NEW YORK, Aug. 5 (UPI) -- There's an old joke about a particular economic model that observers note has predicted five of the last three recessions. Prognosticators, including me, have a similar record on the U.S. housing market over the past few months.
All that was true up until July 21, when China altered its exchange rate policy, and Bottom Line wrote:
"Home-builders that have been engaged in aggressive lending -- 0 percent down; teaser interest rates; sales focused in California, Nevada, Florida -- are a screaming short for a number of fundamental reasons. (Among these are KB Home and Standard Pacific.) The yuan move, as seen in today's impact on the 10-year Treasury, simply adds fuel to the fire."
In the two weeks since that column, prices on both those stocks have declined by nearly 10 percent, a good trade.
There may be some bounce-back and short-covering in the coming days and weeks. But we like this position as a solid core investment over the coming 18 months, for two reasons.
1. Interest rates
The Fed has been raising interest rates now for 15 months. To the frustration of Fed Chairman Alan Greenspan, these increases have coincided with a continued surge in housing prices and activity.
Greenspan needn't regard this as a conundrum. As economist John Mueller has noted, when interest rates begin to rise, there's usually a surge in housing volume and prices for up to 12-18 months.
That's because potential homebuyers, and especially speculators flipping homes or adding second or third properties to their portfolio, rush to lock in at low rates before they move higher. Anyone with an e-mail address has been bombarded with notes urging them to "act now" while mortgages are at historic lows.
With rates on the 10-year north of 4.3 percent, and Greenspan likely to get Fed Funds up to 3.75 percent to 4 percent in the coming months, we appear to be reaching the peak.
As rates reach their top, the opposite dynamic will set in over a 2-3 year period. A top in sales volume and prices, even a modest decline for a few months, will cause would-be buyers to wait. "Prices are awfully high and seem to be heading down," they will observe. "And interest rates are falling. Might as well hold off, or at least, only put in a low-bid offer."
SRS Global recently studied housing market corrections in such markets as Britain and Australia in recent years, Hong Kong and Tokyo in the 1990s, and the United States in 1990-93. The conclusion: housing prices usually continue to surge at the start of the tightening cycle, begin to correct after 15-18 months, and then continue down for up to 2-3 years into the easing cycle.
2. Government policy
The above trends have been fueled synergistically in recent months by over-the-top aggressiveness by the lenders and homebuilders. The share of homes bought with no down payment -- zero money down -- has surged from below 20 percent two years ago to about 40 percent in recent months. Many of these loans were combined with teaser interest rates of 4-5 percent.
Those ARM loans, and the phase out of first-year rates, will, over the next year and a half, cause the monthly mortgage payment of many homeowners to rise by between 30 and 70 percent.
A knowledgeable insider tells me that Fannie Mae has winked at many loans made to buyers who (even at these rates) must commit up to 50 percent of their monthly income to make payments. Fannie Mae and the banks have also looked the other way at buyers who submit revised estimates of their monthly income in the mortgage cycle -- a tipoff, in many cases, that the buyer is trying to stretch into a more expensive home.
Policy-makers have been frustrated at the lack of a correction, but are concerned that if they do anything to prick the bubble, they will harm one of the few sources of income for consumers fueling U.S. growth.
"Nobody here wants to crash the housing market," a well-placed Treasury source comments.
Thus the Treasury Department, which is supposed to oversee Fannie Mae and Freddie Mac, has sat on its hands. The Fed, which regulates the banking system, could also act -- but hasn't. Both the Fed and Treasury, however, are in the process of drawing up policy tightening that could be put in place in the coming six weeks.
The net impact should be to put a ceiling on housing prices, and the stock prices of homebuilders and lenders. If the housing boom picks up for one last leg, regulators will be inclined to crack down on questionable practices. If inventory surges and prices decline even modestly, they may be forced to do so, or lenders may have to curb the excess on their own.
Either way, like generals fighting the last war, regulators and lenders will likely be behind the curve -- acting, but too late, and defensively. This was the pattern during the S & L crisis of the 1980s.
It was also the posture adopted by Greenspan and the Federal Reserve during the tech bubble, when then-New York Fed Chairman John Whitehead pleaded for a modest and prudent increase in margin requirements. (See Whithead's must-read account in his book, "A Life in Leadership.")
By next summer, there will be newspaper headlines and magazine covers, and congressional hearings, demanding to know why the Fed and Treasury allowed the bubble to grow so large -- and hence, made the correction so severe. Greenspan's successor may face proposals to split the Fed in two -- one arm to conduct monetary policy, another to regulate the banking system -- as the late George Champion, chairman of Chase Manhattan, wisely advocated for many years.
Bottom Line
LBMC's Mueller, one of the best economists in the world, forecasts a decline in housing sales to 1.5 million per month by next summer, from record levels of more than 2 million in recent months.
Prices may not decline and could even rise in the Midwest, but on the overbought East and West coast -- which are also, note, heavy users of energy, and have crazy-high property and income tax rates -- there should be a nice price correction of say 25 percent.
In the short term, markets, as George Soros have observed, seem to have a need for reflexivity. They "want" to go to excess. In the long run, of course, reflexivity works both ways. What's gone up too much is likely to come down too much. Patient investors will keep those puts on homebuilders and aggressive lenders in place, and in the event of a last-gasp recovery in the coming weeks, add to the position.
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(Gregory Fossedal, [email protected], is an adviser to international investors on global markets and ideo-political risk and a senior fellow at the Alexis de Tocqueville Institution. His clients may hold long and short positions in many of the investment securities and opportunities mentioned in his reports. Investors should perform their own due diligence and consult their own professional advisor before buying or selling any securities. Fossedal's opinions are entirely his own, and are not necessarily those of his clients, AdTI, or United Press International. Furthermore, they are subject to change without notice.)
