Assessing Housing Risks

December 02, 2009 By Richard Berner New York Despite recent improvements in housing demand, construction and home prices, housing risks are turning negative immediately ahead. A ‘payback' from the end of the first-time homebuyer tax credit likely will be the main catalyst, and additional negatives involve the interplay among less-favorable demographics, looming foreclosures and rising joblessness. Yet we strongly believe that renewed housing recovery is coming, courtesy of improved affordability, some easing in credit availability, a renewed tax credit and a return to positive employment gains. The upshot: Weakness in demand, activity and prices is likely through year-end, but we still expect modest improvement in 2010 and beyond: A 10% rise in demand and housing activity is still the most likely outcome next year. Improvement in many housing metrics. There is no mistaking the improvement in many housing metrics from their trough, at least through October. Sales of new and existing one-family homes jumped by 24.6% and 27.8%, respectively, in the six months ended in October, reflecting some of the positive factors mentioned above. Although one-family housing starts tumbled in October compared with September, they have risen 33% from their February lows. Inventories of new and existing homes have plunged dramatically, promoting a better balance between supply and demand. New home inventories stand at 239,000, the lowest since 1971 in absolute terms. Inventories of existing homes, at 3 million, are well below their peak of 3.8 million in late 2007, although still near the previous peak last seen in 1985. And home prices are either flat or up, depending on the measure used: Over the past six months, the FHFA purchase-only home price index has been flat, while the Case-Shiller S&P home price index is up 2.5%. That compares with declines of 11% and 32% over the previous two and three years, respectively. Payback coming, plus barriers to activity. Yet those improvements must be set in perspective for two reasons: First, the first-time homebuyer tax credit boosted new and existing sales through October, and a payback is coming. Second, three hurdles still linger for housing: The overhang of inventories of existing homes on the market and a ‘shadow inventory' of yet-to-be foreclosed homes likely will continue to depress new home sales and housing activity for some time to come; demographics are still unfavorable; and rising joblessness is a barrier to qualifying for a mortgage. Gauging the payback. To gauge the coming payback in sales of existing and new homes, we must calibrate the impact of the first-time homebuyer tax credit on demand. That is difficult, because the US$8,000 maximum tax credit incentive represented only about 5% of the price of homes typically purchased by first-time homebuyers and because there is scant basis for comparison - there is only one example of a similar credit (in 1975, and that was for new homes only). This time around, lawmakers enacted two credits for first-time homebuyers. A US$7,500 credit launched in July 2008 was really an interest-free loan. Then, in February 2009, Congress replaced it with a true credit running up to US$8,000 for low-income buyers who had not owned a residence in the last three years, expiring on December 1, for both new and existing properties. The just-expiring credit stimulated demand, but it is unclear by how much. According to the National Association of Realtors (NAR), about 350,000 of the 1.8-2.0 million buyers who will claim the credit this year would not have purchased a home without it. But it is uncertain how much of that was genuine additional demand and how much was simply brought forward. Traditional measures of affordability have soared, courtesy of the plunge in home prices and in mortgage rates. But with lenders demanding bigger down payments, and with the credit not available until the deal is closed, down payments and credit availability remain hurdles for many buyers, especially first-time ones. The 1975 homebuyer credit represents the sole historical parallel and may shed light on the potential payback this time. That earlier incentive, which was aimed only at new homes, initially boosted sales and then triggered a second surge as the expiration date neared. Fueled by lower mortgage rates, pent-up demand and the credit, new home sales jumped by 63% over 1975, but declined by 16% over several months in 1976 after the credit expired. That moderate ‘payback' may foreshadow today's experience, and we assume both home sales and single-family housing starts will soften a bit in the next few months (into early next year) and rise moderately thereafter. Indeed, the sharp decline in mortgage applications underway since early October already hints that the payback is coming. Yet, as discussed in more detail below, a new credit that extends through April 30, 2010 likely will limit the weakness. Three hurdles for housing. No catalogue of housing risks would be complete without acknowledging three other headwinds. The recession has slowed household formation, looming foreclosures will dump more inventory on the market, and rising joblessness will deter lenders and buyers. Moreover, homebuilders are struggling to compete with distressed property sales, and financing to start construction is still hard to come by. Less favorable short-run demographics. Demographic trends are critical for assessing long-term housing demand, but short-term changes in demographic fundamentals that are influenced by the business cycle also matter. In the current downturn, both slowing household formation and declining interstate labor mobility have been housing headwinds. The latest Census Bureau report showed that new households grew by only 398,000 between March 2008 and March 2009, compared with increases of 772,000 and 1.6 million in the two previous years. Data are incomplete for March 2009, but it appears that the growth in prime-age households (25-54) slowed even more significantly. That's a time-honored cyclical pattern; many couples postpone marriage and having children in recession, and this time is no different. What is different is the depth of the contraction in payrolls that has affected a broader swath of the population. Thus, the annual demographic increment to housing demand has slowed to perhaps 250,000, even assuming a pick-up in household formation and a 65% home ownership rate. In a related development, the percentage of grown children moving back in with their parents has also escalated according to data from the Pew Research Center. The authors note that, "Overall, the proportion of adults ages 18 to 29 who live alone declined from 7.9% in 2007 to 7.3% in 2009. Similar drops in the proportion of young people who live by themselves occurred during or immediately after the recessions of 1982 and 2001." In addition, the interplay between housing woes and labor mobility has created frictions in the labor markets: Without a new job, workers wanting to move are unable to do so, depressing housing turnover; conversely, the inability to sell one's home has limited labor mobility and thus the capacity of workers to move to take a new job in another venue. The ‘shadow inventory': How big? Fully 4.47% of all loans were in the foreclosure process and 9.64% were delinquent at the end of 3Q09, up 150bp and 265bp, respectively, from a year ago according to the Mortgage Bankers' Association; both are records. With about 55 million mortgages outstanding, some analysts estimate that the ‘shadow inventory' of yet-to-be foreclosed homes will rise to more than 13% of that total, or 7 million mortgages. A key trigger for foreclosure is when home owners are in a negative equity position; that is, when the amount they owe exceeds the value of the home. According to First American CoreLogic, 23% of all mortgagees are underwater. Such a surge in foreclosures, even if spread out over a couple of years (as seems likely in any case), would reverse the improved supply-demand balance seen over the past year, put renewed downward pressure on home prices, further discourage housing lenders from offering attractive loans, and pressure household wealth. Several related factors could reduce the coming rise in foreclosures. First, lenders may be increasingly willing to modify outstanding mortgages by writing down the outstanding mortgage amounts to eliminate negative equity; previous efforts to modify the terms of mortgages by lowering rates or forbearing did not help many lenders or borrowers, because redefault rates ran between 50-60%. Second, lenders may also be more willing to accept short sales (in which they eliminate the sellers' negative equity to allow a sale to occur). Third, the Administration is promising to increase resources to enable eligible borrowers who have undergone trial modifications under the Home Affordable Modification Program (HAMP) to convert to permanent modifications. If successful, these developments could limit price declines by holding otherwise foreclosed homes off the market or taking them out of the supply chain completely. So far, however, delays over documentation and other snafus have held up the modification process, so progress may be slow in coming. Are there upside risks for housing? In our view, improved affordability, a better balance between supply and demand, some easing in credit availability, a renewed tax credit, and a pick-up in job and income growth are all likely to offset these housing headwinds and promote a modest recovery. The improvement in affordability lately has been the result of lower interest rates, but subdued home prices have also helped. Current coupon MBS yields have recently plunged to the lows seen in the spring, or 3.9%. With 30-year conventional mortgage rates already at a record-low 4.78%, and further declines likely, housing affordability is soaring. The 2.5% recovery in home prices over the past six months only represents a tiny offset to that improvement. Further, although supply still exceeds demand, the balance is improving. The rebound in new home sales and the plunge to record lows in September housing completions has rapidly normalized inventories of newly constructed homes. As mentioned, new home inventories fell by 4% in October to 239,000 units, a 38-year low. At current sales rates, supply fell to 6.7 months' supply, close to the six months generally thought to represent balance. We may see a bit of renewed upside in months' supply if there is a temporary pullback in sales, but it now seems likely that inventories of newly constructed homes (although not the total, which includes the ‘shadow inventory') will be back to balanced levels by early next year. Credit availability is also easing somewhat. The proportion of banks reporting that they tightened mortgage lending standards in the Fed's October Senior Loan Officer Survey dropped to 26%, down from 77% a year ago. While lending standards are still tight, it is the change in standards that matters for growth (see Calibrating the Credit Crunch, November 20, 2009). Extending the credit. In addition, the payback from the expiration of the first-time homebuyer tax credit may be short-lived because new relief is on the way. Earlier this month, Congress passed new legislation that extends the credit for first-time buyers and expands it to cover current home owners purchasing a new or existing home (up to a maximum credit of US$6,500) between November 7, 2009 and April 30, 2010 (the purchaser will have until July 1, 2010 to close). Current home owners must have used the home being sold or vacated as a principal residence for five consecutive years within the last eight. Married couples with incomes up to US$225,000 are eligible for the maximum credit, higher than the US$175,000 under the credit expiring this week. Finally, improving job and income growth are critical for any lasting improvement in housing demand. On that score, there is already some good news. High-frequency labor market indicators, such as initial and continued claims for unemployment insurance, point to some improvement in the immediate future. And the just-reported US$82 billion (1.3%) upward revision to 2Q wage and salary income likely foreshadows more cyclical improvement for both pay and payrolls. The upshot is that despite significant headwinds and near-term payback from the expiration of the first-time homebuyer tax credit, we think powerful offsetting factors will help housing mount a modest recovery into 2010 and beyond.