Investing
Kass: The Simple Math of Subprime's Slide
By Doug Kass
Street Insight Contributor
3/26/2007 1:12 PM EDT
It is truly remarkable how the slightest provocation (last week's "solid" home-sales headline) had the media and other permabullish types declare that the housing market has finally bottomed (again!) and that the impact on the subslime mess would be contained.
Here is a more accurate
analysis of what occurred in housing last month:
"Home sales increase in the springtime month over month, every year, even if the world is ending. It's called "the homebuying season" for a reason. So you don't look at February vs. January, or April vs. March. No, just like retailers look at Christmas vs. Christmas, not Christmas vs. July, any dummy that follows the housing market looks year over year. Here's the real numbers, and headline the MSM should have reported: Dubious NAR report shows home sales continue to crater, off 3.7% vs. last year, while unsold inventory explodes by another 763,000 units and median sales price (without incentives) is down 7.6% from peak. February used-home sales (per the dubious NAR numbers) were supposedly 387,000 units, vs. 402,000 units February 2006, down 3.7%. Inventory is now at 3,748,000, vs. 2,985,000 in February 2006, up 763,000 unwanted homes, or 25.6%. And the median sales price (without cash back or incentives) in February of $212,800 is down $17,400 from the July 2006 peak. (Here is a further analysis that underscores the weakness -- not the strength -- in the housing market. -- Housing Panic Blog
Perusing the historically misguided statements by former
Federal Reserve Chairman Greenspan and NAR economist David Lereah that follow suggests almost as much denial as Simmons and Fisher registered 78 years ago -- right before the Great Depression roiled the U.S. economy.
Oops!
October 2006: Greenspan foresees a housing "bottom."
"Last week's rise in weekly mortgage applications" could signal that "the worst may be over for housing." --
October 2006.
2006-07: Lereah on the multiple housing "bottoms" and opining on the quality of mortgage lending.
"It was very clear that the standards had deteriorated ... I'm not a lender though, I kept on saying to myself -- I guess they know what they're doing. --
March 2007.
"It appears we've hit bottom, the price drops are necessary to stir sales. It's working. ... It's important to focus on where the housing market is now -- it appears to be stabilizing and comparisons with an unsustainable boom mask the fact that home sales remain historically high." --
December 2006.
"We've been anticipating a price correction and now it's here. The price drop has stopped the bleeding for housing sales. We think the housing market has now hit bottom." -- September 2006.
"This may be the bottom. It (housing) appears May is a little better." --
May 2006.
1928-29: Simmons and Fisher forecast continued stock market gains in the fool's paradise prior to The Great Depression of 1929.
"I cannot help but raise a dissenting voice to statements that we are living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the near future." -- E.H.H. Simmons, president, New York Stock Exchange, January 1928 "Stock prices have reached what looks like a permanently high plateau. ...
The end of the decline of the stock market will probably not be long, only a few more days, at most." --
Dr. Irving Fisher, October 1929 and November 1929
To be sure, I am not looking for a depression in
housing or for the economy -- but
those who look for housing to stabilize and for an increasingly restrictive mortgage credit market to be anything other than a substantive drag on 2007-08 aggregate economic growth
are just plain wrong. It's sometimes fun to go back and look at several of the above mistaken views and hyperbole from those who should have known better, but it is even more worrisome to look at the state of housing demand and supply today, which leads to my broader economic concerns:
The explosion in mortgage delinquencies in the second half of 2006 has only recently begun to be converted from delinquencies to foreclosures (and for-sale signs). Currently, the housing market's foreclosures stand at a 40-year
peak.
Economy.com estimates that there were about 400,000 foreclosures in 2006. With signs of continued rising delinquency rates thus far this year, 2007 foreclosures should be considerably higher than last year's figures.
I would estimate that foreclosures in 2006-07 will add nearly 1 million units (or 26.5%) to the current level of 3.75 million homes for sale. Stated simply,
most are underestimating the massive supply of homes that will be dumped on the market over the next year to two years.
While record foreclosures will assuredly lead to a rapid rise in the supply of homes available to be sold in 2007 and 2008, tougher lending standards (particularly in the subprime category that is the lifeblood of first-time buyers) will squelch
housing demand. Historically, creative lending (option ARMs, interest-only, negative amortization, etc.) shored up the housing markets by allowing (indeed
encouraging) otherwise unqualified borrowers to participate in the roaring residential market of the last few years. (I suppose that Anthony Hsieh, CEO of
Lending Tree, might now have second thoughts regarding this quote back last year: "If you own your home free and clear, people will refer to you as a fool. All that money sitting there, doing nothing."
First-time buyers and speculators, who, before delinquencies mushroomed, were qualified for high (95% or more!) loan-to-value mortgages at below market interest rates (80% of subprime loans over the last three years were 2/28 ARMs) based on teaser interest rates are now being qualified increasingly by the mortgage interest rate charged after reset.
This is serving to effectively price out a major demand source for homes as they are no longer eligible for low down-payment, nondocumented loans that were previously granted with below market or teaser interest rates. Indeed, subprime mortgages have been the only source for a large amount of homebuyers in the last three years. No more.
Quantifying the Impact of Tightening Credit
I would conservatively estimate that about
55% of the subprime borrowers, 25% of the Alt-A borrowers and 15% of the prime mortgage lending borrowers will no longer be able to secure financing for new homes because of tightened conditions. (This will produce about a 25% drop in housing demand).
Speculators and investors -- who were responsible for nearly 20% of all home purchases in 2004-06 -- also will find it more difficult to secure borrowings, and it is likely that this buying category will revert close to its historical demand role of about 5% of all homes. (This will result in another 10%-15% drop in housing demand). Finally,
end-of-economic-cycle conditions (lower consumer confidence, slowing economic growth and moderating job growth) should contribute to another 10% drop in housing demand, which is as it has done historically.
Adding together the above three influences, new home demand should fall off by almost 50% (vs. the rolling 12-month average showing a 17% drop off in 2007)
even before the effect of a market inundated by record foreclosures is considered. Precipitated by the subprime mess, the entire daisy chain of home demand is deteriorating. With the first-time buyer out of the market and increased demands of higher collateral, better credit and loan documentation,
the trade-up market is also in trouble. So is the Alt-A market. And, in the fullness of time,
as Nouriel Roubini surmises, a more general credit crunch remains possible.
Credit Suisse (CS) projects that about $500 billion of mortgages will reset this year (60% of these are subprime loans). According to First American CoreLogic's
recent study, "Mortgage Payment Reset: The Issue and the Impact," resets will produce
1.1 million additional foreclosures (and more than $100 billion of losses) over the next six years. That's nearly another 185,000 homes per year coming into supply, on top of the nearly 1 million homes foreclosed on in 2006-07!
What is particularly worrisome to me is that home prices remain inflated relative to household incomes (Merrill's Rosenberg did a good analysis on this topic last week;
Today's home prices stand at the highest multiple to disposable incomes in history). We have still not resolved the high price of homes by either prices moving lower or incomes moving
higher. Affordability (or the lack of) will provide another headwind to the housing recovery.
Inventories: Another Headwind of Supply
There remains too much land and finished product inventory owned by the homebuilders. The publicly held companies are positioned to weather the storm, but the more levered private companies will be a continued liquidator of land and homes. Indeed, new home-price incentives look to be on the ascent, another headwind to supply.
With housing activity dropping and resets rising,
consumer confidence should dive in the months ahead, construction employment will plummet and a cessation of mortgage equity withdrawals will further grease an already weakening slide in personal consumption expenditures.
In summary, the general (and specious) notion that the subslime travesty and its concomitant impact on the extension of credit won't have an impact on the broader economy reminds me of another quote, weeks before the stock market crash of 1929 put the U.S. economy in to a Depression (with a capital D): "In most of the cities and towns of this country, this Wall Street panic will have no effect."
-- Paul Block (president of the Block newspaper chain), Nov. 15, 1929
From my perch, investing on the basis that the subslime carnage and exploding ARMs will not affect the consumer, the economy and our equity market is a risky proposition.
Here is the economic equation as I see it:
Restrained mortgage credit plus reset mortgage rates equals more money needed to finance homes and less money available to purchase goods equals
a slowing economy. The Next Down Leg Is Upon Us
Remember, today's weak new-home sales are before cancellations,
which have been running over 20% for most publicly traded homebuilders. Moreover, new-home sales provide a better market feel for the residential housing market, as they are calculated upon signing of a contract, while existing-home sales are counted when a sale is closed.
Ergo, not only will new-home sales for February end up being weaker than stated today, but
the state of housing is far worse than most realize (except the publicly traded homebuilders' managements who were ignored when they suggested the spring selling season was a bust thus far).
The inventory-to-sales ratio ratcheted up (from 7.3 months in January to 8.1 months) to the highest level since January 1991 (which was not a very good year!).
The next down leg in housing is upon us. Employment, consumer confidence and retail spending will be the next victims of housing's retreat.
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At time of publication, Kass and/or his funds had no positions in stocks mentioned, although holdings can change at any time. 
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