically selling one home and moving to another. So, we can point to a few causes for the increase in sales activity. One cause is that the current environment made the housing market more flexible, with some people wanting to move up and others to move down. Easy credit made the first one possible, while taking profits on the current boom is probably the cause of the second one. A more likely cause is that there has been an increase in real estate speculators, who have been buying a house with the desire to flip it in a short period of time. We can see this in the recent HMDA Data Analysis , which I quote:
After declining in the early 1990s, the share of non-owner-occupant lending among first-lien loans to purchase one- to four-family site-built homes began rising in 1994, and it has risen in every year between 1996 (when it was 6.4 percent) and 2005, when it reached 17.3 percent (table 8). For 2006, the share fell somewhat, to 16.5 percent.
We see that the share of mortgage originations being made by real estate investors has increased dramatically. But, and I think this is getting to the heart of the matter, every new house, whether owner-occupied or investment, requires someone to live in it. So ignoring second home purchases, which is a very small minority, this leaves the pool of non-homeowners to look towards. And the important thing to remember is the main thing stopping this group from owning a home is affordability. Every year, a certain amount of people rises into the affordability territory, and so we have new homes and new mortgages.(More on this below) But the recent boom expanded well beyond that into the group of people who could not afford their purchase. So the recent boom has on one hand, relied on increasing sales to the non-homeowner group which can not afford it; On the other hand, it has made it even harder for this group to afford the houses they want to buy. The fault for this lies in easy credit. In one situation, this allowed "sub-prime" borrowers to get a low adjustable rate with the hope of selling the house for a profit when the time for a reset came. The idea was never mentioned to them that if houses did appreciate during their low-interest period and they sold out for a profit before their reset, that any of their gains would just have to go towards paying for a new, now more expensive home. Similarly, we have the real estate "investor",(I use the term loosely) who pushes up the price of homes only to rent it out to someone who could not afford to purchase a home themself. In a way, the investor has financed the well-being of the rentor by paying the interest on the house and then renting it to someone for less.

So, the recent boom saw a huge increase in speculation and turnover, which to diverge again for a second, resulted in a huge increase in frictional costs. In the end, there are X number of homes that will provide shelter to Y number of people. A nationwide game of musical chairs with homes does nothing but make your real estate agent and your mortgage brokers rich. It is a similar situation to a stock market, where increased turnover isn't increasing the value of the businesses you are trading- it is just making your broker rich.

Besides the huge increase in turnover, but there was also some very wrong market signals being sent. We see this in new home sales. Historically, new home sales has always fluctuated within a range of 400,000 and 800,000 units. The reason being that over time there is an increase in the amount of people that can afford to purchase a home because of rises in standard of living and overall population increases, and this number of people has been relatively consistent throughout history. The recent boom went into unchartered territory:

There has been a large increase in new homes sales, but this was mostly achieved by appealing to people who could not afford it. The cycle was maintained as long as house prices went up, but it can only last so long. Lending to people who cannot afford their "true" interest or principal payments is unsustainable.

Where we stand today. There is a large supply of homes that will come on the market, and the market will need some time to absorb this recent boom and adjust to a more reasonable price. I do not know how much home prices will fall, but I would say 20% would not be unthinkable. That would be a 4 trillion decline in Household wealth. I would expect new home sales to have to considerably slow down even from today's levels if the excesses of this boom is to be absorbed. Until I see that, I would say it is too early to be investing in most of these homebuilders, real estate companies, and financial firms, given the uncertainty and the potential downside.

On a final note, here is a chart of an ABX index tracking AAA-rated mortgage backed securities. People should be very concerned that these are now trading at almost 85 cents on the dollar.

Coming soon, a look at Countrywide Financial and what must be some rose-tinted glasses they are wearing.

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