Why The Housing Crisis Will Get Worse Before It Gets Better

The housing market is at a fork in the road. While we don’t know if this is the bottom or the beginning of another downturn, either way we are sure to have volatility and this is where traders make their profit. 

I am going to lay out why I believe we could see things get worse before they get better and what stocks and ETFs might be impacted.  You can place your bets on these ETF’s and stocks based on whether you believe I am right or wrong. 

Just How Bad Is The Situation?

I finished my radio show the other day and while driving home, I caught Karl Case (Case Shiller) on Bloomberg Radio speaking about the housing crisis.  He was speaking about the number of people who are upside down on their mortgages and how that number is about 12 million people right now. There are millions of Americans currently in some stage of foreclosure. There were 2.9 million homes in 2010 that received a foreclosure filing. 

However, if there are 12 million who are upside-down on equity and only 2.9 million foreclosure filings in 2010, there are a lot of potential future foreclosures. In addition, the housing market is running out of steam due to higher interest rates and higher prices for staples like food, gas and clothing.

Higher interest rates and prices are reducing demand in many areas and causing pressure on sellers to lower prices.  I am in the Sacramento area and I recently sat down with a group of realtors who told me they have had to lower prices on many of their homes since interest rates began to march higher a few months ago.

Interest rates are still very low at around 4.75% to 5.0% for a 30-year fixed-rate mortgage but they were as low as 3.75% to 4.0% several months ago. There was more demand for refinancing and purchasing when rates were lower but much of that demand has dropped with an increase in rates.


Strategic Defaults Don’t Help

A strategic default occurs when someone decides strategically that walking away from their home makes more sense than staying. I have personally met many people who decided to stop making payments to try and force their mortgage company to do a loan modification. 

I have met many others who just walk-away strategically because they tell me they can rent the same home for half the payment they are currently making. They know they can walk away in many cases with no liability and within 3 years purchase another home with an FHA loan. A 2009 survey reported that 25% of all defaults were strategic. It is possible the number is higher today. 

While the housing crisis may have initially been started by a small percentage of people who were put into loans they truly did not understand, today the housing crisis is being perpetuated and made worse by many who are using the crisis to their advantage. Again, if we have only 2.9 million foreclosure filings in 2010 and 12 million upside-down, what happens if property values decline further, unemployment rises or commodity prices continue to rise? It has been reported that each time we lose a little more value the number of owners who have negative equity continues to rise and strategic foreclosures increase.

I realise I am painting a depressing picture if you are someone who owns a home and you believe like I do in the American Dream. My point here is that whether we want to believe it or not, we could see things get worse. I am a trader and where there is possible change and volatility, there is also opportunity.  Here are some stocks and ETF’s that could be impacted by any changes in housing. You can decide on how to play them, to the upside or the downside.


ETF’s To Watch In A Down Housing Market

XHB (S&P Homebuilders Index) – The XHB’s name is a little confusing, like many ETFs because it leads one to believe that it is a pure play on Homebuilders like KBH or TOL. In reality, only a few homebuilders (RYL and KBH) are in it’s top 10 holdings and they account for just 8.68% of the total assets of XHB.

This is a broad-based ETF that is weighted with names like Pier-1 Imports, Sherwin Williams and Armstrong World Industries, just to name a few. XHB holds 78% of it’s assets in the Industrial Materials and Consumer Services sector. These are names that do well when the housing market is on the rise but may come under pressure if the housing market continues to remain weak or double dip lower. XHB is within $2 of it’s 52-week high.

ITB (iShares Dow Jones US Home Construction) – ITB is more of a home builder and home construction play, with names like PulteGroup, D.R. Horton, TollBrothers, Home Depot, Lowe’s and KB Home accounting for nearly 45% of all assets. Nearly 73% of ITB is in the Industrial Materials sector. ITB has been in a trading range for the last 6 months between about $11.50 and $14.50. ITB is going to have a hard time rallying much higher if home sales and prices continue their decline.

KBE (SPDR KBW Bank) – KBE is a pure financial play with names like Citigroup, Chase, JPMorgan, Wells Fargo, Bank of America and even US Bancorp. The Financial sector makes up 100% of KBE and it holds over 99% stocks. The financial stocks have had a good run over the last few months and KBE has risen about 20% since the end of November, 2010. However, bank stocks are going to have to fire on all cylinders to do well at these levels.

With the market over 12,000 and KBE within a few dollars of it’s 52-week high, it may come under pressure. In addition, defaults and foreclosures are not showing any sign of going away anytime soon and this will continue to be a drag on many bank stocks if the real estate market declines.
SRS (Proshares Ultrashort Real Estate) – SRS is a 2x leveraged ETF designed to return 2x the inverse of the Dow Jones U.S. Real Estate Index.

If you look at the last 3 years, the leverage has all been to the downside! The chart over the last 2 years of SRS looks like an intermediate run at a ski resort. The SRS was trading near $300 per share at this time in 2009 and is now around $16. However, this is one of those leveraged ETFs that could see a sudden jump based on some really bad news in the area of real estate. I think I would be more likely to play SRS with a short if the real estate market drops and then begins to come back.

TBT (Proshares Ultrashort 20+ Year Treasury) – TBT is a 2x leveraged ETF designed to return 2x the inverse of the Barclays Capital 20+ Year U.S. Treasury Bond Index. I recently wrote a great article on using the TBT to hedge interest rate locks (previous article). The TBT is a great short-term play either up or down on interest rates. In the previous article, I explain how the TBT tracks the 10-Year Treasury over short periods of time and how it will rise when interest rates rise and drop when rates drop. Like many ETFs, it tends to under-perform over a long period of time, so it should ONLY be used for your short-term strategies.

A declining stock market and declining economic news tend to push the TBT lower. If the real estate market continues to soften, this is an ETF that could see it’s price fall. TBT has risen by almost 30% over the last 4 months as QE2 fuelled perceived strength and yields on treasuries jumped by nearly 100 basis points. The TBT will rise if interest rates rise, so it is a great short-term hedge if you believe rates are going higher.


Stocks to Watch

Wells Fargo (WFC) JPMorgan Chase and Co. (JPM) and Bank of America (BAC): Last week it was reported that the Treasury Department and the Department of Housing and Urban Development have a great idea. They think that banks like Wells Fargo, JPMorgan Chase & Co and Bank of America should pay out $20 Billion as a possible penalty for mishandling foreclosures. 

You may have heard of this under the more common name of “Robo-Signing.”  I believe that $20 Billion handed out will make our housing crisis worse. If you give a small percentage of the people who are upside-down a write-down on their mortgages, I can guarantee others will want the same treatment and they will be willing to stop making payments to get it. 

The other issue here is that $20 Billion spread out over say even 4 million is just $5,000. In California, most people who bought near the top are upside-down by $200,000 – $400,000. A $5,000 or even $10,000 write-down on your mortgage is just not enough to make a big difference in your decision to keep your home.  What if you get a $5,000 write down and then later foreclose anyway?

Home Depot (HD), Lowes (LOW), Toll Brothers (TOL), KB Home (KBH), Centex (CTX), Beazer (BZH): I know a lot of people who are very bullish on Home Depot and Lowes and I spend a lot of time myself in both stores. However, both are near a 52-week high and there is a huge restructuring of the American household right now and this eventually could be a negative for Home Depot, Lowes and home builders who have already been hit hard in the housing crisis.  The trend is in combining households and having more people living under one roof. While HD and LOW are great companies they are not immune to a double-dip in housing should it occur. 

The home builders may experience less demand going forward with more and more homes being combined, rising interest rates, rising consumer prices and tougher credit qualifying.  I believe that consumers are going to eventually slow their spending if we can’t get control of rising costs. In my area, gas prices have risen by 15% in the last 90 days and I have seen food prices rising significantly at my local grocery store.

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