The housing bears are right, but prices will go up anyway

Spring of 2012 saw a chorus of housing bulls loudly proclaim the arrival of the recovery. All dissent was squelched as the conversation of housing evolved from debating whether or not the market had bottomed to what form the recovery would take. I’ve never seen such a coordinated effort among journalists to influence public opinion and bolster consumer confidence. Perhaps they think they have a duty to the market. I feel I have a duty to the truth.

The bears have not completely gone away. Zero Hedge, Barry Ritholtz, Keith Jurow, and Mark Hansen have remained bearish, and they provide some of the most compelling bearish arguments in the national conversation today. Some of the bulls (like the NAr) dismiss the bears and their arguments without debating their facts or their bearish interpretations. Obviously, those bulls don’t warrant much respect or consideration. Of those who do address their arguments, a consistent theme emerges: The bears facts are mostly correct, and house prices should fall as a result, but prices won’t fall because other factors will intervene.

So what are these other factors that will intervene and prevent a price collapse? It boils down to supply management. There is still an enormous amount of distressed supply in the market. The numbers are debatable, but few of the bulls debate the supply is there and that if it were released in an uncontrolled manner, prices would crash — hard. Therefore, the bulls point to supply management conditions and techniques as the reason prices will go up despite the huge overhang of distressed supply.

Four reasons house prices won’t crash

First, lenders are not being forced to liquidate. The suspension of mark-to-market accounting relieved any pressure on lenders to clean up their balance sheets. Lenders can continue to show loans on their books at any value they want, and they can even book phantom income on the interest payments they are supposed to receive but don’t. Lenders don’t have to recognize these losses until they foreclose on a property, and that provides them a huge disincentive to foreclose. So with no compelling reason to foreclose and some strong incentives not to, lenders are allowing millions of delinquent mortgage squatters to stay in their homes making no payments at all.

Second, lenders face almost no costs to carry non-performing loans on their books. Usually, lenders go bankrupt if they have a large number of non-performing assets because the cost of capital eats them up. Lenders have to borrow money from depositors and bondholders in addition to its equity capital in order to make loans. If lenders had to pay interest on these loans they take out, the cost would wipe them out. However, since the federal reserve lowered interest rates to zero, banks can borrow as much as they want for nothing from the federal reserve, and as a result, interest paid to depositors has fallen to near zero. Without financial pressure to remove non-performing loans from their balance sheets, lenders can carry the squatters indefinitely.

Third, mortgage interest rates are low and likely to stay that way. Low mortgage rates makes for excellent affordability, and it gives more people the ability to buy homes. As long as interest rates remain this low, the buyer pool should grow larger. Right now, most of the growth in the buyer pool is coming from hedge funds, but eventually more owner-occupants will return to the housing market. Some will emerge as people go back to work, and some will be recycled as they regain good credit after a foreclosure or short sale. The key here is that interest rates must remain at near record-low levels while the distressed inventory is liquidated. This was a big sticking point for me until Ben Bernanke came out and pledged to buy $40 billion of mortgage-backed securities every month for as long as it takes to turn around the housing market and reduce unemployment. With an open-ended stimulus guarantee in place, the risk of crumbling affordability reversing prices is taken off the table.

Fourth, withholding inventory is working. In a normal market, thousands of individual owners control the supply. However, once prices crashed and borrowers owed more than their mortgage balances, they required lender approval for a sale — an approval the lender can and does deny. Also, crashing prices and toxic mortgages caused so many borrowers to default that lenders began foreclosing and acquiring a large inventory of REO. Between the sales they must approve and the properties they directly own, lenders and government entities own or control a huge portion of the housing stock. With such control comes the ability to act as a cartel and manipulate price — and they have. In fact, in 2012, they have been quite successful at withholding inventory as evidenced by 40% or more reductions in for-sale inventories across most of the Southwest. A small uptick in demand, mostly caused by investors, coupled with a huge decline in supply has forced prices to move higher. It worked. And most bulls believe it will continue to work. That’s why despite the fact that the bears are right, prices will go up anyway.

Calculated Risk recently wrote a post, Zillow Housing Forum and The Bearish View, examining the bearish view more carefully. Although he quibbles with some of the numbers Mark Hansen arrives at, he doesn’t dismiss the validity of his basic arguments.

Two months ago I wrote: House Prices and a Foreclosure Supply Shock. In that post I argued the peak of the foreclosure supply shock is behind us, and that suggests prices have probably bottomed. I think the coming modification redefaults and current delinquencies will keep prices from rising quickly, but I don’t think this will push house prices to new lows. There are still large problems to work through, but nothing in Hanson’s discussion changed my views on housing.

Realistically, the only thing that will change Bill’s mind would be a dramatic and unexpected influx of supply that pushes prices down. In other words, he will believe he’s right until he’s proven wrong. So be it. At this point, I agree with him. If the conditions I outlined above persist, it doesn’t matter how dire the numbers are or how correct the bearish view is; prices will not go down as long as inventory is released to the market in a controlled manner. Perhaps in a few years the lending cartel might lose control of the market, but by then, sufficient owner-occupant demand will likely be present in the market to absorb more inventory. It’s a difficult time to be a housing bear.

Each month we tear apart the monthly housing resale and new home sales data in search of items consistent or inconsistent with the consensus view that US housing is experiencing a “full blown, durable recovery with escape velocity and v-bottom that will last for years”. …

I question whether or not even the bulls believe we have hit a V-bottom with escape velocity. The escape velocity part certainly isn’t happening. California home sales fell 16.5% in September, and U.S. Weekly Mortgage Application Volume Drops 14% last week. The market apologists will dismiss this as a normal seasonal drop, but I think we all know it isn’t. Seasonal declines are not near that large.

While the August Existing Sales headline print released last month looked great the internals say something more sanguine.  As such, I believe a demand hiccup (stimulus payback) is here;  right as the rates stimulus, weather, and supply headwinds hit full force and last for a year.As follows I will quickly review the data that has me looking looking elsewhere than “recovery” for answers and should have perma housing bulls overweight this sector looking at a hedge or three.

Data Overview

  • Housing Demand by Buyer Cohort…very forward looking. Points to significant demand slowing here and now
  • A Serious Negative...Investors volume NEGATIVE YoY
  • A closer look at the Demand equation…First Timers and Investors Flat to Lower / Repeats driving this market until they go away as well in the off season
  • Builder Sales – Not as “Robust as Headlines would have you believe
  • Santa Clara County…past 7-years pending sales. Closing in on record lows

This one caught my attention because it demonstrates that withholding supply may cause prices to go up, but it also causes sales volumes to plummet.

  • Phoenix Home Sales Demand Paralysis…the Epitome of a “stimulus hangover”
  • “Lost” Vegas single family and condo sales at record lows for September
  • Gas prices have been at record highs for weeks now. In CA they broke to $5 in recent days.
  • Record Low Supply…a function of never ending foreclosure process delays and 6 million mortgage mods created in the past 2.5 years, which in structure, are worse than Subprime loans ever were;  and 50% of all mortgage’d homeowners being zombies.
  • House price gains…a function of the Fed Twist Ops plunge in rates of 150bps YoY increasing “purchasing power” by 15%
  • The one bright spot…but it’s transitory – Organic Repeat Buyers will go away as quickly as they came

Item 1)  Housing Demand by Buyer Cohort…very forward looking. Points to significant demand slowing here and now

a)  First-Timer demand went flat in May and have remained there for months.  Shows house prices already out of whack with flat incomes of first timers

This is not necessarily true. Affordability is actually quite high. The lack of first-timer demand is largely a result of high unemployment and a seriously diminished buyer pool. If employment picks up, so will the first-time buyer demand.

b)  Investor demand DOWN YoY in August.  This cohort won’t come back until Foreclosures start churning back up.  Remember, if Foreclosures triple I will be bullish housing.

This is a big deal. The big hedge funds pulled out of Phoenix as they’ve already driven prices up about 30% off the bottom, and the returns don’t make sense any more. They will return if prices drop, but I foresee a big decline in Phoenix area sales until the first-time homebuyer demand comes back. I expect to see a strong increase in prices in Las Vegas over the next year or two until prices there reach the same investor return thresholds where the hedge funds lose interest.

c)  Repeat Buyers carrying this market…a temporary phenomenon.  Low rates and ample supply at mid-to-high end has drawn out years of pent-up supply.  But this cohort is thin and weak relative to any time before in history, as over 50% do not have the equity in their present house to sell and rebuy or the credit to get a loan.

Ordinarily, the buyers from three to fifteen years ago would be taking the equity from their starter homes and buying a move-up property. That demand is almost entirely absent from the market. Many of these buyers are underwater and have no equity through a combination of bad timing and rampant HELOC abuse. Any strength we see in this market today is entirely due to low rates and restricted supply. Even the smallest supply shock will create air pockets. If there are good deals to be found in the market over the next few years, it will be at the first level move-up price points ($650,000 to $1,000,000 in Orange County).

d)  Repeat buyers driving the market bodes ill for the off-season when they go away.  That’s because last year’s off-season was strong on Twist, lack of rain and snowfall, and inventory.  These all become headwinds in Q4.

“August Existing Home Sales” — that resulted from purchase and pricing decisions made in June and July — were stronger than expected.  One could call the report a “breakout” if this exact thing didn’t happen last August to an even greater extent.  Then in September 2011 sales dumped 15% MoM even as rates plunged 150bps from the Fed’s Twist ops.  If sales drop 21% this month then they go negative YoY and remain negative for the next 12 months at least.

Sales didn’t drop the 21% he feared, but 16.5% is still pretty bad.

Bottom line, the August Existing Home Sales consensus ‘beat’ came exclusively from a late season surge in “repeat” buyer ‘closings’.   This is unsustainable…they are a seasonal cohort.   Moreover, I think much of this has to do with short sales closing not only ahead of the school year but the Bush 2007 Mortgage Relief Act fiscal cliff.

I strongly suggest reading Mark’s post in full. He has some great charts and makes a strong case for a decline this fall and winter stretching into next year.

Mark makes a very strong case as to why house prices should fall. However, unless inventory gets on to the MLS, prices will not fall. It’s really that simple. Right now, it looks like lenders will continue to successfully limit the available inventory and keep prices up. How long that lasts is anyone’s guess. Banks show no signs of changing their policies.