Green Shoots Have Shallow Roots

I am an optimist. I believe that things in the future will generally be better and better over time. I believe that Capitalism and Democracy are the best economic and political philosophies to provide the foundation for a superior quality of life. I am not a pollyanna, and I do not believe in black and white reasoning. The older I get, the grayer things look, but there are no compromises when it comes to ethics. As I write, I recognize that I sound defensive. I’m feeling defensive about criticism for not jumping on the Happy-Happy train that is currently so popular among my Wall Street crowd. Markets are up almost 40% since early March, and I simply don’t believe we’re out of trouble. I am encouraged by the “green shoot” indications that declines are slowing, but I don’t believe that danger of further declines has passed, and I believe that investors who have suffered greatly over the past year should exercise great caution and dispassionate discipline.

Geithner was laughed at when he suggested that the US was a very safe credit and that we are more worried than anyone about our deficits.

Bernanke said US Budget Deficits threaten financial stability.

Bernanke said either spending cuts or tax increases are necessary to stabilize the fiscal situation.

This year’s budget deficit will likely be 4x last year’s.

On housing data…

The most commonly-sited “green shoot” to date is the stabilization in monthly new and existing home sales. For the most recent month of data, April, 2009, new home sales came in at 352,000 on an annualized basis, or 7% above the low reported for January, 2009. Existing home sales came in at 4.68 million on an annualized basis in April, or 4% above the low reported for January, 2009. So indeed it does appear that new and existing home sales have stabilized in recent months. This should not be a huge surprise given: 1) the 30%+ decline in home prices from the peak; 2) the drop in mortgage rates to below 5%. The combination of these two factors has resulted in an all-time high reading on the housing affordability index of 172.5 for the first quarter of 2009. More affordable housing is undoubtedly a positive for the economy at large and is a precondition for eventual economic recovery, but we are not convinced that a stabilization in housing prices is necessarily imminent.

Housing market participants are benefiting from a large number of government initiatives designed to prevent foreclosures, lower mortgage rates, increase sales activity, and ultimately arrest the drop in housing prices. Banks are being essentially forced to rewrite existing mortgage contracts to make payments more affordable for homeowners in trouble. Freddie Mac and Fannie Mae are accepting refinancings for up to 105% of the value of a home, and this percentage may go higher. The Federal Reserve has been in the market aggressively buying Mortgage-Backed Securities (MBS) and Treasury bonds in an effort to drive down mortgage rates. Banks have been required to take government TARP funds and raise private capital so that they are healthy enough to extend new mortgages and other consumer loans. Tax credits have been offered to new home buyers.

According to most pundits, the combination of all these initiatives and others has resulted in a stabilization in the housing market. But despite all the government intervention, a full 45% of the existing home sales reported for April were the result of distressed transactions, which usually involved a foreclosure. Banks that had agreed to a “foreclosure moratorium” have now started to foreclose again, creating a large shadow inventory of properties on bank balance sheets. According to the most recent data, 3.85% of outstanding mortgages were in foreclosure as of the first quarter of 2009. If we combine the loans in foreclosure with those that are delinquent (mortgage-holder is behind in his payments), roughly one in eight mortgages is not making timely payments. Furthermore, according to most recent estimates roughly 20% of existing mortgages are underwater, meaning the “homeowner” owes more than the value of the house. As home prices continue to fall, more and more homeowners may be incentized to simply walk away from there loan, leaving the bank with house and the loss when it is sold. Therefore, it would appear that the cycle of higher foreclosures, forced sales and lower home prices has yet to run its course. And finally, we continue to worry about the huge amount of Option-ARM and Alt-A loans scheduled to reprice over the 2010-2011 time frame. These so-called “exotic” mortgages could pose the next big problem to the housing market.

Best not to get too excited with this particular green shoot. Any sector that is so dependent on government assistance makes us nervous. How will the government extricate itself from the support it has lent the housing market?

Hang in there!