Housing Market Unlikely To Be Derailed Significantly By Higher Rates Anytime Soon

With 30-year mortgage rates having risen by a full percentage point in recent weeks, investors are selling homebuilder stocks on fears that the rebound in prices that has been in place for over a year will come to a screeching halt. But is that really the correct takeaway with mortgage rates still sitting at just 4.5%? I'm not so sure.

While there is no doubt that rising rates will cut into refinance activity in a major way, I do not think the thesis for being bullish on housing demand is dented by the recent rate increase. The main reason is because I do not think the housing market rebound was as much due to falling rates as it was the structural normalization of the supply/demand picture within housing more generally.

Let's think about this. The dramatic collapse in housing prices (down 30% peak-to-trough nationally) was caused by the simultaneous divergence of supply and demand. Demand for new homes collapsed during the recession due to soaring unemployment and general economic uncertainty, both of which reduced the desire to buy a new home. And many of those who actually wanted to buy could not get a loan because the banks were in retreat, just trying to manage through the downturn and stem their credit losses. At the same time, housing supply was soaring due to record foreclosure rates, which flooded the market with homes available for sale, despite the lack of buyer demand. Those two factors combined meant that home prices had nowhere to go but down, and the drop was precipitous.

So what has been behind the rebound in home sales and prices since the housing market bottomed nationally in 2012? Was it just mortgage rates going from 5% to 4% to 3.5%? Was it a loosening of credit standards? To an extent, sure, both of those factors contributed to some of the turnaround. However, I believe other factors had more of an impact.

For instance, for several years the industry essentially stopped building to allow the market to absorb all of the foreclosures. Now that foreclosures have dropped dramatically, the builders have begun to really crank up new home construction. In addition, demand has been helped by a combination of loosening credit standards and an improving employment picture. As a result, home demand is rising as new households are formed and they are in a position (both from a financial and underwriting perspective) to not only qualify for a new home loan, but also afford one.

My main point here is that the demand for housing now has less to do with interest rates and more to do with household formation and the ability to get and pay for a mortgage. That should be the case even if mortgage rates are 5% (instead of 3.5% or 4%) because those rates are still very low on a historical basis and do not really flip the home affordability equation away from buying. If 30-year mortgage rates went to 8% the story might change, but that is simply not in the cards. If I am right and the housing market rebound has more to to with underlying structural supply and demand trends than interest rates, then the housing uptrend should continue even if rates go up a bit more in the coming months. In that scenario, the homebuilders will continue to see volumes and profit margins increase, which will support stronger stock prices than the stock market is pricing in right now.

Still Very Much A Buyer's Market in Housing

A reader recently asked me why I have not updated my housing inventory chart lately (it has been about a year since my last periodic update) and the simple reason is that I forgot.  As you can see after I added the last 12 months or so of data, the U.S. housing market was unable to continue drawing down inventory during 2010. Months of supply have risen again despite price stability in most markets.

What this tells me is that we have many more months (and probably years) to go before inventories get worked down enough to see meaningful price appreciation in the housing market. Now, this does not mean that prices will be taking another large leg down in coming months. Ratios of incomes and home prices are now much more realistic so there will be buyers eager to step up when deals present themselves. I would expect several more years of a relatively flat housing market (I am talking about the national market -- any individual area always has its own supply-demand dynamic). Long term buyers will likely be shielded from material downside risk in all but the most overbuilt markets, but they will truly have to be long-term thinkers when counting on equity appreciation above and beyond their principal repayments. As a result, there is little need to hurry into the home builder stocks. There will be a turn there at some point, but it is likely a ways off.

The Big Short: Another Excellent Book from Michael Lewis

I took a few days off earlier this week and used the down time at the beach to read Michael Lewis' latest book, The Big Short. Lewis has written some of my favorite books, not only about the financial markets (Liar's Poker), but also baseball (Moneyball), and the inspiring story of Baltimore Ravens offensive lineman Michael Oher (The Blind Side) which was made into a hit movie last year starring Sandra Bullock (for which she won an Oscar award).

The Big Short did not disappoint and it further secured Lewis' spot on my short list of favorite non-fiction writers. Lewis tells the story of a handful of market watchers and investors who both correctly identified the housing bubble as it was happening and made big bets based on their views. Unlike many other accounts discussing the financial crisis, Lewis follows a handful of people who most of us had never heard of before. John Paulson always gets a lot of attention, but small investors such as Michael Burry at Scion Capital and the founders of Cornwall Capital, which started as a $110,000 private investment fund of $110,000 managed in a shed, now are having their stories told and frankly they are fascinating (and they beat Paulson to the punch by 1-2 years).

The Big Short uses a different approach than most other authors have in trying to place blame on those responsible for the housing market's bubble and bust. While some have insisted that Lewis' focus on those who made money off the crisis does little to help regulators and politicians prevent another bubble from happening by focusing on the big issues, I find this view unconvincing.

In order to tell these stories, Lewis is forced to include nearly every detail throughout the entire process (the book focuses on chronicling the period from 2003 through 2008). It becomes abundantly clear to the reader which parties are responsible for propping up the housing and mortgage market and the problems are discussed in detail. The story works so well, I believe, because the reader can simultaneously see what all of the interested and conflicted parties are doing, rather than only getting one side of the story.

If you have either enjoyed Michael Lewis' previous books or are interested in reading an excellent account of exactly how the housing bubble kept going for so long, bringing the nation's banks to their knees, or both, a copy of The Big Short is definitely worth picking up. In only 264 pages, Lewis does a great job telling the story from various Wall Street perspectives.

Despite Having No Chance of Passing, Bob Corker's Homeowner Responsibility Amendment is a No-Brainer

When people ask me who was primarily responsible for the credit crisis, I give the typical "well, it was various groups acting together" answer but there is no doubt in my mind that the core of the problem was the emergence of poor home lending in this country. While I believe that both the bankers and the borrowers need to share in the blame for enabling millions of bad loans from being originated, it should be pretty clear to everyone (across the political spectrum) that if the United States had reasonable mortgage underwriting standards in place, the credit crisis would have been prevented. If I could rewind the clock to the early 2000's and legislate underwriting standards that mandated income verification, the inclusion of a down payment, and forbade interest-only loans and mortgages where the borrower could pick from several payment amounts each month, I have no doubt the country would have looked a lot different over the past few years.

So imagine my surprise to learn that Bob Corker and four other senators have proposed an amendment to the current financial regulation debate (number 3955), which despite having obvious, reasonable, and necessary underwriting standards, has absolutely no chance of passing. The Homeowner Responsibility Amendment would, within five years, impose federal mortgage underwriting standards including a 5% down payment requirement, verification of income and employment history, private mortgage insurance for loans above 80% of the home's value, and consideration of ability-to-repay metrics such as a borrower's debt-to-income ratio.

Even more concerning than the fact that this amendment will be defeated handily is that one would have thought just by reading it that Republicans would be the side that had come out against it. Can't you envision them claiming that this is over-regulation by the federal government and that it gets in the way of our capitalist, free market system? Instead, this amendment is being introduced by five Republican senators and is likely to get more Republican votes than Democrat votes. It may turn out that a majority of Republicans oppose the amendment for the reason stated above, but regardless I think it is a shame that after all our country has been through in recent years, our politicians cannot even agree that reasonable underwriting standards are needed in the mortgage industry.

If you cannot afford to buy a house, you should not be allowed to. You are not entitled to a home simply because you want one. And if you cannot put down a modest 5% down payment, verify your income, and demonstrate an ability to pay back a traditional 30-year fixed mortgage, then you should not be buying a home. And if the government wants to mandate that to avoid a future filled with billions in taxpayer bailouts and deep recessions, I don't see why it shouldn't, or why the American public should not be demanding such action.

Homebuilder Stock Favorites with Data

This week I have taken a closer look at the valuation metrics for a dozen large publicly traded home building companies with a goal of identifying attractive investment opportunities to play the likelihood of a rebound in new housing starts over the next few years. As a value investor, I looked mainly at valuation data rather than fundamentals for each individual company. For the most part these stocks trade together as a group, so I am trying to find ones I think could outperform the sector based on a lower entry point price relative to the rest. The fundamental backdrop (i.e. housing market conditions) are likely going to impact them all in a similar fashion.

Below you will find a summary of the 12 stocks I looked at. I created my own screening criteria to weed out smaller companies, those with above-average debt levels, as well as those that, for some reason or another, have a valuation metric that is meaningfully above the rest of the group.

The four stocks highlighted in yellow are the ones that fit my criteria and therefore are the companies I am going to focus on for this investment thesis. The black boxes indicate a data point that eliminated a certain company from contention. Not all of the black boxes indicate bad metrics. In fact, they include market values below $1 billion (which itself is not a negative) as well as one outlier metric that actually indicates company strength (NVR trades at a premium to the group on a price to book basis because it has the strongest balance sheet). This does not mean NVR is a bad investment, but I eliminated it because I am not getting enough value in the market because investors have already identified NVR as being in a strong financial position. I did eliminate stocks with a high proportion of debt relative to cash and investment holdings, so that was a negative metric that I used.

As you can see, I have identified four home building stocks that appear to have strong valuations relative to the group as a whole. Among these companies there is not much valuation differential, so other factors may play into how I would go about choosing one to invest in for the longer term. As with most of my potential investment candidates, these housing stocks are contrarian ideas. The housing starts data is unlikely to rebound in the short term, so investors looking to play this potential improvement should take a multi-year view of the investment thesis.

Full Disclosure: Peridot Capital had no position in the common stocks of any home builders at the time of writing. However, clients of the firm do currently own positions in the debt securities of Pulte Homes, although positions may change at any time

More Housing Start Data from Hovnanian

After reading my housing starts post from yesterday, Hovnanian Enterprises (HOV) CEO Ara Hovnanian was kind enough to have his investor relations department send over some additional information on trends and demand for U.S. housing starts. Of course, we need to keep in mind that Hovnanian is a home builder, so they have a dog in this fight, but their data certainly jives with the other figures I have seen. Here are some of the more interesting data points included in their materials as it relates to what I wrote yesterday.

• Average U.S. housing starts since 1971 have been 1.6 million per year

• Demographers estimate new home demand of 1.7-1.9 million units per year going forward

• Prior cycles all showed housing start troughs of at least 1 million units per year (1975, 1982, 1991), compared with about half that level in 2009, indicating an over-correction during this current housing cycle

• Housing starts per capita have hit the 7th lowest level on record, with the prior six lows occurring during World War I, World War II, and the Great Depression

Now, one of the reasons we are likely seeing this "over-correction" in housing starts is due to the credit crisis and the huge number of foreclosed properties coming onto the market. Foreclosure filings are running at about 300,000 per month right now, which equates to more than 3.5 million foreclosed properties per year. As long as foreclosures are at such a high level, in my view, it is probably unlikely that housing starts could rebound to a more historically normal level. However, as the economy continues to improve and unemployment slowly drops, foreclosures will decline as well. At that point, there appears to be nothing in the demographic data that suggests that housing starts should not rebound to a level of at least 1.5 million annually over time, which is nearly three times greater than today's annual run rate.

Later this week I will post some information on the dozen or so large publicly traded homebuilding companies I have taken a look at and will highlight a few that I think represent excellent ways to play an eventual rebound in residential housing starts.

Full Disclosure: No position in Hovnanian Enterprises at the time of writing, but positions may change at any time

Is a Boom in U.S. Homebuilding Coming?

Crazy headline, right? At first I thought the same thing. After all, with nearly 10% unemployment and a flood of foreclosed properties hitting the market, why would anybody need to dramatically boost new home construction anytime soon? Last week I saw a statistic from a former Goldman Sachs economist that estimated new home demand in the United States (from the combination of new household formation and the replacement of old homes) of approximately 1.5-1.6 million units per year. Given that the U.S. population is around 300 million, this figure does not really stand out as being unreasonable, and it is in-line with other forecasts I have seen.

In the short term, current inventory combined with foreclosures, weak loan demand from the recession, and tighter credit standards all contribute to the fact that new housing starts in the U.S. today are near record low levels, coming in at an annualized rate of around 500,000 per year. At some point, however, it does seem likely to me that housing starts would have to begin to trend upward toward that 1.5 million figure, which is three times the current annual run rate.

Before you dismiss this potential need for new homes as being years and years away, consider the graph below showing annual U.S. housing starts from 1991 through 2009.

You can easily see the effects of the housing bubble (from the early 2000's through the 2005 peak of more than 2 million units), which resulted in home construction far outstripping demand (by 400,000-500,000 units if you use the 1.5-1.6 million base demand estimate). However, we also see if we ignore the bubble period that housing starts of 1.5-1.6 million per year would simply put us back to the level housing starts were in the mid 1990's, when the U.S. population was much lower than today.

Despite the foreclosure glut we have in many states nowadays, this chart makes me think that the current housing start rate of 500,000 or so per year really is not sustainable for any prolonged period of time. Such a thesis would lead one to consider analyzing the leading homebuilding companies to try and find some attractive long term investment opportunities. Accordingly, I will share some data and thoughts on specific companies with you once I conclude my work on the leading publicly traded U.S. homebuilders. Do you have any favorites, or do you think this investment thesis is unattractive?

Housing Market Stabilizing, As Long As Tax Credit Expiration in 2010 Does Not Halt Buying

For some reason I have not updated my long running home inventory chart in recent months, so I figured I would show the most recent data from the National Association of Realtors. As I have long discussed on this blog, inventories are the crucial part to the story because a balancing of longer term supply and demand is the only thing that will halt the home price decline for good.

As you can see below, inventories really took a turn for the better during the recently ended prime selling season (the data here is as of October 2009). The first-time homebuyer tax credit definitely played a big role in that, so the question going forward is "what happens when the extension of the credit expires in 1H 2010?"

I think sales will certainly slip at that point, but if the economy is growing, monthly job gains come to fruition by then, and consumer confidence is reasonable, there is a good chance inventories might not see another large spike higher. In that case, I believe we will see home prices stable in 2010. Long term, home owners should expect historically normal appreciation, which means about 3% annually.

Investors' Thirst for U.S. Government Debt Yet To Be Quenched

We have been hearing warnings for years. Just wait until China stops buying our debt... the borrow and spend cycle in the U.S. will come to a grinding halt. Since the Obama Administration has already spent about $1.4 trillion (~$800 billion on stimulus and ~$600 billion on a down payment for healthcare reform), these calls are growing ever more prevalent.

Of course, China will continue to have excess cash reserves that need to be invested, and they only own a fraction -- less than 10 percent -- of the total U.S. debt outstanding (contrary to the widespread belief that they effectively own the United States), but it is not unreasonable to think demand would drop a bit as we continue to borrow money. The interesting thing, however, is that demand for U.S. debt is showing no signs of slowing down.

Part of the reason the stock market is doing so well today (Dow up 150 with less than one hour of trading left to go) is because we got the results of yet another U.S. debt auction and it went very well. The U.S. successfully sold $27 billion of seven-year notes with strong demand.

Demand can easily be gauged by what is called the "bid to cover ratio" which simply tells you how many dollars of bids were submitted for each dollar of debt that was auctioned off. Today's note offering registered a bid to cover of 2.82 so we received $76 billion of bids for only $27 billion of notes.

Are we paying through the nose for this money? Not exactly. The yield on the 10-year bond right now is around 3.5% or so. I wish I could borrow money for 10 years at 3.5%. Not only is the government trying to do so, but it is finding great success even in this fiscal environment. To me, that bodes well for the future of the United States.

Contrary To Media Reports, Rising Housing Starts Are Not A Good Sign

From the Associated Press this morning:

"Construction of new homes jumped in May by the largest amount in three months, an encouraging sign that the nation's deep housing recession was beginning to bottom out. The Commerce Department said Tuesday that construction of new homes and apartments jumped 17.2 percent last month to a seasonally adjusted annual rate of 532,000 units. That was better than the 500,000-unit pace that economists had expected and came after construction fell in April to a record low of 454,000 units. In another encouraging sign, applications for building permits, seen as a good indicator of future activity, rose 4 percent in May to an annual rate of 518,000 units. The better-than-expected rebound in construction was the latest sign that the prolonged slump in housing is coming to an end, which would be good news for the broader economy."

Pretty lousy analysis if you ask me. It is true that more construction will show up in GDP calculations as so-called "economic growth" but the idea that growth in housing starts is good for the housing market and means the housing recession is coming to an end is completely wrong.

In case the AP hasn't noticed, housing prices are cratering due to a supply-demand imbalance. When supply exceeds demand, prices drop (economics 101). It is widely believed (and I agree) that a bottom in housing prices (and therefore an end to the housing recession) is needed before the U.S. economy can really begin a sustainable recovery (such an event would boost consumer confidence and spending, and help the banks feel better about extending credit). In order for home prices to stabilize, we need the supply-demand picture to balance out.

How will supply and demand meet if we build more supply when the problem has been (and continues to be) an excess supply of unsold homes? They won't, which is why a pick up in housing starts will only serve to prolong the housing recession, not help to curb it. Hopefully the pick up in May is a one month phenomenon.