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Outlook 2008: Lots of Pain But No Gain For Housing Market

By , Contributing Writer, Money Morning •

Editor's Note: This is the 12th Installment of an Ongoing Series Highlighting the Global Investing Outlook for 2008.

By Don Miller
Contributing Writer

The situation in the U.S. housing market appears to be about as bad as it can get.  No one can be sure where or when the bottom will be, but don't bet the farm on 2008 being the flash point for a turnaround.

"We are navigating through one of the most challenging housing environments in the past 25 years," says Tim Eller, chief executive officer of Centex Homes, the third-largest homebuilder in the U.S. market.

And that may be an understatement. The reason: The latest numbers paint a picture of a market in freefall.

This Time, the Numbers Tell the Story

According to the National Association of Realtors, home sales for November ran at a seasonally adjusted annual rate of 5 million units, up slightly from 4.98 million units in October, but down a hefty 20% from November 2006.  The inventory of unsold homes stands at about 10.3 months, far above the six-month supply that's considered normal.

A record 6.7% drop in the Standard & Poor's/Case-Shiller Home Price Index also marked the 23rd consecutive month in which housing prices either grew more slowly than normal, or experienced an outright decline. All 20 metro areas used in the index declined, and 11 posted monthly declines that were records.

While the hardest-hit region was in the West - which includes California, Arizona and Nevada - the bloodshed reached its nadir in Florida.

Miami posted the largest decline among the 20 metro markets in the index.  Home prices in the Miami metro area were down 12.4% in October on a year-over-year basis, surpassing Tampa (11.4%) as the worst performing city of those measured. Detroit, Las Vegas, Phoenix, and San Diego also posted double-digit declines.

"No matter how you look at the data, it is obvious that the current state of the single-family housing market remains grim," said Robert Shiller, who helped create the index in 1991.

And the forward-looking indicators don't telegraph any improvement. Clearly, homebuilders who don't already have a shovel in the dirt will be waiting for the housing market to demonstrate a real sign of improvement before they start investing anew.

According to the National Association of Home Builders, nationwide building permits for 2007 plummeted by 29% from 2006. But the carnage was much worse in some individual markets. For instance, building permits dropped a whopping 52% in Florida, 31% in Arizona, 36% in Nevada and 37% in California.

Big developers are also dumping land inventory like hot potatoes. Centex Homes, recently bit the bullet and wrote-down $1 billion in land inventory.  In the third quarter of 2007 alone, homebuilders D.R. Horton Inc. (DH), Pulte Homes Inc. (PHM), M.D.C. Holdings Inc. (MDC), and The Ryland Group Inc. (RYL) saw $3.3 billion of land inventory and options go up in smoke.

Moody's Investors Corp. (MCO) recently cut Centex's investment grade debt to junk status, along with that of Lennar Corp. (LEN) and Pulte. Moody's foresees "extremely weak industry conditions through at least 2009, with any sector recovery likely to be listless for some time after that."

The Fed: A Global Slowdown Catalyst

 Aside from investors who have been living in a cave [the wave of the future, given the subprime crisis?], everyone should be thoroughly familiar with what caused this mess.

Responsibility for the twin-tier crises of the dot-com implosion and the housing-bubble implosion can be left on the "Welcome Mat" of the U.S. Federal Reserve.

In the late 1990s, with U.S. growth accelerating from a trot to a gallop, the nation's central bank began lifting interest rates to throttle down growth and ward off inflation.

But then the double-whammies of the Asian Contagion and the collapse of the Long-Term Capital Management hedge fund forced then-Federal Reserve Chairman Alan Greenspan and central bank policymakers to shift gears. To avoid a major blow to the global financial system, the Fed reversed course and started cutting interest rates, adding the fuel of cheap credit to an already brisk U.S. economy.

Low rates pumped up the Internet bubble, which burst in 2000, and also sent the U.S. housing market off to the races. Housing prices, which usually advanced at annual rates in the low single digits, roared ahead at hefty double-digit clips. In markets where there were shortages of entry level and so-called "move-up" housing, bidding wars erupted [in many cases, the "asking price" was no longer the starting point for prospective buyers to negotiate the price downward. It became the starting point for pitched bidding battles among multiple prospective homebuyers, and sent home prices further skyward].

Consumers, banks, mortgage brokers and real estate brokers began looking at the U.S. housing market as the next Internet-type gold rush, and searched for ways to bring more potential buyers into the market. Lenders and real estate players turned to the so-called "subprime mortgage" - previously a little-used type of loan for marginal credit risks - as a mass-market tool to expand the pool of homebuyers.

The easy credit let scores of marginal buyers jump into the housing market, and that further inflated prices. Most of these loans offered low payments up front, followed by a floating interest rate that changed when market rates shifted.

But when interest rates started to escalate, the "reset" provisions of the loans kicked in and borrowers were unable to make the higher payments. That, in turn, led to defaults and foreclosure rates that hit record levels. And that induced lenders to put a big stopper in the money spigot.

The upshot: Home sales plummeted and price deflation set in.

Investors should know that there were also some factors besides cheap interest rates and easy credit that spurred the housing boom and subsequent bust. It was the nature of all the "exotic" - and ultimately risky - financial engineering that took place behind the scenes to free up a lot of the capital that fed into the lending boom. Known as "pay-option adjustable rate loans," or "negative-amortization loans," they are also the dirty little secret behind the bust.

These tricky lending schemes lured in subprime borrowers with very low rates at the start.  But the money that the borrowers supposedly "save" upfront gets tacked onto the back end of the loan. The less paid at the start, the faster the extra costs get piled on the back. When the costs swell too high, the loan "resets" - with a new payment as much as twice what was paid in the beginning.

Many of these subprime loans were actually home refinancings - "re-fies" in the parlance of the mortgage business - that enabled homeowners to treat the equity in their houses like a perpetual ATM machine. As long as their home's value kept climbing, they were okay. Borrowers could use the cash to buy SUVs, flat screen TVs and swimming pools - and even to buy stocks - really exacerbating their ultimate plight when they bought those stocks on margin.

During the past three years to five years, hundreds of thousands of first-time buyers and home-equity borrowers jumped into these risky loans. As much as $390 billion in pay-option mortgages were initiated in 2004 and 2005, alone.

Many of these started to reset in 2006, just as the housing market peaked and started to reverse course.  Over $100 billion more of these loans were written in 2006, which means they will reset this year, causing further pain.

No wonder George McCarthy, a Ford Foundation economist, calls the option ARM "a neutron bomb. It's going to kill all the people but leave the houses standing."

No Jobs - No Money

The housing bust has huge implications for the entire U.S. economy. Consumers got used to drawing down on their rising home equities to fund spending.  According to the U.S. Bureau of Labor Standards, consumer spending accounts for about 60% of the country's $13.2 trillion economy.

The subprime-mortgage crisis has resulted in far more damage than usual to consumer cash flows. The American Bankers Association recently reported that delinquency rates on consumer loans increased at their highest rate since 2001.

Other dark economic clouds are forming.  Recent government reports paint a dismal picture of the U.S. jobs market, hinting strongly at weaker job growth and longer unemployment lines. When businesses stop creating jobs, the economy begins to stagger toward recession.  And there are real doubts that the all-important U.S. consumer can come to the rescue this time around. Those reports - and the doubts the statistics raised - have fed into the stock swoon U.S. investors have had to endure so far this year.

If anything, this gloomy outlook underscores the need to diversify beyond U.S. borders, capitalizing on the growth opportunities opening up elsewhere across the world. As Money Morning Investment Director Keith Fitz-Gerald repeatedly says: "Go global or go home."

The Bush Administration's housing bailout plan could make a difference in the recovery timetable - although that's far from a universal viewpoint.  Allowing subprime borrowers to refinance with FHA loans will save some homes from foreclosure.  And the agreement by mortgage-servicing firms to allow certain borrowers to "freeze" their interest rate at the low initial rate for five years will at least delay some ARM defaults.

But the bailout is no panacea for what ails the housing market.  It will serve to insulate the market from free-market forces.  And that could actually delay the recovery by allowing the "subprime sludge" to remain part of the U.S. economic system for a longer period of time. That could actually exacerbate the subprime-mortgage mess over the long haul.

The Way to Play Housing's Rebound

In short, the U.S housing market will take at least until 2009 to purge itself of all the bad loans now in place. After that, it could take several years of slow healing before the patient can be declared fully recovered.

Still, if you feel that the bottom is near - or you're a Contrarian at heart and have both patience and a reasonably long investment time horizon - you might want to start sampling currently depressed homebuilder stocks. History shows Horton (DHI) and Beazer Homes USA Inc. (BZH) are two stocks that tend to jump out early and begin their recovery in advance of any turnaround in the U.S. housing market.

Again, viewing the industry as a long-term recovery play, consider a look at Plum Creek Timber Co. Inc. (PCL), the largest timber owner in the world. Plum Creek has rock solid financials, and top-flight management. And it has the added potential of possibly also benefiting from the soaring worldwide demand for commodities, which will likely send lumber prices to much-higher levels in the decade ahead.

If you are a higher-net-worth investor, Forbes magazine recently identified a number of pension and hedge funds looking to "bottom-fish" the market.  Dalton Investments, a Los Angeles hedge fund, is raising as much $1 billion from wealthy individuals and institutions to buy delinquent mortgages in such troubled markets as Phoenix, Las Vegas and Southern California.  They figure they can pick up distressed loans for as little as 50 cents on the dollar.

"A lot of defaulted mortgages need to be restructured, but this is a classic distressed investing opportunity," says CEO Steven Persky. "This market will be cleared by investors restructuring distressed assets, not by government unilaterally changing credit terms."

Altogether, private equity firms raised over $23 billion in the first eight months of 2007, with all that money strictly focused on investing in distressed properties.

No one knows for sure when the housing market will bottom out.  But whether private or government solutions appeal to you, look for any workout to take some time.

Editor's Note: Money Morning's "Outlook 2008" series last covered The U.S. Dollar. Next up: The Takeover Market.

News and Related Story Links:

  • Money Morning News Analysis:
    Housing Plan no Panacea for What Ails the U.S. Housing Sector