Yikes, California Home Values Drop 26% in February

From the LA Times:

Signs of distress are piling up in the California housing market, where prices are falling at three times the national rate of decline. Statewide, median sales prices fell by a stunning 26% from year-ago levels in February, with home prices dropping at a rate of nearly $3,000 a week, the California Association of Realtors reports. Further, the CAR says the Fed's interest rate-cutting campaign "will have little near-term direct effect on the housing market."

That's right. If you live in California chances are your 401(k) has outperformed your home over the last year. Normally that would be expected, but we're in a bear market for equities!

I am amazed that it has become conventional wisdom that a house is the best way to accumulate wealth in this country. Hopefully a year-over-year decline of 26% in the California housing market will diminish some people's desire to accumulate as much property as possible. Remember everybody, homes appreciate by 3% per year over the long term, so they don't even outpace inflation.

That reminds me. Has anyone seen the television ad currently being run by the National Association of Realtors? It states that homes "nearly double in value every 10 years." I'm shocked they are claiming such a ridiculous statistic.

If we go back to high school math class, we recall the Rule of 72, which lets us divide an annual appreciation rate into 72 to determine how many years it takes for something to double in value. A double in 10 years implies a 7% annual return. That is twice the actual long-term appreciation of U.S. housing. Does anyone really think that homes return 7% per year?

How can the NAR get away with this ad? Because they simply chose a time period where the average return was 7% (yes, it includes the recent housing boom) and implies that was a "typical" period. Gotta love the fine print...

Fed Finally Showing Rate Cuts Aren't Everything

I know they cut 75 basis points at today's meeting, but the 400+ point gain in the Dow probably isn't in reaction to more rate cuts. Many people have made the argument, myself included, that rate cuts are not the magic anecdote for our economic problems. Sure they're nice, but the structural issues we are dealing with cannot be solved by simply lowering the Fed Funds rate.

Recent steps by the Fed show that they realize they can and need to do more to help. Things like opening the discount window to investment banks, not just commercial banks, and backing the first $30 billion of liabilities to help avert a Bear Stearns (BSC) bankruptcy are doing a great job in restoring confidence to the market. I would not be surprised to see them take another step and start buying mortgage backed securities from the likes of Fannie Mae (FNM) to ensure orderly markets for bonds backed by the U.S. government. Fannie bonds are trading well below par despite the fact that they have no default risk.

Do the Fed's recent actions mean we are completely out of the woods? Of course not. We have gained some footing over the last week or so by holding the closing lows of 1270 on the S&P 500. Even more positive, we are seeing the market react well to bad news, a good indicator that a lot of terrible news has already been priced into stock prices.

Even though JPMorgan (JPM) accounted for the gains (making the feat less impressive), the Dow finished up on Monday, the day the fifth largest investment bank narrowly avoided going belly up. Good news has been hard to come by, but today marks the second 400 point daily Dow gain since last week. Remember, since markets are forward-looking, news itself is far less important than the market's reaction to it. On that front things are looking up, at least for now, although we all know the trend can change on a dime.

Full Disclosure: No positions in BSC, FNM, or JPM at the time of writing

Pulse of the Housing Market

Given that the housing market malaise is the prime culprit for our economic and market adversity, I decided to post some charts showing key indicators such as delinquencies, foreclosures, and inventories. Sources for this data are Countrywide Financial (CFC), which has the nation's largest mortgage servicing portfolio ($1.48 trillion), and the National Association of Realtors, which tracks home sales.

First up, Countrywide's mortgage delinquency rates and pending foreclosure rates for the last twelve months:

As you can see, delinquency rates have stabilized the last few months, with foreclosures still headed higher, but not severely. While certainly a good sign, we can not call it a trend just yet. After all, last summer we saw a leveling off, only to see another spike shortly thereafter.

The next chart is home inventories, I believe a key proxy for the future direction of home prices. We will not see stabilizing home values (and eventual gains again) until we work through very high inventory levels. Typical inventories levels are about 50% below current levels.

Again we see a curtailment of rising inventories in recent months, but I still do not think we can call it a long lasting trend of stabilization as of yet, given that we will not pass the peak in ARM rate resets for the next quarter or two.

But let's assume for a moment that these indicators do stop getting worse in coming months. Does that mean the housing market will stabilize also? Probably not. Inventories need to come down. The only way we get that is to increase demand. With home buyers now needing the "trifecta" to get a mortgage loan application approved (good credit, proof of steady income, and money for a down payment), demand won't outstrip supply unless prices come down further to get qualified buyers to pull the trigger in greater numbers.

Will the Fed Really Cut Rates Twice in a Week?

This is what I'm worried about. The market got severely oversold and has had a nice bounce as a result. We are not out of the woods by any means. Most market participants will want to see a nice rebound out of the oversold condition, and another leg down (preferably with signs of capitulation). How long will this current rally last? It's hard to know, but I think it could face some issues as early as next week.

After the Fed's emergency 75 basis point rate cut on Tuesday, a full week before their scheduled meeting, the futures market immediately priced in another cut for their upcoming meeting. At first the market was expecting another 75 bps, but now it is down to 50 bps. Do you really think Bernanke is going to cut rates again next week? I'm not so sure.

The point of an emergency cut is to act early because they don't think they can wait. In this case, they didn't want a market crash on Tuesday (overseas markets were indicating a 5% drop of 600 Dow points). By moving a week early the Fed averted such a meltdown, but I would think there is a good chance they simply pushed up their move to accommodate the markets (we can argue whether this was warranted or not, but that is why they did it).

If so why would they cut again next week? Will they have gotten any new data in a week's time that shows things have deteriorated since the last cut? If not, how can they justify cutting rates more than 1% in such a short amount of time?

Call me skeptical of the market's thinking on this one. Next week should be another interesting week, albeit less exciting if you are long equities.

Why Rate Freezes Won't Solve Foreclosure Problem

The wires are reporting that the White House is working on a plan that would freeze rates on adjustable rate mortgages for certain borrowers, in an attempt to help curb the rapid increase in home foreclosures expected in coming months. While it certainly will help the situation, consider a slide from Countrywide's Keynote Presentation at the 37th Annual Bank of America Investment Conference in September which showed the following:

Causes of Foreclosure (July 2007)

58.3% Curtailment of income

13.2% Illness/Medical

8.4% Divorce

6.1% Investment property/Unable to sell

5.5% Low regard for property ownership

3.6% Death

1.4% Payment adjustment

3.5% Other

Very interesting...

Do Rate Cuts Really Matter?

I find it very interesting that Wall Street has soared the last two days on hopes of more Fed rate cuts. On one hand, this makes sense, but on another, it baffles me.

First of all, stocks do better historically when rates are falling. It's a mathematical relationship; lower interest rates increase the present value of future cash flows and vice versa. Lower rates also make stocks more attractive relative to other income-related asset classes. That's the general concept propelling stocks higher this week, but what about the specific situation we face today?

The current dislocation in the credit markets has really hurt the market lately. We all know the state of the housing, mortgage, and mortgage-backed securities markets, but a general lack of liquidity in many other areas of credit are really having a negative impact on the ability of many companies to conduct normal business lines that require liquidity to fund operations.

Will more Fed rate cuts help this part of the problem? The market's move in the last two days signals that it will, but I am skeptical. My thought process isn't very complex. The liquidity crisis has gotten meaningfully worse since the Fed started cutting rates (there have been 75 basis points of cuts so far). To me, that indicates that another rate cut on December 11th (even 50 more basis points) won't have as much of a positive impact on the credit markets as recent stock market action would have you believe.

What do you think?

Alright Bernanke, Enough with the Rate Cuts

Do you get the feeling that FOMC Chairman Ben Bernanke is lowering interest rates more because that is what the markets want, and less because it is actually helping the problems we have in the housing and credit markets? The debate has long been whether or not the mortgage crisis will be contained or spread into the rest of the economy and cause a recession. With third quarter GDP growth coming in at 3.9%, the highest rate since early 2006, it is clear that the economy is a lot more than just the housing market.

While GDP growth should slow meaningfully in Q4, it does appear the mortgage problems are contained. Unless rate cuts will help stabilize the housing market, which is not a likely result, I don't see the need to go ahead with them just for the market's sake. After all, commodities like gold, oil, wheat, corn, etc are soaring. The result will be higher prices for consumers, which we have already begun to see as companies like FedEx, Colgate, and Procter & Gamble are all raising prices to maintain their profit margins and stock prices.

In the face of apparent inflation pressures, interest rates could ultimately be headed higher, which would make the recent cuts even more baffling. It's true that the government's inflation data doesn't seem to jive with reality, and maybe that will reduce the likelihood that rate increases are in our future, but when press release after press release announce price increases from major manufacturers due to record commodity prices, it's hard to deny inflation is real.

So what will cure the housing market's woes if rates cuts won't do the trick? Honestly, just the laws of supply and demand. The housing market is still falling with no signs of stability in sight. As long as delinquency and foreclosure rates continue to rise, and home prices continue to fall, the credit market issues (loan losses and asset backed securities writedowns) will continue. The value of loans won't stop falling until the performance of such loans improves, or at least stop deteriorating.

Rate cuts won't help because they have no direct impact on home prices or mortgage delinquency rates. This will be apparent when we see fourth quarter loan performance continue to get worse, not better. As home inventories are worked off and more home owners refinance into fixed rate loans, the markets will eventually stabilize. It will take time though. I don't know when, nobody does, but hopefully we can get there by the end of 2008.

As for whether the housing market weakness has spread to other areas, this debate obviously will continue. From third quarter earnings season we see that the weakness has really been contained to home builders, mortgage lenders, banks and investment firms that own securities backed by mortgage loans, and companies that provide insurance for mortgages and mortgage backed securities. It is my belief, and many will certainly disagree, that consumer spending is not as bad as some would have you think, and the fact that growth in spending is lackluster has much more to do with the face that real wages have been stagnant for years, and not because of the housing market. In addition, the fact that consumers are staying current on all their other monthly bills, even when they are delinquent on their mortgages, shows that the housing market's issues really are fairly well contained.

As for policy moves, I think actions should be focused exclusively on stabilizing the housing market. While pleasing to the markets, I don't see any direct impact on housing from rate cuts. Just imagine how great it would be if we could get back to a "normal" housing market. People would have to get used to not making much money on their homes (real estate returns historically don't outpace inflation), but the credit markets would stabilize and corporate earnings could resume their growth trend. Even a flat housing market would be welcomed by investors, to say the least.

Full Disclosure: No positions in the companies mentioned

Countrywide Predicts Trough, Shares Soar 24%

Gauging the outlook for pure mortgage lenders like Countrywide (CFC) is a tough game and one that I am choosing not to play. The company is predicting that the third quarter was the trough and profits will return in Q4 and 2008, but nobody really knows for sure. Delinquency rates are still rising at CFC, standing at 7.1% as of September 30th, up from 5.7% three months before.

Until there are signs of stability and that stability hangs around for a while, I'm not going to bottom fish in mortgage-related companies like pure lenders or mortgage insurers. Honestly, those stocks are down so much, trading far below even recently slashed book values, that I think eventually there will be plenty of upside without even needing to time the bottom of the cycle.

Until then, I continue to like the bigger diversified banks with fat dividend yields. With these stocks yielding more than treasury bonds, I think you can justify buying low and being patient, knowing that calling a bottom is essentially impossible. I would, however, start making a list of the kinds of stocks you might want to target when things start to rebound. You won't be able to time a purchase perfectly, but there is no way that most of the home builders, mortgage insurers, and big lenders won't survive and be consistently profitable when the markets get back to some sort of more typical environment.

There will be money to be made, but I'm not comfortable jumping into pure plays just yet. Hopefully by sometime in 2008 things will stabilize and we'll have a better idea of what "normal" conditions look like. At that point, making bets will be much more prudent.

Full Disclosure: No position in Countrywide at the time of writing

Should We Cheer or Jeer Bernanke and the Fed?

A reader asked if I would share my thoughts on the views expressed in a Yahoo! Finance article written by Wharton Professor Jeremy Siegel on Thursday regarding the Fed and whether or not it should be flooding us with rate cuts.

The piece, entitled Don't Blame the Central Banks -- Thank Them, was well written and sought to comfort readers that coming to the aid of the banking industry is a good thing and could potentially help avoid a recession. Opponents of the Fed's recent rate cut point to the fact that it is a bail out, and contributes to a moral hazard problem.

From my perspective, I think it is important to differentiate between a bail out and a Fed that provides additional liquidity and reduces the discount and federal funds rate. I am firmly against a bail out of any kind because it rewards (or at the very least seeks to reduce the negative repercussions from) poor decision making by the private sector. I agree that moral hazard is a real concern.

We live in a nation that is fueled by incentives. In most cases, people make decisions based on the incentive structure that is present at the time. If we bail out lenders who made stupid loans as well as the borrowers who were so eager to borrow money than they couldn't afford to pay back, then nobody will learn from their mistakes and they will be made again and again, at the expense of taxpayers.

An important point to make, however, is whether or not the Fed's actions thus far should be considered a bail out. Surely the Congress and President Bush could sign into law some sort of plan that essentially bails out troubled lenders and borrowers, but let's focus on what our central bank has done so far. As Siegel points out in his article, the Fed has taken the lead in increasing the level of available liquidity. It allows those who want access to capital but can't get it due to short-term market inefficiencies to have ways to get it. Our market-based economy will be better suited when we can eliminate, or at least sharply reduce, a liquidity crisis.

In my view, this is not a bail out. No borrowers are having their loans forgiven and no lenders are getting reimbursed for unrecoverable loans. When you have market participants providing capital into a market based system, and the system temporary stops working (i.e. capital becomes scarce), I applaud the Fed for stepping up in their role as a lender of last resort. We can argue how much of an impact it has had thus far, and will have in the future, but I have no doubt it is helping in some measurable way.

What I find interesting with this mortgage crisis so far is that the companies that have filed for bankruptcy (there have been more than 50 mortgage lenders go under so far) and the companies that have stopped making new loans, have fallen upon hard times due more from a lack of liquidity than loan defaults and property foreclosures. Interestingly, most home loans are being paid on time. As of August 31st, the nation's largest mortgage lender had 95% of its loans being paid on time. Other lenders have seen their loan portfolios perform even better than that (delinquency rates at another banking institution company discussed last week on this blog are 50% below those of Countrywide).

Now, that is not to say that there isn't a problem. The sub-prime sector of the market has seen delinquent rates reach more than 20% at some of the more careless lenders, and many of them are no longer in business as a result. I just hope that the actual performance of these loans is what ultimately causes the lenders to sink or swim. If you made bad loans, you deserve to go face the consequences, with no help from anybody.

However, companies whose loans are performing okay also found themselves teetering on the brink due to a lack of capital in the marketplace. If the Fed can provide liquidity to maintain an orderly market, I think they are doing the right thing. That won't have any impact on how many loans are defaulted on, and I think that is what should determine how much money these firms lose and whether or not they can continue to stay in business. The might lose a lot of money in the short term, but very few can argue that isn't justified based on the lax nature of their lending standards in recent years. What I'd prefer not to see is a lender be forced into bankruptcy due to lack of liquidity, only to see their loans bought up by third parties who actually recoup most of the outstanding money.

I am all for the Fed's aiding in the liquidity crisis, but let's make sure the people who lent money to people who couldn't pay it back don't get bailed out, even if that means a family has to give up their house in the process. If they can't afford the house, I see no reason to fight hard for them to stay in it when they can move into another one (or rent) they can afford.

So Much For That Theory

If you want to know just how difficult it is to predict short term market events, such as interest rate moves, just look at what happened over the last two weeks. I wrote back then about how the futures market was pricing in a 50 basis point rate cut and postulated that the odds of no cut or only 25 basis points appeared to be much higher than the market was indicating. It turns out that neither the market nor my contrarian view two weeks ago turned out to be right.

By the time the Fed meeting came around yesterday afternoon, the market was only expecting 25 basis points, which I obviously agreed with. Then out of nowhere we get a 50 basis point cut, the bulls were ecstatic and the shorts got burned big time. The end result was a 336 point jump on the Dow, the biggest single day point gain in about 5 years.

Rather than try and predict why the Fed did what they did, or what they will do in the future, let's focus on what yesterday's action does. First and foremost it was a positive symbolic move that the Fed does have the market's back. We can argue if such a role is in their official job description or not, but that's another conversation entirely. I'm not sure why they waited so long if they thought a dramatic 50 basis point cut was needed, but maybe they are hoping decisive action will prevent further deterioration that would require more cuts in the future.

An important point regarding rates is the effect on the housing and mortgage markets. Remember, for all of those home owners who will desperately be trying to refinance their adjustable rate mortgages into fixed rate loans, this rate cut won't help them. Fixed rate mortgage rates are based on long term bond rates, not the Fed Funds or Discount rate. The move will help those with variable rate home equity loans and credit card debt (which are generally based on the Prime rate), but I don't think a half a point change in rate, or even a full percentage point if we get more cuts later on, will dramatically alter the ability of consumers to pay their bills on time.

The main problem with the housing market is supply and demand and overly excessive pricing. Despite press reports to the contrary, most people can get a mortgage if they want to buy a house. For those sub-prime borrowers who can't get a loan, now isn't the time they' be looking for one anyway (they have already gone down that road). Instead, they will either be forced pay their mortgage, refinance into a fixed rate mortgage (which the banks can make a profit on and therefore are willing to offer), or lose their home and begin renting again.

So what will really help the ailing housing market? In my view, above all else, it's reasonable pricing. Not only can most people still get loans, but another myth out there is that you can't sell your house. Well, that's not really true. What is true is that you can't get top dollar for your house or always make a profit on every property that you purchase. However, if you price your home competitively, you will find buyers.

Want proof? How about what Hovnanian Enterprises (HOV), one of the larger home builders in the country, did recently. HOV just completed a 3-day sale on their homes, which they dubbed the "The Deal of the Century," where they slashed prices by up to 25% or $100,000 in an effort to get rid of inventory. The results were beyond impressive. Hovnanian either sold or received deposits on 2,100 homes in just 72 hours. That compares with 2,539 homes sold in the entire quarter ending July 31st!

Now, some press reports compared these numbers directly to gauge the sale's impact, which is not correct given the 2,100 number was gross sales and 2,539 was a net sales figure. If you use HOV's most recent cancellation rate of 35% you get net 72-hour sales of 1,365 homes. But still, the implications are very strong. If you price your homes aggressively as HOV did, there are plenty of willing buyers. By doing so, Hovnanian sold more than 6 weeks' worth of homes in only 72 hours.

Full Disclosure: No position in HOV at the time of writing