US Housing Sector: Micro Foundation, Macro Realities

The mild mid summer bounce in sales activity inside the housing sector has stimulated broad market discussion around whether a bottom is forming in the market. Price declines in some major markets have turned around over the past two months and in other major markets they are falling at a slower pace. Combined with the starts data, which we believe is close to finding a bottom; this is the first glimpse of positive news in the sector for quite some time. Although, these developments provide a potential turning point we believe that conditions for stabilization in the housing sector are not ripe at this time.
The major issue looming over the housing market is the continuing problems at Fannie Mae and Freddie Mac. The twin GSE's guarantee over 70% of all mortgages currently originated in the financial sector and to be blunt, at this time the financial system cannot properly function without them.
We have consistently since the start of the crisis around Fannie and Freddie made known our preference for the orderly privatization of the two government behemoths after the credit crisis abates. But, without the government either providing cash as a backstop to them or nationalization at this point the probability of stabilization of the housing sector in the near term is low.
Second, the inventory levels in stock of new homes and existing homes stands at 10.1 and 11.2 months respectively. While prices have adjusted, it has not been sufficient to begin clearing inventories. To make matters worse, foreclosure rates in the Alt-A and prime categories is beginning to pick up. Our forecast is that home prices in the aggregate will have to fall another 10% to begin to move back toward stable equilibrium levels between 4-6 months.

Moreover, when one looks at the spread between the ten year treasury and the thirty year fixed mortgage rate one notices a 248 basis point gap, which is far between the 170-180 basis point spread typical during the last stable era in the housing market during the late 1990's. With rates actually higher than they were one year ago when the meltdown in the mortgage market began we believe that there is more room to the downside in the housing market ahead.
Perhaps, more interesting is the behavior shift among potential buyers. During the height of the mania the expectations of many homeowners were shaped to believe that 20% returns per annum was the norm. This led to the unsustainable extraction of home equity and is one of the primary reasons so many individual find themselves under water on their mortgages.
Today the pendulum has swung back in the other direction. The mean reversion occurring in the pricing of real estate assets is on its way to overshooting a bit, and now many potential homeowners that remain on the sidelines have expectations of potential losses should they enter the market prematurely.
Housing sales have picked up midyear, as one would normally expect during the summer months. Yet, we think that the market may be making a bit too much out of the slight improvement in the data. The housing market will eventually turn. But that is unlikely to occur in 2008 and we do not expect to observe it until prices fall another ten percent. Until the problems at Fannie and Freddie are resolved and prices adjust further to being clearing the outsized inventory on the books and that on the way due to the coming wave of foreclosures in the Alt-A and prime categories, the discussion regarding a bottom forming in the housing sector is all but prologue.
Joseph Brusuelas
Merk Hard Currency Fund
http://www.merkfund.com/
The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard Currency Fund. Foreside Fund Services, LLC, distributor.