Revisiting the Housing Market

For many months now, we have placed a great deal of emphasis on the housing market (and have since even before the financial crisis began) because we believe it affects our consumer-centric economy in profound ways. First and most obviously, housing prices affect consumer spending through a phenomenon known as the “wealth effect.” The wealth effect simply refers to the notion that consumers spend more with increases in perceived wealth. As housing prices soared, consumers felt more confident to borrow and spend some of their paper gains on things like home improvements and other luxuries. When housing prices collapsed and more and more homeowners were faced with negative equity (not to mention job losses), consumers tightened the purse strings and spent less. Given that 70% of GDP is consumer spending, the effect of a pullback in spending on economic growth was highly significant. This phenomenon is know as the “paradow of thrift” – what’s good for the individual consumer is not good for the economy at large. This could happen again if housing prices are to fall meaningfully from here.

Secondly, a stabilization is housing prices is the key to banks’ regaining enough confidence to start lending again. During the course of the financial crisis, the banking system experienced the most dramatic contraction in consumer credit since record-keeping began in 1943. At the same time, the securitization market completely shut down, eliminating a huge source of funding for all kinds of consumer loans as well as commercial real estate loans. The impact on economic growth from this contraction in credit has been dramatic. Still today, bank balance sheets continue to contract (ie, loan balances are shrinking) with each quarter that passes. Nearly 100% of new mortgage loans are being either funded (through Fannie Mae or Freddie Mac) or guaranteed (through FHA) by the federal government. While banks remain reluctant to lend for a variety of reasons (capital shortages, uncertain regulatory landscape, closure of securitization market, high unemployment), we believe the most plausible explanation is the possibility of further housing price declines and their impact on residential real estate-related loan losses. Given that up to 30% of existing mortgage loans are now underwater, we believe bank management teams are acting rationally and that their fears may be justified.

And finally, we have long been concerned about the long-term financial condition of consumers, especially baby boomers. Given that consumer debt levels have barely budged from record highs and that many boomers had been depending on home price appreciation for retirement, we believe the recent housing price declines will cause somewhat of a permanent shift in the saving and spending patterns of middle Americans. It is true that savings rates have already rebounded a bit from the near-zero levels posted in the 2005-2007 time frame. However, the ratio of total consumer debt to personal income is still near record levels of over 100%. The average baby boomer is ill-prepared for retirement, and further home price depreciation will exacerbate the crisis. Therefore, we must go through an inevitable long-term process of “deleveraging” such that consumer debt levels recede, retirement savings are rebuilt, and confidence is restored. This process is likely to play out over a period of years rather than months, and the prospect of higher future tax rates to cover massive government spending may increase the urgency felt by retiring boomers.

Our prognostications about the housing market were and are based on a variety of different indicators we regularly track (inventories, foreclosures, delinquences, repricing schedules of adjustable-rate mortgages, etc.), but they all come down to simple supply and demand. In a nutshell, the massive housing bubble was possible due to a dramatic liberalization in lending standards. Easy money through widespread use of exotic mortgages such as “no-doc” and option ARM loans, combined with generationally-low mortgage rates, caused demand for housing to soar and the homeownership rate in the US to go from a long-term average of about 64.5% to over 69% in a little over a decade. This source of funding is now gone, and demand has collapsed. In the latest sign of this collapse, new home sales for May fell 32.7%. The important point to remember is that the easy money that enabled housing prices to rise so dramatically is not coming back any time soon. Therefore, prices must adjust to the new reality. Are we there yet? Unlikely.

We have been concerned that the government’s efforts to support the housing market have led to a situation whereby housing prices were not allowed to clear at appropriate levels. It is becoming increasingly clear that as the stimulus is removed, prices will eventually have to continue downward such that supply ultimately meets demand. Importantly, despite the expiration of the $8,000 tax credits and the Fed purchases of MBS, the government’s support for the housing market is still very high. As stated above, nearly every new mortgage extended today is either funded or guaranteed by the federal government. Mortgage rates remain very low due to Fed monetary policy and quantitative easing. And banks are being compensated (or more accurately, forced) to rewrite existing mortgage loans so they become more affordable. Based on all of this, one has to ask the question: Where would we be if mortgage rates weren’t near record lows and if the government weren’t backing almost every new mortgage?

The economy is stablizing and most parts of the contraction appear to have bottomed. However, it is not difficult to make the argument for another dip down based on the aforementioned risks. The soft landing that government intervention provided for housing may not be sustainable. As the US and the world soldier on through economic difficulties, we search for ways to protect and grow capital. Blue-chip multi-national companies that operate in different countries and currencies look very attractive. They are not the market movers on high volatility or when the quick-risk trade is on, but we believe that they offer superior value for the longer term. Adhering to your investment philosophy through the short-term noise is essential for success.

Hang in there,