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Wednesday, June 28, 2006

RE: A Failure To Engage With Reality

This should actually be meat for the blogging shrinks. Why are so many economists refusing to admit what is so obviously happening in the housing market? Why is Congress unable and unwilling to deal with fiscal reality?

Let's start with NAR by reviewing the Lereah writeups for its Pending Home Sales Index. The next release is slated for July 6th and will contain June data:
February, 2006:
Pending Home Sales Down, But Expectations Up
Pending home sales continue to decline but are expected to recover in the months ahead. The Pending Home Sales Index, based on contracts signed in December, was down 3.0 percent to 116.4 in November, and is 5.5 percent below December 2004. David Lereah, NAR’s chief economist, attributed the decline to a delayed effect of mortgage interest rates that peaked in November. With the recent upswing in mortgage applications pending home sales are poised to rise in the next couple months, he said.
March, 2006:
Decline in Pending Home Sales Slowing
The slide in pending home sales is leveling out, an indication of more sustainable sales activity in the months ahead. The Pending Home Sales Index, based on contracts signed in January, slipped 1.1 percent to 116.3. This is 4.8 percent below January 2005. David Lereah, NAR’s chief economist, says: “We are at a much more sustainable level of home sales now – a welcome cooling from the super-heated conditions that were driving exceptional price gains. This will give people the time to be more thoughtful about a process that is the biggest single investment most of us make in our lifetime.”
April, 2006:
Pending Home Sales Leveling Out, Market Balancing
Pending home sales are showing signs of leveling out, indicating that the housing market is stabilizing. The Pending Home Sales Index, based on contracts signed in February, slipped 0.8 percent to 117.7 and is 5.2 percent below February 2005. David Lereah, NAR’s chief economist, said most of the cooling in the housing market has already occurred, and a historically strong market can be expected moving forward.
May, 2006:
Pending Home Sales Ease
NAR's Pending Home Sales Index eased again in March as interest rates continued to rise. The March index dropped to 116.2 -- down from 117.6 in February. This means a modest slowing can be expected in home sales in the months ahead, although the market will hold at historically strong levels, according to NAR Chief Economist David Lereah.
June, 2006:
Pending Home Sales Index Slides
Pending home sales, the leading indicator for the housing sector, are continuing to ease. The Pending Home Sales Index, based on contracts signed in April, fell 3.7 percent to a level of 111.8 from an index of 116.1 in March, and is 11.7 percent below April 2005. This marks the third consecutive monthly decline. David Lereah, NAR’s chief economist, explains: "We’re in a period of transition. Pending homes sales probably give us the best measure for the overall direction of the housing market, which is falling from historical highs,” he said. “Home sales will level out toward the end of the year. Over time, homeownership remains the best investment a family can make.”
In other words, don't expect to make a profit in the short term, because most buyers won't. He's right about this being a period of transition; these figures are worse than they seem. As of the latest stats, we have a 6.5 month overall supply. In some markets it is more like 10-12, and in a few abysmal markets, condos and townhouses on the market will take 3 to 5 years to absorb at current sales rates. Some first-time home buyers will not get mortgages because, in an evironment of falling RE prices, the appraisals will not justify the amount of credit the borrower is requesting. Furthermore, conditional clauses in sales contracts are coming back into vogue as the number of prospective buyers competing for a home plummets. In many cases, contracts now include the provision that the buyer is able to sell his or her home, and under current conditions, this means that many of these sales will not go through.

NAHB provides excellent summaries of housing stats in spreadsheet format. The census bureau's report on new single-family (house and land, scroll down to the end) reports a raw 8.95 month supply at the current sales rate. For a state and MSA breakdown of building permits, which is a long leading indicator, go here. This will give you some sense of the generalized slump in the housing market. There are a few hot markets, such as Texas, which reports an overall 15% increase. But there are many regions reporting 20-30% drops in building permits.

For those who have been captured in RE sales offices lately or read the NY Times consistently, let me offer this gentle hint: A drop in building permits generally translates into an equivalent drop in employment/housing supply revenue. Thus, when San-Diego, Carlsbad reports a 44% drop in building permits, it is safe to assume that local employment and building supply sales will, in the future, suffer a similar drop. This is a pretty broad-based trend; the states reporting a no-growth or negative growth rate in building permits are:
Connecticut, -6%
Maine, -8%
New Hampshire, -22%
Vermont, -7%
New Jersey, -9%
New York, 0%
Indiana, -12%
Michigan, -30%
Ohio, -13%
Wisconsin, -9%
Iowa, -19%
Minnesota, -12%
Missouri, -7%
Nebraska, -16%
North Dakota, -35%
Delaware, -10%
Florida, -6% (but local areas show large drops over 20%)
Maryland, -18%
Virginia, -5%
Alabama, -8%
Kentucky, -30%
Arkansaw, 0%
Arizona, -9%
Colorado, -1%
Idaho, -2%
Montana, -1%
Utah, -5%
Wyoming, -6%
California, -10%
Hawaii, -21%
Oregon, -4%
Washington, -1%

To give an example of what this means for the suppliers, let's look at what happened to Darling Rinker's (concrete, primarily) share prices. The stock was targeted at a price of $25.00. Analysts just lowered its target to $17.55, and the stock closed at $16.80 yesterday. Profits remain strong, but analysts are looking at leading indicators and expressing severe doubt that sales can continue to increase, as well as the shrewd suspicion that lowered sales mean lowered profit margins on remaining sales.

Here I want to point out the obvious: building, upgrading and repairing housing is a capital-intensive business. Banks have huge concentrations of lending to these businesses, both for land purchases and for building supply purchases. In some cases, banks will lose their capital as land prices fall and cash flow to builders suffers. The resulting contraction in credit will be significant, and will be exaggerated by the number of borrowers who will owe more than their home is worth, and who cannot continue paying on their mortgages due to resets. Through 2007, the mortgages resetting are at least 1.5 trillion dollars, and many of those are recent purchases with little or no real equity in their homes. It is true that housing prices have overall increased greatly within the last few years - but it is also true that loans on housing equity increased monumentally, leaving relatively little spare equity overall. Banks will take significant losses on their 20% loans to purchasers and their home equity loans and lines of credit in many hot areas.

Bloomberg takes a look at the current housing sales environment:
Many sellers are finding they must cut their initial asking prices by 10 percent or more to entice buyers, according to brokers.
The average U.S. rate for a 30-year fixed mortgage was 6.62 percent. Adjustable-mortgage rates have climbed by more than 2 percentage points to 5.7 percent, removing from the market most investors who plan to ``flip'' properties and first-time buyers who are stretching to qualify for a loan, says David Berson, chief economist at Washington-based Fannie Mae, the largest U.S. mortgage buyer.
Investors who buy homes to resell at a profit are rushing out of the market, putting more pressure on prices, Berson says. Such investors bought a record 2.34 million homes last year, according to data from the realtors group. Excluding investments, home sales rose 0.9 percent to 5.99 million last year.
This is not a stable market, because at least a million of those investor purchases were bought under terms that will not allow investors to hold them long-term. It's notable that the current drop in prices has produced a strong sales environment for buyers who are seeking a principal residence. In May, the annualized sales rate was greater than last year's - 6.67 million. The reason inventories are rising and prices are falling is purely that the investors have largely exited or are trying to exit the market.

We are now seeing the first predictions of a housing-related recession in 2007 from US sources, but many economists still insist it isn't going to happen:
The U.S. housing market is now tracing a clearly downward trajectory that economists say will steepen as interest rates rise, raising chances of a recession by early 2007.

The key will be the extent to which the slowdown in sales activity translates to a decline in selling prices, eating away the cushion of home wealth and spending power that U.S. consumers have accumulated in recent years.

Merrill Lynch economists say there is now about a 40 percent chance of a recession in the first half of 2007 -- even without a widely anticipated 25 basis-point Federal Reserve rate hike this week.
The Reuters article linked and quoted here is worth a read, but the second paragraph basically outlined the situation. There is not really an accumulation of overall equity; it has been tapped already by those who are willing to tap it. The decline in sales prices is already occurring, and is hardly going to stop given the fundamentals - falling median US incomes, widespread speculative buying, building projects based on speculative demand, not owner-occupied demand, more units coming on the market from both builders trying to improve cash flow and investors trying to bail, and the certainty of additional forced sales and tightening credit standards within six months. These are self-reinforcing trends.

One thing that relatively few people realize is that a great deal of speculative buying was done by people whose jobs are based on the housing market. Real estate brokers, mortgage brokers, construction workers and contractors all tended to buy housing on spec and on margin, and now both their jobs and their purchases are endangered. This will translate into significant losses for banks and real estate investment trusts.

The question is not whether there will be a recession beginning in 2007. The question is how severe the recession will be and how long it will last. There are things the US would be able to do to shorten the severity and duration of the recession, such as opening up oil fields (especially the sand fields) and moving quickly to construct nuclear plants. Expanding the SBA program would be an excellent move at this time.

Unfortunately these steps would require action by Congress, which is getting bad economic information and is barely able to pour piss out of a boot if the instructions are written on the heel. These are people who are still unable to grasp the reality that Medicare is cash-flow negative now, and that Social Security will be cash-flow negative within a decade. Since we have been using surplus revenues from these taxes for general spending, the net affect is to greatly increase the required level of income and excise taxation required to fund entitlements and governmental operations. It's a double fiscal hit amounting to at least 300 billion a year by 2020.

Thus any stimulative measures cannot come either in the form of tax cuts or any investment programs that will not generate a real return, or such programs will generate further imbalances in the economy and make the economy worse instead of better. Subsidizing ethanol is not precisely the most brilliant way to spend our patrimony under the circumstances; neither are amnesty programs and additional entitlement commitments when many of the jobs the illegals are doing now are going to disappear in the next year and a half.

if and when the fed lowers rate, this trend ends.

there is no risk they will let a full blown recession occur.

home markets in some of the areas you cite arer already improving again.

the sky is not falling.

the earth is not warming because of man-made greenhouse gases.

we are not stuck in a quagmire in iraq nor are we losing.

and this is not a housing bubble about to burst.

and the bird flu pandemic is still a year to 1.5 years away.
Interesting. I just sold some Rinker ADRs...although they were considerably below the peak, they were still more than 2X what I paid for them in early 2004--which indicates how much the market had overcorrected on the low side in valuing companies of this type at that point in time.

Reliapundit--I don't think the fed can control this trend by lowering rates. Lowering short rates precipitously would send a message that inflation may well be allowed to get out of control, and the bond market would respond to this perception by increasing yields on the longer bonds, which are more tied to the morgtage rate.
Reliapundit, mortgage rates are not producing this trend. Buyer exhaustion is, and most specifically speculative exhaustion.

David is correct about mortgage rates being related to future expectations of inflation rather than the Fed's manipulation of short-term rates. The other factor involved is risk - it will in the future be far harder and more expensive to finance 100% mortgages in an environment with falling prices. What fueled the explosive growth in the neg-am, interest-only and 100% financing mortgages was the belief of the lenders that their capital was secured by rapidly inflating RE prices.

That is unequivocally over in most of the country, and every lender knows it. Do you want to know what mortgage programs are in demand now? SBA loans, FHA loans and VA loans.

Consider the fallacy in your statement that the fed funds raises are driving the situation. Mortgage rates rose significantly only AFTER the market had begun to fall significantly - the peak was last summer to September. Furthermore, the fall in prices has generated a growth in non-speculative home purchases compared to last year because prices are falling more than rates are increasing.

However this will only last a few more months, because many of those who were qualified buyers are being drawn into the market now. By September, this pool of buyers-in-the-wings will have been largely exhausted. In late spring and summer of 2007 the Bilgemans will come into play in the inflated areas, and they will only start buying at 25-30% decreases. The Robert Cotes (professional investors) will wait until 2008-2010. They have cleared the market and are getting good returns on parked money, so they will not move back until things have clearly shaken out.

As to bird flu, with every month that passes the liklihood of a human pandemic grows less. With this wide a distribution of H5N1, the chances that it will recombine and/or assert in a milder form grow. But no one can tell what WILL happen - it is a roll of the dice. What appears to be an H5N1/H3 reassortment has already been found in pigs in the US, so the mixing bowl process is well under way.
David, regarding Rinker, I think that the up/down nature of the pricing was produced by earlier expectations that the building trend wouldn't last as long as it did. It is weird how the building/building supply stocks often peak right before the market crumples.
1) Why is Michigan taking a dive bomb? Are people moving out in droves?

2) Where is Texas in all this? Our area seems pretty stable but we've had steady value increase no huge gains.
Most areas in Texas are doing well. They have relatively high employment and relatively low housing values.

The slumps we are seeing in a very good economy are affordability ceilings in the erstwhile hot areas.

Michigan is hurting because of unemployment. The auto industry, for one thing, continues to slump.
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