Figure 1. Total New and Existing Home Sales and the gap between them (source: The CalculatedRisk blog).

1) The stimulus funding for home buyer tax credits has generated demand for homes, at the expense of draining the pool of future home buyers.  There does not appear to be any political will to extend these credits.  Short-term demand for total homes is likely to fall (Figure 1).

2) Foreclosures and distressed pricing of existing home sales will continue to increase in the mid- to high price ranges, but appear to have peaked overall in 2009.  They will continue to remain at higher than historical levels in the lower price ranges (Figure 2).

Figure 2. California foreclosures (source: The CalculatedRisk blog).

I am personally concerned about the possibility of a double dip recession.  While economic demand is increasing off of last year’s lows, we are not growing top line economy-wide revenues as would have been expected for recessions of this size.

This period looks remarkably like the 1974-1976 period; and the key to housing, and the economy in general, is unemployment. If we stay above 9% through the end of this year, I believe that the economy, and therefore housing, will remain (at best) at anemic levels.

3) The continued high levels of foreclosures, combined with high unemployment, will continue to drive pricing in housing to low levels.  These levels will probably be below replacement costs, and we will continue to see low levels of new homes to existing homes sales ratios (Figure 3).

It took 4 years to reach this level of lows in the new home to existing home sales ratio.  Given the current economic (and political) environment, I would expect that it will take a similar amount of time for new home sale to recover to the long-term average of ~15-20% of existing home sales.  However, return to this level would also be commensurate with a return to total new home sales of about 600,000 to 800,000 units, which is nearly half of the peak in 2005 (Figure 1).

This, of course, is a national average.  Places like Florida, California, Nevada, and Arizona may have a longer recovery period.

A recovery of the new home housing market, to half of its peak, in 4-6 years, will not feel like much of a recovery.  It will feel more like survival.

There are some who would argue for an expected increase of 50 basis points in spread widening between treasuries and Mortgage-Backed Securities (MBS). (By the way, Calculating Risk is becoming one of my favorite financial blogs.)

It certainly makes sense to suggest that the price for MBS will fall (and hence yields will rise) once the major buyer of these securities stops buying. However, I don’t think that this will happen, and its a perfect example of why statistics can bite you in the rear when analyzing market trends.

This graph from Politico.com shows the history of 30 yr mortgage rates in relation to 10 yr treasury bonds.

The problem is that it is in the past, and does not reflect the fact that today the GSE’s are wholly-owed subsidiaries of the US Government. The current private market buyers of MBS now consider these bonds to essentially be the same as treasuries (and so does the Congressional Budget Office). Until this changes, the MBS will continue to trade at historically compressed levels compared to treasury bonds, and mortgage rates will continue to remain low.

One could also argue that the recent troubles in the EU may actually cause money to flow into the US fixed income markets, further compressing spreads as foreign buyers of these fixed income securities seek greater yields than are offered on treasuries.

For mortgage rates to significantly change, the following needs to happen – (1) inflation begins to be priced into the market and 10 yr treasury yields go up (maybe), and/or (2) the US Government stops backing the GSEs (unlikely), and/or (3) the Fed starts selling its $1.25 trillion holdings of MBS (again unlikely).

Groups like ACORN were invited by House Banking Committee Henry Gonzalez to -

draft statutory language setting the law’s affordable-housing mandates. Interim goals were set at 30% of the single-family mortgages purchased by Fannie and Freddie, and the Department of Housing and Urban Development has increased that percentage over time.

This eventually led to zero percent down mortgages, the (continued) bailout of Freddie Mae and Fannie Mac, and our current credit difficulties. Make no mistakes about it. The economic problems that we suffered over the last 18 months, and continue with today, have their roots in Congressionally-mandated actions to rewrite the standards for credit-worthiness to help facilitate home ownership.

While these were (are) admirable goals, the road to economic hell is paved with good intentions.

Nationally, the supply and demand of new homes also appears to have reached a balance. New home starts in February of 358,000 is within 6% of new home sales 337,000. For homebuilders, this suggests a possible end to the downward spiral in pricing for their new products. However, it does not necessarily suggest an end to the downward pricing pressure of existing homes, as foreclosures, job losses, and general insecurity in the employment market continue to pressure existing home prices.

The building industry may see a pricing bottom here, but the potential supply of homes will probably exceed new home demand for some time to come. Times will continue to be challenging for the home real estate market, but the phase of speculative excesses appears to be at an end. Hopefully the next phase will be one of recovery, but it will depend on the general economy to right itself.

On to the Numbers -
In the spring of 2008, I put together the following graph and calculations based on the Case-Shiller Index (CSI). I was trying to decide what to do with our house in Tampa, as we were moving to Oregon.

(The spreadsheet used to create this graph may be found in this hyperlink.)

We had listed our house in Tampa in January 2008, but by February we were receiving very little interest. We were wondering whether we should lower the price to help generate its sale. In retrospect, I wish I had done this “back-of-the-envelope” calculation in the Fall of 2007, as I might have listed our house at a lower price to begin with and perhaps sold earlier at a higher price.

In any case, it is a pretty straightforward calculation that charts the CSI versus time (blue diamonds). I regressed time versus the index from January 1987 to April 1994, which appeared to be a period of stable pricing. I projected this forward in time (pink line) to create a basic long-term trend. I then regressed time versus the index between September 2007 to March 2008 to create a short-term trend (blue line).

As is pretty evident, the pain in the housing market predicted from this short-term/long-term relationship suggested that things would get much worse. We quickly lowered the price of our home to sell it as soon as possible (and had contract within two weeks).

Remarkably the trend since February 2008 has pretty much followed the blue short-term trend line, with a little jog during the credit crisis of the summer of 2008. The question now is whether the pricing in the housing market will continue to fall.

The top of the Tampa market was September 2005, and the median asking price of a house at this time was $287,500. A fall back to the pink long-term trend line would yield a median price of $107,200. However, the CSI is a nominal pricing index, and none of the values have been inflation adjusted. Since 1994, there has been some real inflation in the cost of building a home beyond the speculative increases in price. In addition, there have been other factors impacting the cost and pricing of new homes since 1994 beyond the most recent speculative excesses. These include increasing median square footage and upgrades in finishing costs (e.g. granite counter tops) that are beyond the norm of the typical 1994 new home. These factors would yield a rise in the price of a new home based on true costs differences that would need to be considered when trying to find a “bottom” in the median home price today that removed speculative excesses.

Rather than trying to account for all of these factors, let us try a quick addition of inflation to the trends to see if we can surmise a possible end to the median home pricing declines. Average inflation in the CPI over this period was 2.7%. Let us assume a 3% inflation rate in the pricing of homes from May 1994 and add it to our Long-Term Trend (Long-Term+Inflation; red line). This new inflation adjusted trend line shows a crossing with our blue short-term line at $161,221 during March 2009. Recent sales in January 2009 averaged $160,530 (ERA Polo Group), suggesting we are close to the inflation-adjusted price parity with the median home sold in 1994.

However, it does not suggest a complete end to the pricing declines. The woes of the general economy will continue to impact the housing market. Pressures in the employment market will translate into continued pressure in the housing market, reducing overall demand, and possibly increase supply through short-sales, foreclosures, and relocations.

Fannie Mae posted a $25.2B Q4 loss, full year loss of $58.7B. Freddie Mac is expected to post a similar, if not greater loss.

In response, Freddie Mac’s Chief Executive David M. Moffett said that they would take steps to “rebuild our house” including … efforts to reduce foreclosures and boost financing of affordable mortgages. This is social engineering, not rebuilding the balance sheets and income statements of a public company.

These organization were once implicit political beasts that made money by borrowing cheaply as “government-sponsored entities” and leading in the housing market. The tax on these entities for this implicit guarantee was excess lobbying donations to both Democrats and Republicans, and the use of the profits to fund “affordable mortgages”, i.e. sub-prime mortgages.

Now the gloves are off and they are explicitly owned by the government under conservatorship, with the backing of $400B since September of last year. Their new goals are to stabilize the housing market by making mortgages more affordable and forestalling foreclosures.

According to the Wall Street Journal -
Fannie’s government-appointed CEO, Herbert Allison, said: “It’s not about maximizing returns on equity or profits. It’s really about being of use to the country during this very difficult period.”

The administration is taking the approach that slowly pulling the band-aid off the patient (i.e. the housing market) will reduce the likelihood of shock. In the process they are pumping the patient full of expensive life-support drugs (capital injections and regulatory “cram-down” contract changes) that are doing great damage to the vital organs (i.e. our financial, credit, and legal systems).

For those of us who lived through the eighties and nineties and got to watch the Japanese government try to spend their way out of a balance sheet recession, this path seems to be a poor approach to our problems. The Japanese Nikkei average peaked at 38,916 in December, 1989. Yesterday it closed at 7,510. A -80% return over 20 years. This period in the Japan was replete with “zombie” banks, zero federal reserve interest rates, and huge government deficit spending. I don’t think this is the model we want to follow.

My choice – pull the band-aid off as quickly as possible. Have the FDIC take over the zombie banks, what assets can’t be priced, put onto the government books to collect the interest until they can be sold. Foreclose on the homes that need to be foreclosed. I feel for the people that can not afford their homes anymore. However, renting may be a better option. It will probably be cheaper in terms of their cash flow, allowing those individuals to repair their balance sheets until they can accumulate a sufficient down payment for a new home. A new home that can probably be purchased at a better basis than the home they are in at the moment.

This approach will probably cost about the same in the short term, but in the long term be much cheaper because a floor will be established in the asset market. This will reduce the current deficit financing being used to flood the mortgage market with cash. Once established, the asset floor will provide a level of certainty to the financial markets that will release the credit markets, and allow individual optimism to drive new wealth creation.

Without wealth creation, the hole we are in gets deeper and darker. If I was leading the current administration, I would want every decision to be colored by this thought, “how do we get people to create more than they consume?”. It’s that simple. If you are not creating more than you consume, you will have to be supported by someone, somewhere, at sometime. Any “investment” by the government in any activity or enterprise should be focused on getting people to create more than they consume.

Giving money to support mortgages and assets values to individuals via a nationalized mortgage market is not creating wealth, it is transferring it. In the end, you will run out of money.

So the housing market is to get some direct help. First, by recapping Freddie Mae and Fannie Mac with $200 billion. They are effectively creating at least $4 trillion in new mortgage money if the 20X leverage ratio for these monstrosities holds. More if the leverage ratio is allowed to increase (at the end of 2008 these ratios were 20X and 70X for Fannie and Freddie, respectively). This will continue the path of nationalization of the mortgage industry. Will someone please show me one example where the nationalization of an industry provided the long-term benefits it was meant to secure?

In addition, the administration will now back “cram-down” legislation. This will force the rewriting of mortgage contracts in a bankruptcy filing. The effect of this legislation will be to increase the mortgage spreads to treasuries, as issuers will demand more risk premium for issuing the mortgage. This will insure we will all pay more for our mortgages in the future.

A possible solution to the increasing mortgage spreads will be to “fix” mortgage rates. The administration will be able to do this because they will have effectively nationalized the mortgage market (see above).

Price fixing always fails in the effective distribution of goods and services. It creates winners and losers by subjective rules that have no relationship to individual incentive.

In this perverse case here, Congress forced Freddie and Fannie to underwrite sub-prime mortgages in an effort “increase” home ownership. This led to price dislocation (i.e. a bubble) from too many people chasing too few houses. The pricing bubble led to a misallocation of resources in the housing industry, which built too many houses because of the excess demand caused by the excess available credit.

A tremendous amount of those bubble home purchases are now underwater. And since the owners never could afford the homes in the first place, they find bankruptcy their only option to relieve them of their contractual obligations. The same people in government who set these homeowners up for failure now want to penalize the rest of the housing market with more expensive mortgages.

Look for this severe warning sign, price fixing of mortgages. Either explicitly via mortgage rates, or implicitly via a “credit worthiness” criteria outside of the true bill paying capability of the borrower that helps some buyers over others get mortgages from our national mortgage providers. If you see this happen, our troubles are just beginning.

They point to some of the problems with this proposal, but there are other problems with the government trying to qualify borrowers.  The manipulation of lending standards at Freddie Mae and Fannie Mac for the purpose of trying to expand the ranks of home ownership are what got us into the mess in the first place.  However, imagine if the government errs on the other conservative side of the credit markets (which is exactly what the federal regulators are doing to commercial banking right now).  While interest rates may be 4%, very few people will be able to qualify, and the credit markets will remain frozen.

The Great Depression did not result from the Crash of ’29, but rather the regulatory and monetary practices that followed in response.  Price fixing and regulatory limitation of market are what produced 25% unemployment.

The recent economy was highly leveraged, which resulted in asset inflation.  The over-leverage resulted from lots of reasons, not the least of which was poor regulation rather than the absence of regulation.  The process of de-leveraging the economy will cause asset deflation and economic dislocation, but it does not necessarily have to cause extensive price deflation for other goods and services.  Bad regulation, bad fiscal policy, and bad monetary policy will give us the exact problem they are trying to solve.