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Housing: ARMed and Dangerous

Risks to the economy, stocks and your net worth

This time last year, a hot topic at cocktail parties was how high real estate prices could still go. Now, with evidence of falling prices in many parts of the U.S. dominating not only the financial media but the general press and even the tabloids, we’re more likely drowning our sorrows than clinking our glasses. Although the debate still rages over whether housing’s fall will result in an economic hard or soft landing, there’s no debate about housing. A hard landing it appears to be—and it’s not over yet.

That has implications for equity investors as well as homeowners. As you can see in the graph below, over the last decade there has been a remarkably tight connection between the Housing Market Index, a measure of confidence among homebuilders, and the S&P 500® one year later. Before 1994, the two measures were much less correlated. However, if the recent pattern continues, the graph suggests a potentially significant downside for equity investors. This remains one of the reasons we maintain our recommendation to slightly underweight U.S. stocks in favor of cash (see the Schwab Market Perspective). In Schwab parlance, “slightly” means five percentage points of your total portfolio value. So we are not recommending clients completely replace their stocks with cash, just that they make a minor adjustment.



A different kind of downturn

As cited by many a homebuilder CEO lately, there is something very unique about this cycle: It’s the first time in American history that a severe housing downturn has been led not by rising unemployment or falling incomes, but by too much inventory and speculation. For the past century, home prices adjusted for inflation have been relatively stable, with long cyclical swings but no long-term trend. The major anomaly was the sharp spike in home prices over the last decade (up over 80% since 1997), which was totally out of line with the long-term experience. Fundamentals can’t fully explain this spike, so what can?

Speculative fever

Five years ago, the Federal Reserve was determined to keep the popping of the Internet bubble, the economic recession and the aftermath of the terrorist attacks of September 11, 2001, from turning into a self-reinforcing collapse. Short-term interest rates were lowered to 1%, banks encouraged mortgage holders to refinance and withdraw equity, lending standards were lowered and a rash of new adjustable rate mortgage (ARM) products was introduced. All served to fuel speculation in residential housing, boosting prices to an unprecedented degree, which in turn reinforced speculation. The increase in prices spurred the boost to net worth, which fueled a consumption boom and sustained economic growth.

Supply, supply and more supply

And with demand came supply...in spades. Note the unprecedented increase in inventories of existing homes on the market in the graph below:



Existing homes represent 85% of the housing market, but the data for new homes shows a similar inventory surge and pricing reaction. There is typically a lag in the adjustment of home prices to a gap between supply and demand. This time, the massive increase in inventories of unsold homes has yet to trigger a full-fledged price bust. As you can see in the chart “Inventories Skyrocket, Prices Stall,” the rate at which prices are increasing has declined precipitously but remains in positive territory, albeit slightly.

Pricing pressure is not just relegated to the coasts or speculative hot spots. Prices are also under pressure in the Midwest, the region where the conventional wisdom was that there was no bubble. The June 2006 release of the S&P/Case-Shiller Index reported an expected decline in prices in Chicago of 6.4% during the course of the next year. The three regions in which prices are expected to fall most over the next year are Las Vegas, San Diego and Boston (–8.0%, –8.0% and –7.6%, respectively), while those expected to fall the least are Denver, New York and Los Angeles (–5.6%, –6.0% and –6.3%, respectively).

Want granite countertops and a pool? Just ask.

Looking under the hood of pricing statistics, one finds some interesting incentives being used to spur buyers. Home sellers are now providing a variety of financial benefits that effectively reduce the price of a sold home, even if the headline price is not officially reduced. The typical incentives from a homeowner who is selling range from paid closing costs to buyer-side realtor bonuses, seller-subsidized mortgages and even free swimming pools. From a homebuilder they include countertop and appliance upgrades, down-payment “cash-backs,” auto leases and even country club memberships. When adding back best-guess estimates of these incentives, median home prices are already falling on a year-over-year basis—the first time this has occurred since the 1930s.

The boom in ARMs

There are other lags still working through the system, many of which relate to the nature of lending that fueled the boom. As reported in the August 21 issue of Barron’s (“The No-Money-Down Disaster”):

• 32.6% of new mortgages and home equity loans in 2005 were interest-only, up from 0.6% in 2000.
• 43% of first-time home buyers (25% of all buyers) in 2005 put no money down.
• 15.2% of 2005 buyers owe at least 10% more than their home is worth.
• 10% of all homeowners with mortgages have no equity in their homes.
• $2.7 trillion in loans will adjust to higher rates in 2006 and 2007.

In addition:

• By July the ratio of house prices to incomes had risen 30% above its prior peak in the early 1980s.
• A recent Fed study shows non-prime mortgages made up nearly 25% of conventional home purchase loans in 2005, compared to 11.5% in 2004.
• Real estate as a percentage of household net worth has jumped from under 25% in 2000 to 38% today.

Juvenile delinquencies

With home prices set to move even lower as inventory is reduced, and monthly payments set to rise as mortgage rate resets kick in, more and more homeowners are in danger of delinquency, suggesting more widespread foreclosures. As you can see in the chart below, housing affordability has been in a free fall.



Delinquencies lag affordability, but note the big subsequent surge in delinquencies after affordability sank in 2000–2001. Affordability is much worse today than it was during the last recession, in 2001, while household debt payments have jumped to nearly 14% of disposable income, an all-time record. With home prices and mortgage rates receding, there is hope for a bottom in affordability. But given the lagged effect, a rise in delinquencies may already be baked in the cake.



Banks may be at risk as well, as they have become steadily more dependent on residential real estate loans. As seen in the chart above, residential real estate loans as a percentage of total bank loans have surged from about 23% in 1999 to about 31% today.

Mortgage equity draw-downs on their last legs?

One of the remaining vestiges of the real estate boom is sustained mortgage equity withdrawals, which have continued to spur consumer spending. Much to many economists’ surprise, mortgage equity withdrawals in the second quarter have remained at an $800 billion annual rate, about the level of the past year. Of course, this suggests that the inevitable fall in home equity draw-downs and its effect on consumer spending are still very much in front of us. The ultimate danger is the potential unwinding of the massive debt that has built up over the past decade and renewed trepidation about deflation, as housing prices fall. This concern could supplant the current distress over inflation, which has been fueled by rising commodity prices, also coming off the boil.

Housing: more pain ahead

Many investors assume the damage to the housing industry is an isolated event (much as it was assumed that the dot-com implosion was an isolated event). I find myself more concerned than the consensus, believing the housing industry is vastly more important to the overall economy than many are currently assuming. Given that prices have yet to fall enough to drain inventories, and mortgage rates have yet to fall enough to stimulate another mortgage refinancing boom, there is still likely more pain and suffering to come before we can close the books on this housing cycle. And the harder housing falls, the harder it will be for the economy to land softly.


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Homebuilders:
Not the Time to Buy!

By John Zbesko, CFA, Senior Research Analyst
Schwab Equity Ratings®

For important disclosures and Regulation Analyst Certification, see the Important Disclosures section at the end of this article.


Given the approximately 20% drop in the S&P 1500 Homebuilding Index since May, many clients have been asking whether now’s the time to venture back into that battered neighborhood. The resounding answer from Schwab Equity Ratings is not yet, even though the value component of these stocks has improved overall. Of the 26 homebuilding stocks covered by Schwab Equity Ratings, three are rated C (“hold”), eight are F (“sell”) and 15 are rated D (“sell”). None are rated A or B (“buys”). Check out eight stocks in the table below that are now getting an F.



http://www.schwabinsights.com/2006_09/mktoutlook.html