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Friday, September 01, 2006

RE: Pending Home Sales For July

Pending Home Sales are released on the 1st of each month for two months ago, which means today we got Pending Home sales for July, 2006. Pending Home Sales are important because they capture the market conditions for the reported month far better than existing home sales, which reflect market conditions previous to the month being reported.

The June numbers were of course revised downward, but you have learned to expect that, haven't you? These continuous downward revisions reflect the numbers of cancellations and dropped contracts, and are a measure of the severe weakness in the market.

You can read NAR's Pending Homes Sales Index figures at this page, which links to the release (pdf) and the news release. First the spin from the "news" release:
David Lereah, NAR’s chief economist, said there’s a closer relationship between annual changes in the index and actual market performance than there is with month-to-month comparisons. “In looking at year-to-year comparisons, the pending home sales index has been very close in predicting the actual pace of home sales,” he said. “Based on recent changes from a year ago, the index shows existing-home sales should continue to ease after a stronger-than-expected decline in July, but are likely to flatten in the months ahead.”

Lereah said psychological factors account for much of the decline in July home sales. “We’ve never seen a general decline in the housing market against a healthy economic backdrop where jobs are being created, the economy in growing and interest rates are favorable,” he said. “Psychological factors are causing some buyers to remain on the sidelines, waiting for prices to stabilize or for more favorable news about the market and the economy. Contributing to this hesitancy is a lot of negative news stories, but in the end we believe that underlying market fundamentals will prevail.
I hope you're laughing. Of course you are not if you are in pre-foreclosure, and some very, very good people are. As to Lereah's little discussion of fundamentals, the fundamental governing the real estate market are massive inflation in housing values that is historically disproportionate to the incomes of the people who buy houses. This was never going to be sustainable and it will not be sustained now, and this was quite obvious last year. The only reason prices got to this point was because of funny-money loans, and we will now see a truly staggering deflation of those inflated values.

Now to the actual figures. Lereah is correct that the year to year comparison is more important than the monthly figures, so let's look at those first. And let's look at the figures that aren't seasonally adjusted, because there is absolutely no need to seasonally adjust figures when you are comparing July 2006 to July 2005.
Nationwide: -14.5%
Northeast: -15.3%
Midwest: -18.8%
South: -9.7%
West: -18.0%
These figures do not bode well, do they? Now look at the month-to-month change (July 2006 compared to July 2005):
Nationwide: -14.1%
Northeast: -20.8%
Midwest: -17.8%
South: -11.7%
West: -9.6%
The northeast is the truly staggering figure. Pending home sales are a pretty decent sample size, and the Northeast rolled over in July. Since July is historically a good RE season in that area, it is clear that the situation will get worse instead of better. Such a large drop in one month confirms that the downturn is extremely wide in scope. The northeast has been the healthiest area of the country in terms of incomes. Worse yet, the actual index for the Northeast is now below 2001 figures for two months running. It is a steep downturn.

These figures are already having a wider effect. Forbes reported that the dollar fell on this news:
The dollar's early afternoon recovery, in the wake of a solid US jobs report for August, came to an abrupt halt on mounting concerns that the US housing market is teetering on the verge of collapse.
Paul Ashworth, senior US economist at Capital Economics, said outright falls in house prices would appear to be unavoidable if this trend continues.

'Housing is in freefall and that is the key to the economic outlook,' he said.

'There are now clear downside risks to our longstanding forecast that GDP growth will slow to 2.0 pct next year,' he added.
No kidding. A 2007 recession is in the bag. The coasts account for most housing equity in this country, and so downturns there have more of a macro effect. Again, the month-to-month drops were worse for the south and the northeast than the year-over-year drops.

It might be time to review some of Greenspan's comments about the wealth effect, and reflect that what was a source of strength to the economy then will now necessarily be a significant drag on consumer spending, employment, furniture and appliances, housing sector jobs.... This will mount rapidly. It generally takes six months for these impacts to radiate through the economy, and I would say that the recession will begin in the first half of 2007. I don't think this will be a good Christmas season for many folks, and I expect the stores to throw the Santas out there ASAP with fake snow and icepacks under their Santa suits in a desperate attempt to jumpstart holiday sales.

The Housing Bubble Blog posted on this and other news, including the rather sudden recognition by Motley Fool that guess what! If borrowers are suddenly handing out major incentives, home prices are being overstated! Imagine that.... Job losses in the building industries are starting to mount as well. Florida's economic worries are a preview for the nation.

I am hoping that gas prices fall significantly, which would help to curb inflation. In my area, they have fallen to about $2.50-$2.55 for lowest grade. But lower fuel costs can do nothing to offset the effect of demographics (declining workforce participation, expected sales of houses in high-priced areas, lower spending) and what I see as the coming wave of asset deflation.

Dear Mama; I agree with your view of a recession in 2007. The bond market agrees as well. The yield curve is flat, and the Eurodollar curve has easings priced in. What's not clear to me is an imminent housing collapse. I think a decline is baked in the cake, but for a few reasons a huge one may be avoided. First, even with 17 tightenings, the Fed is not in a restrictive monetary posture. Most agree they're neutral. A financial conditions index, including the stock market, credit spreads, value of the dollar and level of intrest rates is not restrictive. Credit default swaps are at or close to all time narrows. And finally (I think) the banking system is fairly healthy. I;m sure you can poke many holes in these arguments, but there is still plenty of cash around, and with 4.75% ten year notes the demand for yield will continue to make credit available to low qualified borrowers. Just some food for thought.
Churchill Fan - I would agree with everything you say, except for this reality: By any reasonable standard, at least 10% of mortgage holders measued by value had negative equity six months ago. Given the reality of significant price drops in many coastal areas, that means that at least 20% of all mortgage value will be negative equity mortgages by the end of the first quarter of 2007.

This would not be so bad if most of those with negative equity had traditional fixed-rate mortgages at low rates. But there is also an unfortunate risk concentration.

The areas in which housing values inflated sharply are the areas in which negative-equity, interest-only or option pay (neg-am) mortgages were by far the most likely to be written. Most commenters are using figures of between 1.8 trillion and 2.7 trillion of mortgages due to readjust through the end of 2007. This means that many mortgage holders will not be able to refi out. Those who are able to will be refi-ing into more costly mortgages.

On most of these risky mortgages, payments double or triple within a few years. Unfortunately, most of the borrowers who took these mortgages did so because they had affordability issues, and it is likely that at least half of them who are not able to refi will end up losing their houses. You can expect HLTV mortgages that do get rewritten into these areas to demand a risk premium too, which is why the FNMA cited rates now mean little.

In general, once forced sales and foreclosures reach 5% in a particular area, you see price declines. It's well documented that predatory lending, and the subsequent forced sales, has on occasion produced local housing value drops of at least 10%. So we have created a self-reinforcing situation.

Unfortunately the areas that saw high housing inflation also saw very significant investor/second home buys, although at least some of the applications were processed as owner-occupant mortgages. Vacancy rates in some of these areas demonstrate that many false applications were filed. People don't fight the same way to save an investment that they do to keep their home, so this is another risk concentration.

Then we have HELOC's, which in some of these areas have been used widely to strip equity. Some of the "investors" pulled out all their book equity in order to buy new homes as an investment, and are now upside-down in their original homes. Some used the money to finance personal spending.

It is the risk concentration which makes the housing market so fragile. For an explanation of some of the risks of HELOC's, please see my prior post. One of the reasons lenders haven't tightened underwriting standards yet is that they really need to roll over their portfolio to maintain its quality. But with far more scrutiny on LTV's, that is going to come to an end quickly.
Afternoon Mama. I think our differences may be a matter of degree. If you're calling for a 15-20% priced decline, I can see that happening. If your view is for a Japan style end of the world with 7-10 years of rolling recession, I can't buy in to that scenario. A few reasons. First, lenders will be trying to restructure payments, renegotiate terms or some other tricks up their sleeves to keep the loans performing. My Mortgage desk tells me that lenders are requiring more collateral than they were a year ago (I'm a govie guy so I've got to take their word for it). Also, while a small data point, rental demand and yields in NYC are climbing. The bond market and the stock market are strong. Unless Ben B keeps raising the funds rate (which I don't think he has the sack to do) I suspect the market will clear, and some wealth will get redistributed, but it will mostly be that old joke. A recession is when your neighbor is out of work, a depression is when you're out of work.
I think it is quite possible that asset deflation in housing will coexist with some increase in price inflation for goods. Certainly, there are upward price pressures in both China and India, which have previously tended to act as a downward force on inflation. And the imputed-rent methodology for housing prices will tend to push the CPI upwards. For these reasons, I'm not too high on long-term bonds at the moment.

It also seems possible that some of the money that trend-followers have been putting into housing will now make its way into stocks, exerting an upward force in those markets.
Churchill Fan & David - I believe that it is impossible to predict how severe this will be, largely because there is no good solid independent measure of the real collateral value behind several trillion dollars of MB securitizations. Then there is at least another 700 billion held by banks, and an unknown amount by REITs. In the next two years, I can't see how we won't have at least 800 billion of losses on RE on the investment side, plus at least that amount sucked out of consumer spending. That's a pretty large deflater.

Junk bonds concern me, and I have mentally moved a lot of builder bonds to that category. Some state debt concerns me. Are CA & NJ ever going to find their way out of the financial quagmire? Unfunded state, local and federal pension commitments concern me. The growing disparity between private sector and government sector incomes has me very worried.

My basic concern is that this bubble seems to cap an era of financial wishful thinking and that this correction coincides with a set of demographic challenges that should not be overlooked.

I also don't believe Bernanke will hike much. Certainly not before the election, and not if they see real signals of a recession, although I think our stats are poor. Anyone who wanders through stores once a month and tracks pricing is better at assessing pricing pressures than the stats we get. I have inflation running at 7-8% for about 16 months now, and that inflation is focused in a very regressive way. I believe that will back off if gas prices go down.

I foresee a long-term shift in consumer psychology arising from this.

On the bright side, if some of the truly ridiculous public policy mistakes could be corrected, I can foresee strong upward pressures rising from that. I am referring to overly restrictive environmental laws, the de-facto ban on new domestic energy production, and our bizarre and highly costly tort system.
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