Housing Woes to Continue in 2008

The prognosis for the housing market remains poor, and any expectations that sector has bottomed is premature. Housing starts and prices are likely to continue deteriorating throughout 2008, recent interest rate cuts by the US Federal Reserve notwithstanding. Since mortgage defaults are the base cause of the global credit crunch that started in August, the prognosis for financial markets and the US economy remain poor for the next year.

A recent report by Moody’s Economy.com entitled Aftershock: Housing in the Wake of the Mortgage Meltdown makes for sobering reading. The authors of the detailed report forecast continued weakness in housing starts to mid-2008, falling by 55 percent, and a fall in house prices by 13 percent before the market hits bottom in early 2009. House prices have fallen roughly 5 percent to date according to the Case Shiller Index.

Falling house prices and weak sales and housing starts will amount to greater losses for financial institutions holding mortgage-backed securities and collateralized debt obligations (CDOs). Many of the CDOs are comprised of subprime mortgages that are seeing rising delinquencies and default rates which seriously compromise their value. Expect further write-downs from Wall Street and European investment banks.

Mortgage defaults are very high and expected to rise to 1.5 million units on an annualized basis in the third quarter of 2007 according to the Moody’s report. With roughly US$250bn. in adjustable rate mortgages expected to reset in 2008 according to First American Core Logic, defaults are likely to rise. An estimated 3 million loans are expected to be defaulted on between 2007 and mid-2009, according to the Moody’ report. The President’s mortgage restructuring plan will obviously reduce these pressures in the near-term, but it will also serve to extend the length of time that these imbalances are worked through the system and could prolong the weakness in the housing market.

Banks are curtailing lending to even creditworthy borrowers because the severe losses they are enduring is reducing their capital-asset ratios. These ratios need to be maintained according to international banking regulations. You can bet that the lower the credit-worthiness of borrowers, the lower is the availability of loans, the effect being fewer potential house buyers and more downward pressure on the housing market. In fact, mortgage origination for subprime, Alt-A and Jumbo loans fell heavily in the third quarter of 2007.

Inventories of home for sale are unfortunately rising to levels not seen before in the Post World War II period according to the Moody’s report. The current vacancy rate, at 2.6 percent, representing 2.1 million vacant unsold homes, is well above the long term “unwavering” historical average of 1.7 percent between 1980 and 2005. New and existing home sales are below 6 million units per annum, a level so low it representing sales not seen since a decade prior.

I have repeatedly suggested that homebuilder stocks were vulnerable to this weakness and could be shorted by buying puts on the PHLX Housing Sector Index. The index is down roughly 40 percent since February when I suggested that US housing was vulnerable and down 30 percent since July when I recommended this specific short. The Moody’s report suggests that it is partially due to the “hubris” of homebuilders that the housing oversupply remains high: “The substantial financial resources of these firms allowed them to continue building longer even in the face of weakening demand.” Most recently, homebuilders appear to be retrenching: single-family housing starts fell 5.4 percent in November 2007; it is tough to see how homebuilders can be profitable in this type of environment.

The US economy has slowed dramatically in recent months and the risks of a full-blown recession are rising. Consumer spending has slowed but has held up reasonably well, all things considered. The specter of further retrenchment by the consumer looms large over the US economy and suggests that investors should continue to play it safe when investing. Commodity stocks, the Canadian dollar and U.S. financial and consumer stocks remain vulnerable to further weakness in the US economy. Falling interest rates in the US are supportive of financial stocks, but only where companies have had minimal exposure to the mortgage securitization business. Those banks that danced this dance in recent years remain fraught with risk.