When I saw the new numbers from S&P’s S&P/Case-Shiller home price index yesterday I wasn’t all that surprised. I suspect my readers were not surprised either. For those that are not familiar, the Case-Shiller Index is a closely followed metric of U.S. home prices (See a PDF summary of the report). It shows that prices are falling sharply across most of the nation. This obviously is putting more pressure on the consumer.
Home prices in 10 major metropolitan areas in October were down 6.7% from a year earlier, according to the S&P/Case-Shiller home-price indexes. That exceeded the previous record year-to-year decline of 6.3% in April 1991, when the economy was emerging from a recession. Some economists say that the decline is a signal that the market is making a necessary adjustment, pushing prices back closer to Americans’ ability to pay. The realtor lobby’s economist believes that prices will bottom out beginning in 2009 but most investment bank economists see the bottom closer to 2010. That would put the correction not even half over. I tend to side with the bank economists since I believe that resets on ARM mortgages will continue to pressure on prices since lenders taking out ARM mortgages were the marginal buyers of housing.
The effect this will have on the American consumer is the biggest takeaway from the housing data. It has rarely paid to bet against the American consumer but in this case I think playing that trend will yield a great return. As homeowners are unable to take out more home equity or refinance for more cash they will cut down on spending (See my related story on the drop-off in women’s clothing purchases). Remember that consumer spending accounts for about 70% of economic activity in the U.S. It has an enormous effect on revenues and profits for U.S. and foreign firms through the multiplier effect. There is no doubt in the Prince’s mind that growth is going to slow as consumer spending slows. Recent numbers from the government have claimed that consumer spending is healthy but I think that those numbers are lagging behind current conditions. Holiday sales were weak and many investors are taking that out on discretionary consumer stocks’ prices.
But the recovery of the housing market is a gradual process because the boom put prices out of reach with incomes. The Case-Shiller index showed home prices jumping 74% in the six years through 2006. During the same period, U.S. median household income rose 15%. That made housing unaffordable for many Americans but more aggressive lending still allowed many to get into homes.
It is not at all surpassing that the Case-Shiller index showed that some of the fastest declines in home prices are in metropolitan areas that were among the hottest during the boom. Prices were down 12.4% from a year earlier in Miami, 11.1% in San Diego, and 10.7% in Las Vegas. Home prices are still up from a year ago in some places, such as Seattle and Charlotte, N.C. And people who bought their homes several years ago still typically are sitting on sizable gains in most of the country (Take a look at the chart above if you need proof). The boom more than doubled prices in many populous areas near the coasts. This happened because of unusually low interest rates, which slashed the cost of monthly mortgage payments. Home sales began to slow in mid-2005 then prices leveled off before starting declining in 2006.
Over the past year, mortgage defaults have soared, leading to rapid growth in foreclosures. Foreclosed homes are being listed for much lower amounts than homes for sale by real sellers. If you are seller in a market with high foreclosures you are not going to get anywhere’s near what you expect. It will take some time for expectations to adjust. I remember what my favorite economics professor used to say, "Expectations are Everything". Nothing sums up the housing market better right now. Inventories of unsold homes remain very high and may increase in the new year as lenders dump more foreclosed houses on the market. The number of detached single-family homes listed for sale in October was enough to last 10 months at the current sales rate, according to the National Association of Realtors. That was more than double the level of two years ago and the highest since 1985.As the market adjusts, single-family housing starts have fallen 55% from their January 2006 peak to a seasonally adjusted annual rate of 829,000. More pressure on prices is coming from homebuilders, because builders are aggressively chopping prices to clear inventories. Recent cuts by builders may have reduced demand in the short term because they encourage potential buyers to expect further discounts.
The mortgage market also needs to adjust further. Most of the funding for home loans comes from investors who buy securities backed by bundles of mortgages. Since August, many of those investors have shunned the market amid fears of rising defaults. As a result, lenders generally are focusing on loans that can be sold to government-sponsored investors Fannie Mae or Freddie Mac, or insured by the Federal Housing Administration. Jumbo loans, above $417,000, which can’t be sold to Fannie or Freddie, have grown much more expensive, deterring buyers in high-cost areas. Prices are going to get hit by how tough it is to get a mortgage because there is a much smaller supply of buyers that qualify given tougher standards. The current scarcity of funds available for mortgage lending creates a chicken-and-egg situation, says Prof. Leamer. Investors who provide funding for home loans don’t want to commit more money until they believe the housing market is getting better. But it’s hard for the housing market to rebound as long as mortgage credit is tight. Lower prices eventually will break this impasse, by luring buyers back into the market and reassuring investors that the market is finding a bottom, he says.
I am not crazy about using the Case-Shiller Index because I believe that it is a lagging indicator. I think things are going to get much worse. Just look at the chart below from Credit Suisse. It basically shows the notional value of mortgages that will reset on different dates. Many of these are forced resets that are written into the mortgage documents. Out to month 24 gets us to January 2009 with another big wave starting shortly thereafter. Many of the people in these ARMs (Adjustable Rates Mortgages) are not going to be able to refinance to rates that are affordable and will default. This paper that was issued with lax standards is going to be affecting the mortgage market for 3 to 4 years as foreclosures linked to it continue. Look at subprime ARM resets through Jan 2009 and it is easy to see that we haven’t really even hit the peak of Subprime ARM resets. It is going to get worse before it gets better. Then look at the wave of Option, Alt-A, and Unsecuritized ARM coming after Jan 09.
ARM resets are going to have a huge impact especially if housing prices continue to fall in hot markets and/or sales continue to slow. This is because people will have negative equity and be unable to refinance which leads to foreclosure. If the housing market continues to deteriorate ARM resets on higher quality ( i.e. not subprime) ARMs like Option ARM and Alt-A ARM will be even more painful since it is more likely that people will not see the appreciation in home value they were anticipating when they took these ARM mortgages out. Without that appreciation the may not be able to refinance or keep up with their unaffordable mortgage payments. Get ready for more pain in housing, The Prince guarantees it.
More Trouble in suburbia is Coming! A for sale sign in every yard and every other house in foreclosure.
http://www.princeofwallstreet.com/2007/12/27/all-about-resets-numbers-wi...
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