One of our favourite economists, Gary Shilling of A. Gary Shilling & Co., has given us permission to publish the following excerpt from his latest monthly report.Gary is also offering a special discount on his research service for Business Insider readers. To learn more, please visit Gary’s web site or call 1-888-346-7444. Please mention Business Insider.
Housing: Great Expectations vs. Reality
Last spring, many believed that not only was the housing collapse over but that a robust rebound was underway. Investors were crowding into foreclosed house sales and bidding up prices in California, often the bellwether state for new trends. The tax credit of up to $8,000 for new homebuyers that expired in April spurred buyers and promised to kick-start housing activity nationwide. TheHomeAffordable Modification Program was trumpeted by the Administration to help 3 million to 4 million homeowners with underwater mortgages by paying lenders to reduce monthly payments to manageable size and then paying homeowners to continue to make those payments.
But then a funny—or not so funny—thing happened on the way to housing recovery…
With low mortgage rates and collapsed house prices, the National Association of Realtors' Housing Affordability Index had leaped to all-time highs.
It's also become clear that the NAR's Housing Affordability Index in the earlier post-World War II years is not relevant to today's conditions. Back then, unemployment rates were usually much lower than now (Chart 7, page 4) and the current threats of layoffs, wage and benefit cuts and being forced into part-time jobs were almost nonexistent. Who ventures into homeownership if he doesn't know the size of his next paycheck or even if he'll have one?
Also, with almost a quarter of all homeowners with mortgages under water with their mortgage principals exceeding the value of their houses, many can't sell their existing abodes even if they wanted to buy other houses.
About 60% of all borrowers with 30-year fixed-rate mortgages could lower their interest costs by one percentage point at current rates. But only 38% could actually refinance due to tighter lending standards.
Nevertheless, lower mortgage rates have encouraged many whose mortgages aren't under water to refinance them. Some are even paying down their mortgages to bring them above water so they can refinance at lowerinterest rates. Mortgage applications to refinance have jumped lately, but remain well below the levels of early 2009.
Closing fees in refinancings, however, are an important offset to the reduction in mortgage rates. Closing costs in July were 37% higher on average nationwide than last year's $2,739.
And don't forget that we now have MUCH TIGHTER lending requirements -- so much so that Fannie and Freddie and FHA now have to underwrite almost all mortgages
At the same time, the house price collapse and subprime mortgage meltdown has led to a drastic tightening in lending requirements. In contrast to the no-document loose-lending practices of yesteryear, just listen to what it takes today to qualify for a mortgage. You'll need a job and at least two recent paystubs, two years of W-2 forms, proof of other assets you own and your tax returns.
Then there is the property appraisal, which has morphed from ultra-liberal to excruciatingly conservative. So the appraisal may be well below your purchase price, especially in markets with falling prices, so you'll have to come up with more cash for the downpayment or convince the seller to cut his price.
Downpayments have also leaped from the zero or even negative levels of the housing salad days, and Federal Housing Administration-insured loans as low as 3.5% require up-front mortgage insurance payments of 2.25%. Your alternative is essentially a loan insured by Fannie Mae or Freddie Mac since the Government-Sponsored Enterprises account for almost all new mortgages today (see chart above).
Mortgages with downpayments under 20% require mortgage insurance and mortgage insurers insist on FICO credit scores of at least 680 out of 850 and charge $300 to $1,000 per year for every $100,000 borrowed. Estimates are that almost a third of Americans can't qualify for a mortgage because of low credit scores.
The Administration's HAMP initiative, introduced in April 2009, has been a huge disappointment...
But while mortgage modifications were attempted, lenders and servicers were basically forced by the government to suspend foreclosures. Now, as that program unwinds, foreclosures will again jump (Chart 12). Ironically, foreclosure rates have moderated recently because lenders tightened their standards in mid-2008 when housing and mortgages were in free fall. In 2009, two-thirds of all FHA- guaranteed new loans were to borrowers with credit scores over 660, up from 45% in 2008.
Nevertheless, lenders have been loosening in recent months. In January, Fannie initiated a program that allows first-time homebuyers to put down $1,000 or 1% of the purchase price, whichever is greater. In the first half of this year, credit card companies sent out 84.8 million offers to American subprime borrowers, up from 43.7 million a year earlier. In the second quarter of this year, 8% of new car oans were to borrowers with the lowest rank of credit scores, up from 6.2% in the fourth quarter of 2009.
Nevertheless, look for delinquencies (Chart 13) and foreclosures to spike in the slow economic growth, high unemployment quarters that probably lie ahead.
Already, Real Estate Owned by lenders due to foreclosures--perhaps the most hated term among bankers--is climbing (Chart 14). Estimatesare that a major share of the 7 million houses that have delinquent mortgages or are in some stage of foreclosure, as well as those yet to come, will be dumped on the market, adding to the already huge excessive inventory glut. Some 4.5 million loans are now in foreclosure or at least 90 days delinquent.
Mortgage delinquencies are linked to job losses... and the number of weekly unemployment claims is still too high
Mortgages delinquent 30 days, many of which will probably end in foreclosure, have risen lately. They peaked in the first quarter of 2009 at 3.77%, then fell to 3.31% at the end of 2009, but have since risen to 3.51%, according to Tom Lawler.
He goes on to observe that 30-day delinquencies are linked to initial claims for unemployment insurance, which fell last year but subsequently leveled off and are now rising (Chart 15). Also, the delinquencies are rising as weak borrowers with modified loans again miss payments. Fitch Rating believes that 65% to 75% of mortgages modified under HAMP will redefault within 12 months.
Indeed, bank-owned houses for sale jumped 12% in August from July when newly-initiated foreclosures jumped 25% to a six- year high.
Unlike most homeowners, banks tend to slash prices to unload REO quickly. As a result, average prices fell rapidly in 2008 when lenders sold foreclosed houses at low prices, as noted earlier. By January 2009, the share of distressed sales leaped to 45% of the national total (Chart 16). With the default moratorium on foreclosures due to HAMP, the distressed share has fallen on balance more recently, coinciding with the flattening in prices. But now with HAMP unwinding, foreclosures will probably leap, REO sales at low prices jump, and average prices resume their slide.
The homeownership rate (per cent of households that are homeowners) continues to decline, probably headling back to its long-term average
Back in the salad days of 10% annual price appreciation, a homeowner and/or investor who put down 5% enjoyed a wonderful 200%returnonhisinvestmentper year, neglecting taxes, interest and maintenance. But that hapless homeowner who bought at the peak lost all of his downpayment six times over as prices fell 30%.
No wonder that the homeowner rate, which spurted from its 64% norm to 69%, is now back to 66.9% in the second quarter and probably on its way back to 64% (Chart 18).
The converse of the ownership rate is the rental rate, which obviously fell from 36% to 31% and is now back up to 33.1%. We'll explore the newfound zeal to rent vs. own later.
Meanwhile, we'll consider another important component of the equation, household formation. Many believe that household formation and, therefore, demand for either owned or rented housing units is closely linked to population growth. A Beazer Homes official said recently that demographics would normally produce household growth of around 1.5 million a year.
But note that those trendless series are extremely volatile, ranging from a peak of almost 2.3 million at annual rates in the current cycle to less than 500,000 recently. Household formation is similarly volatile (Chart 19), not surprising since a household is defined as one or more people living in a separate dwelling unit and not in jail, college, an institution or an army barracks. So household formation is affected bythelustforhouseappreciation, income growth, employment prospects, family size, mortgage availability and all the other factors that determine the desirability of owning or renting.
With the negative zeal for homeownership of late and weak incomes and high unemployment deterring renting, household formation has been weak.
No wonder that the vacancy rate for single- and multi-familyhousingunitsremains high (Chart 21). Of course,
The number of houses for sale is still abnormally high... and house prices, like everything else, are a function of supply and demand
This huge and growing surplus inventory of houses will probably depress prices considerably from here, perhaps another 20% over the next several years. That would bring the total decline from the first quarter 2006 peak to 42%.
This may sound like a lot, but it would return single-family house prices, corrected for general inflation and also for the tendency of houses to increase in size over time, back to the flat trend that has held since 1890 ( Chart 26).
We are strong believers in reversions to the mean, especially when it has held for over a century and through so many huge changes in the economy in those years--two world wars and the 1930s Depression, the leap in government regulation and involvement in the economy, the economic transformation from an agricultural base to manufacturing and then to services, the post- World War II population shift from cities to suburbs, the western and southern transfer of population and economic strength, the movement from renting to homeownership and the accompanying spreading of mortgage financing, etc.
Furthermore, our forecast of another 20% fall in house prices may be conservative. Prices may well end up back on their long- term trendline (Chart 26), but fall below in the meanwhile. Just as they way overshot the trend on the way up, they may do so on the way down, as is often the case in cycles. Furthermore, another big house price decline will spike delinquencies and foreclosures leading to more REO sales by lenders,whichwillfurtherdepress prices. Our analysis indicates that a further 20% drop in prices will push the number of homeowners who are under water from 23% to 40%, resulting in more strategic defaults, more REO, etc.
At that point, the remaining home equity of those with mortgages would be wiped out on average (Chart 27. That, in turn, would impair already-depressed consumer confidence and their willingness and ability to spend, to say nothing of residential construction.
In California, epicentre ofthe housing boom-bust, construction jobs dropped 43% from June 2006 to June of this year, compared to a 28% decline nationwide, and the unemployment rate in the Golden State jumped to 12.3% in June, far above the 9.5% rate nationally.
It's not surprising that the confidence of those involved in residential real estate is low and declining. The NAR Realtor Confidence Index is again plunging (Chart 30). A neutral reading for this index is 50, and it's now 24.1. In June, 42% of realtors expected prices in their areas to fall in the next 12 months compared with 33% in May.
Fannie and Freddie are ending up owning more and more foreclosed houses (at taxpayer expense). This is prolonging the problem...
Fannie and Freddie are also allowing homeowners who face foreclosure and qualify for mortgage modification to stay in their houses for up to a year by renting them. The goals are to help those folks, keep the homes occupied to avoid deterioration, realise some positive cash flow and keep more houses off the market. The rents, at market rates, are often lower than their monthly mortgage payments. Still, these programs simply add to shadow house inventory, which will be revealed as those one-year leases mature and foreclosures are implemented.
Due to foreclosures, Fannie and Freddie owned 191,000 houses at the end of June, double the year- earlier total (Chart 33). And the inventory is growing as they take back houses faster than they sell them. Newly-initiatedforeclosures at Fannie and Freddie rose to 150,000inJuly,up60%fromApril, as borrowers failed to qualify for loan modifications. And they are encouraging the lenders of the mortgages they guarantee to seize foreclosed houses more rapidly to avoid them deteriorating or being trashed. Fannie took a $13 billion charge in the second quarter for cleaning pools, mowing lawns ad other carrying costs on the properties it owns.
As noted earlier, traffic through new homes by prospective buyers is again falling, according to home builders (Chart 37).
New mortgage applications for home purchases continue to drop (Chart 38).
And those planning to buy a home within six months persist in declining (Chart 39).
Depressed yet? We are, too. But at least, as a Business Insider reader, you'll get a discount on Gary Shilling's research...
The previous essay was excerpted from the latest monthly research of Gary Shilling of A. Gary Shilling & Co. Gary is offering a special discount on his research service for Business Insider readers. To learn more, please check out Gary's web site or call 1-888-346-7444. Please mention Business Insider.
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