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Is Deflation in the US Housing Sector Accelerating?
May 23, 2011

Is Deflation in the US Housing Sector Accelerating?


This week in The Institutional Risk Analyst, we offer our view on the housing sector as we travel to Philadelphia on Tuesday to participate in the 29th Annual Monetary and Trade Conference sponsored by the Global Interdependence Center and Drexel University. The blissful topic: the US housing sector and whether a bounce is in prospect.

IRA co-founder Chris Whalen will be on a panel with Josh Rosner, Michael Lewitt and Gretchen Morgenson of the New York Times, talking about the GSEs. By no coincidence, Morgenson and Rosner will be releasing their new book, "Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon." You may sample the book in the New York Times Sunday Business Section.

After reading the book excerpt, non-bank lender NovaStar Financial certainly seems to be an outlier, does it not? The aggressive management practices and financial statements certainly make the company seem to be a very noisy subject -- but this assumes that somebody is watching for red flags. Indifference is the operative posture in Washington and no time more than the present, even when the housing market is still melting down.

In a presentation at the REthink conference sponsored by Housing Wire, John Burns walked the participants through the current situation in the US housing sector and the outlook for a recovery in prices. The bottom line: Even though affordability has returned, new home sales are likely to remain depressed for years to come due to massive inventories of unsold homes, dwindling finance and weak employment markets. Now you know why IN governor Mitch Daniels would rather see Barack Obama spend another four years in the White House -- held captive to a Republican controlled Congress. But even Obama may not want the POTUS job by next year.

The stark presentation by Burns provides a reminder that it took most of the 1990s right through to 2001 before the US real estate market recovered from the S&L crisis of the late 1990s. Given the far larger degree of movement over the past five years in terms of metrics such as demographics and home ownership, as well as available financing and home prices, it seems reasonable to ask whether the cure period this time around will not take a bit longer.

One of the key points made by Burns is that new home construction is not likely to recover until a substantial dent is put in the backlog of unsold homes. He sees the backlog going out four years or more. With the degree of price contraction experienced in many markets, starting a new home construction project does not make any sense. Even though home selling prices have dropped by low to mid double digits, the cost of building a home has not dropped significantly. Indeed, costs such as project overhead have gone up 10-20% since 2006, according to Burns Real Estate Consulting.

As crazy as home prices had behaved in the past several decades, the sad fact is that the rate of inflation for many of the inputs that go into building a new home today were galloping along at double digits. The true, underlying rate of inflation in the US during this same period has been several times higher than the officials statistics suggest -- both in terms of rising costs and compression of real wages -- making the replacement cost for many existing homes far closer to current market than home owners and policy makers appreciate. We can call it real margin compression, perhaps a new economic metric?

Channel check: Call your insurance broker and review the replacement cost assumptions in your home owner's policy. Then send us a note and give us (1) your current valuation for tax purposes and (2) replacement cost for insurance purposes. We face the strange prospect of a market where many homes are trading at or around true replacement value, but remain unsold due to a lack of financing and also a shrinking home owner population. Homes are still not affordable vs. available consumer incomes.

Consider this thoughtful comment we got from one long-time reader named Gary, who for decades has worked along the US-Mexico border as a banker and businessman. Note what he says about the nature of the housing market and also the potential role that community banks can play in rebuilding the market for residential home finance on sane terms:

"The single family housing boom was substantially caused by giant subsidies from DC at every level. Not just the GSE's but the Fed, Congressional winks and nods, local and state encouragement of eating up farm land to grow tract houses, and on and on. 'Securitization' of mortgages was a temporary phenomenon, not the balanced, normal state of the industry. Now that the bubble has burst, Humpty Dumpty can' t be put back together.

"The consumer is 'done' with tract housing. Demand for single family housing in much of the U.S. has changed for a generation. The Case Shiller models are really misleading the policy makers and talking heads. Fed policy is primarily still driven by their desire to achieve full employment. The Fed does not yet understand the huge impact of the collapse of the old manufactured housing model on employment. The Fed is setting policy at every level as if they can 'jump start' or push start housing from the top down. They can't. Most consumers can't afford housing, even at drastically reduced valuations, because of a change in savings patterns. The consumer wants to get out of debt and have a nice and safe "savings" of some form so it is the family back stop. That used to be housing, but they know the home ATM is no longer...and won't be for very long time.

"The greatly reduced number of families who will be able to afford a new home, or to change homes, should go to their closest bank for a mortgage and demand contracturally, that the bank hold the servicing and at least 25% of the balance outstanding on the loan for as long as the borrower owns the home. Deeds of Trust and loans can be a two way street. The bank can still have pretty much unfettered rights to forclose, but the borrower can write stuff into the docs as well. If enough borrowers got together and said: NO, you can't securitize 100% of my mortgage and export the servicing...the housing finance market would respond.

"Dodd-Frank has so far done more harm than good. Saving the independent banks is critical. Breaking up the 5 largest banks is equally critical. Ben Bernanke is still Alan Greenspan on steroids and does not understand how business decisions are made, how a bank works nor how the economy should work. Fed policy should be to forget about the housing sector and focus on the 'production' sector. More banks are better for the economy than fewer. Small is better than big. Caterpillar or Ford Motor Co don't care how large the balance sheet is of Bank of American or Wells Fargo! Nor should the Fed allow them to dominate deposit and loan business as they now do...very bad for the economy in both near and longer term."

The factors discussed above are just some of the "sources of friction" we see slowing or retarding a recovery in the US housing sector. One of the members of our continuous online housing study group, Alan Boyce, told the attendees of REthink that the credit spread for prime collateral going into private label securities is +100bp to the GSE curve, but that the spread for the bottom 90% of borrowers is "incalcuable." More, the veteran mortgage market observer predicts that in the futrure spreads on private label collateral will widen during times of market stress or interest rate ease by the Fed, even as Treasury paper and GSE obligations tighten. "That super 'procycality' cannot be allowed to happen," Boyce argues.

Unfortunately in our federalist system, macro economic coordination remains a challenge, especially when the government-sponsored players pretend to be private sector entities. The changes in the LLPA hurdles at Fannie Mae and Freddie Mac, for example, now drive minimum FICO score to 740. Loans below that FICO score attract huge upfront fees and effectively discourage lending. Once the maximum conforming loan limit is reduced in September, the flow of new credit to the housing sector will constrict further, perhaps accelerating the deflation that we believe is already gaining speed in the housing sector.

Of note, Redwood Trust CEO Martin Hughes testified last week before a Senate subcommittee hearing on the dismal state of the private securitization markets. He noted that the government's dominance and regulatory uncertainty keep the entire market from restarting, according to Housing Wire. ""The consequences of failing to attract sufficient private-sector capital to this market include a contraction in the availability of credit to home buyers, an increase in mortgage rates, and continued decreases in home prices," Hughes said in testimony before the Senate Banking Committee.

Today investors remain unwilling to take first loss risk on private label mortgage securities. That is why for the next several years, at least, the government and legacy agencies such as Fannie Mae and Freddie Mac will remain the only game in town. It is all fine and well to talk about the private sector supplying mortgage finance, but in today's markets with hundreds of billions of dollars in cash sitting in reserves at the Fed and in non-interest bearing deposits at banks, the problem to us still looks like deflation -- even today, now more than half a decade into the crisis. And the Obama White House seems determined to ignore the meltdown in the housing sector.

On Wednesday this week, IRA's Chris Whalen will be addressing a luncheon in Manhattan sponsored by BNY ConvergEx. We will be discussing the outlook for financials given the prospects for the housing sector, EU defaults and the scheduled end of the Fed's quantitative easing operations. Please contact your ConvergEx representative for details.

Questions? Comments? info@institutionalriskanalytics.com


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