Today’s guest post comes from David J. Merkel, CFA, FSA. David is Chief Economist and Director of Research of Finacorp Securities. Previously, he has been a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Asset Liability manager after working with F&G Life, Provident Mutual, AIG and Pacific Standard Life. Merkel holds bachelor’s and master’s degrees from Johns Hopkins University.
He writes daily commentary at Aleph blog.
Dave hits on a subject that has been a favorite of pundits a lot lately — what will it take for Housing to bottom . . .
This piece completes a series that I started RealMoney,
and continued at my blog. For
those with access to RealMoney, I did an article called The Fundamentals
of Market Tops, where I concluded in early 2004 that
we weren’t at a top yet. For those without access, Barry Ritholtz put a large portion of it at his blog. I then
piece at RM applying the framework to residential housing in mid-2005,
and I came to a different conclusion: yes, residential real estate [RRE] was
near its top. Recently, I posted a piece a number of readers asked me to
write: The Fundamentals
of Market Bottoms, where I concluded we weren’t yet at a bottom for the equity markets.
This piece completes the series for now, and asks whether we are at the bottom for RRE
prices. If not, when, and how much more pain?
Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are different. The
signals for a bottom are not automatically the inverse of those for a top. Tops and bottoms for RRE are different
primarily because of debt investors. At market tops, typically credit
spreads are tight, but they have been tight for several years, while seemingly
cheap leverage builds up. There is a sense of invincibility for the RRE
market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.
As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.” The
same is true of RRE and that is what differentiates tops from bottoms. At
tops, no one cares about the level of debt or financing terms. The rare
insolvencies that happen then are often due to fraud. But at bottoms, the
only thing that investors care about is the level of debt or financing terms.
Why Do RRE Defaults Happen?
It costs money to sell a home – around 5-10% of the sales price. In a
RRE bear market, those costs fall entirely on the seller. That’s why economic incentives for the
owners of RRE decline once their equity on a mark-to-market basis declines
below that threshold. They no longer have equity so much as an option on the equity of the home, should they
continue to pay on their mortgage and prices rise.
As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 12%. It may go as high as
20% by the time we reach bottom.
Defaults occur in RRE when there would be negative equity in a sale, and a negative life
mortgage payment rise from a reset or a recast
The negative life events, which,
aside from changes in mortgage payments, can’t be expected, cause the borrower
to give up and default. During a RRE
bear market, most people in a negative equity on sale position don’t have a lot
of extra assets to fall back on, so anything that interrupts the normal flow of
income raises the odds of default. So
long as there are a large number of homes in a negative equity on sale position,
a certain percentage will keep sliding into foreclosure when negative life
events hit. For any individual, it is
random, but for the US as a whole, a predictable flow of foreclosures occur.
Examining Economic Actors as We near the Bottom
Starting at the bottom of the housing “food chain,” I’m going to consider how various
parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve
policy is loose, and the yield curve is very steep. Financial companies, if they are in good
shape, can profit from lending against their inexpensive deposit bases.
This presumes that the remaining banks are in good shape, with adequate
lend. That’s not true at present. Regulation has moved into triage
the regulators divide the institutions into healthy, questionable, and
dead. The bottom typically is not reached until the number of
questionable institutions starts to shrink. Right now that figure is
growing for banks, thrifts, and credit unions.
The Fed’s monetary policy can only stimulate the healthy institutions.
time, many of the questionable will slow growth, and build up enough
assets to write off bad debts. Those free assets will come through
capital raises and modest profitability. Others will fail, and their
assets will be taken over by stronger institutions, and losses realized
by the FDIC, etc. The FDIC, and other insurance funds, will
have their own balancing act, as they will need to raise premiums, but
not so much that it harms borderline institutions.
Another tricky issue is the Treasury-Eurodollar [TED] Spread. Near
the bottom, there should be significant uncertainty about the banking
and the willingness of banks to lend to each other. Spreads on
corporate and trust preferreds should be relatively high as well. Past
the bottom, all of these spreads should
be rallying for surviving institutions.
Financing for purchasing a house in a RRE bear market is expensive to
nonexistent, but the underwriting is strong. At the bottom, volumes
increase as enough buyers have built up sufficient earning power and
savings to put a decent amount down, and be able to comfortably finance
the balance at the new reduced housing prices, even with relatively
high mortgage rates relative to where the government borrows.
Many other players in RRE financing will find themselves stretched, and some will be broken. Consider these players:
1) Home equity lenders will be greatly reduced, and won’t return in size until well after the bottom is
2) Many unregulated and liberally regulated lenders are out of business. The
virtue of a strong balance sheet and a deposit franchise speaks for itself.
3) Buyers of subordinated RMBS have been destroyed; same for many leveraged players
in “high quality” paper. Don’t even mention subprime; that game is over, and may even be turning up now as vultures
pick through the rubble. This has implications for MBIA, Ambac, and other financial
guarantors, since they guaranteed similar business. How big will their losses be?
4) Mortgage insurers are impaired. In earlier RRE bear markets, that meant earnings went
negative for a while. In this case, one has failed, and some more might fail as well.
5) Do the GSEs continue to exist in their present form? That question
never came up in prior bear markets, but it will have to be answered
before the bottom comes. Will the FHLB take losses from their mortgage
holdings? Will it be
severe enough that it affects their creditworthiness? I doubt it, but
anything is possible in this
down cycle, and the FHLBs have absorbed a lot of RRE mortgage financing.
6) Securitization gets done limitedly, if at all. This is already true for non-GSE-insured loans; the question is how much Fannie and Freddie will do.
My suspicion is near the bottom, as loan volumes increase, banks will
be looking for ways to move mortgages off of their balance
sheets, and securitization should increase.
7) The losses have to go somewhere, which brings up one more player, the US
Government. Through the institutions the US sponsors, and through whatever mélange of programs the US uses to directly
bail out financially broken individuals and institutions, a lot of the pain
will get directed back to taxpayers, and, those who lend to the US government
in its own currency. It is possible that foreign lenders to the US may rebel at some point, but if the OPEC nations in
the Middle East or China haven’t blinked by now, I’m not sure what level of
current account deficit would make them change their policy.
That said, the recent housing bill wasn’t that amazing. Look for the US Government to try again after the election.
A Few More Economic Actors to Consider
Now let’s consider the likely actions of parties that are closer to the building
and buying of houses.
1) Toward the bottom, or shortly after that, we should see an increase
in speculative buying from investors. These will be smarter speculators
than the ones buying in 2005; they will not only not rely on capital
gains in order to survive, but they require a risk premium. Renting the
property will have to generate a very attractive return in order to get
to buy the properties.
2) Renters will be doing the same math and will begin buying in volume
when they can finance it prudently, and save money over renting.
3) At the bottom, only the best realtors are left. It’s no longer a seemingly “easy money” profession.
4) At the bottom, only the best builders survive, and typically they
trade for 50-125% of their written-down book value. Leverage declines
significantly. Land gets written down. JVs get rationalized. Fewer
homes get built, so that inventories of unsold homes finally decline.
As for current homeowners, the mortgage resets and recasts have to be past the peak at the bottom, with the end in
sight. (In my piece on real estate market tops, I suggested that after the bubble popped “Short rates
would have to rally significantly to bail these borrowers out. We would need
the fed funds target at around 2%.” Well, we are there, but I didn’t expect the TED spread to be so high.)
5) Defaults begin burning out, because the number of the number of
properties in a negative equity on sale position begins to decline.
6) Places that had the biggest booms have the biggest busts, even if
open property is scarce. Remember, a piece of land is not priceless,
but is only worth the subjective present value of future services that
can be derived from the land to the marginal buyer. When the marginal
buyers are nonexistent, and lenders are skittish, prices can fall a
long way, even in supply-constrained markets.
For a parallel, consider pricing in the art market. Many pieces of art
are priceless, but the market as a whole
tends to follow the liquidity of the rich marginal art buyer. When
liquidity is scarce, prices tend to fall, though it is often masked by
a lack of trading in an illiquid market.
When financing expands dramatically in any sector, there is a tendency
for the assets being financed to appreciate in value in the short run.
This was true of the Nasdaq in the late ’90s, commercial real estate
in the mid-to-late 1980s, lesser-developed-country
lending in the late ’70s, etc. Financing injects liquidity, and
creates confidence in the short run, which can become self-reinforcing,
the cash flows can’t support the assets in question, and then the
become self-reinforcing on the downside, as buying power collapses.
The Bottom Is
Coming, But I Wouldn’t Get Too Happy Yet
are reasons to think that we are at or near the bottom now:
• What little lending is being done is being done on relatively sound terms.
• Securitization has slowed dramatically.
• The major homebuilders do trade for 50-125% of book value, generally. The question is how much remains to be
But I don’t think we are there yet, and here is why:
• Foreclosures are still increasing.
• The inventory of
unsold homes continues to rise. At the bottom, inventories will have started to shrink, but are not yet
to normal inventory levels. (There is
also significant dark supply, or shadow inventory as well.)
• The inventory of depository financial institutions in trouble continues to rise. Regulatory triage is only
• The future of the GSEs, mortgage insurers, and financial guarantors are still up in the air.
• The US Government will try some more policy ideas after the election.
• We aren’t seeing a lot of speculative buying yet.
• The biggest booms have had the biggest busts, but affordability is yet to be restored in what were the hottest markets.
My best guess is that we are two years away from
a bottom in RRE prices, and that prices will have to fall around 10-20%
from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is
projecting a 25% decline.
Not all of the indicators that I put forth have
to appear for there to be a market bottom. A preponderance of them
appearing would make me consider the possibility, and that is not the
Some of my indicators are vague and require subjective judgment. But
they’re better than nothing, and keep me in the game today. Avoiding
the banks, homebuilders, and many related companies has helped my
performance over the last three years. I hope that I — and you — can do
well once the bottom nears. There will be bargains to be had in
housing-related and financial stocks.
Good stuff, Dave — thank!