Short Housing for the Long Term

Market conditions make shorting the home builders and their cousins - suppliers, Home Depot (HD) et al - very difficult in the short run. In the long run, housing in the US will be permanently different, the ongoing profitability of these companies is in question and several of these outfits are going under. For sure and for certain.

Housing is a wreck and compared to market expectations, getting worse. Why does this matter so much?

• Housing has been, for more than two generations, the segment of the economy the Fed could manipulate through interest rate management and in turn stimulate the economy when needed. This is no longer the case -- even with recent increases mortgage rates are very low, with no discernible impact on the sector or economy.
• Housing, for the past two decades, had been a growing source of credit for consumers and in the past five years was virtually the piggy bank of the consumer through the increased use of home equity credit lines. This is no longer the case - with so many homes under water, 67% of mortgage holders have less than 15% equity in their homes at yearend 2008 home values, credit standards are tightening and banks are, in general, pulling back.
• Housing continues to be the largest single component of credit exposure for banks quasi-banks, government supported banks and any other bank you can think of - and the quality of these assets is declining minute by minute. As long as housing suffers, and asset quality not only does not improve but declines, the banks will continue to reserve too little and lend too little to add to reserves.

Why do I think housing is in the tank for the long term?

First, I listen to people smarter than I am - a key to success from investing to recreation league baseball. When my rec team had its first losing season - after twelve consecutive great seasons (two per year) I did the logical and hired a professional coach. They were winners the next season. Ditto for analyzing stuff - and I follow Ivy Zelman and Whitney Tilson. They have been dead on about the mortgage meltdown - and see a larger one coming.

Listening to them, reading data and being objective has led me to see the key to a rebound in housing is clearing inventory - too much supply and too little demand, and since lower than five percent interest rates have not spurred buying, supply is the issue. Supply comes from the sale of existing homes, the sale of new homes, and the sale of foreclosed homes.

• Typically ten to fifteen percent of Americans sell or want to sell their home in a given year. Recent survey data shows the number is now 30%. Keep that in mind.
• New home sales are incredibly low. Market wisdom said home building stocks would rise once the new housing start rate hit a million and inventory became tight. New home starts are roughly half of that and there ain't no rebound. As the poet said, times, they be a changing.
• People are not selling, and builders are not building, not just because people are not buying - it is because prices are low and going lower and the driver here is foreclosures. Data can be found here, there and everywhere but the salient data points are a) banks are accelerating foreclosures, b) the next wave of resets of mortgages, the cause of most foreclosures, does not peak until the summer of 2011, c) banks are already sitting on more than half a million homes they have not listed for sale, and the whopper is d) the New York Times has reported that there are nineteen million empty housing units and only six million are listed for sale.

This last point, when combined with another couple of million foreclosed homes, then with desire for people wanting to sell their home as soon as they can, means excess inventory for as far as the eye can see. I originally projected housing prices would, nationally, bottom at the end of 2011 and prices would begin to pick up in mid 2012. I may have been premature. With resets peaking in mid-2011, defaults will probably peak in early Q4 2011; this means foreclosure listings will peak in mid-summer 2012, after the peak selling season, not good for managing down inventory. Assuming demand picks up - a near heroic assumption at this time as interest rates will be higher and unemployment could be the same or higher at that time - you will start to see inventory declining in a meaningful way until 2013 at the earliest.

I have focused on supply - was I too cavalier about demand? Well, that is more problematic - resets, defaults and foreclosures are fourth grade math and although the only thing I knew about housing was my own mortgage before this mess started, I can do fourth grade math and every forecast I have made about foreclosures and inventory has been right within a 30-45 day period.

Using fourth grade math as our primary tool does have value in estimating demand. Roughly 40% of demand in the peak year - 2006 - was sub-prime or near sub-prime - and these buyers are out of the market for a considerable period of time. And a very large percentage - some analysts estimate as high as a third - of all sales were for investment and second homes. Most of this demand is gone for the foreseeable future. Add tightening credit standards, recession ravaged incomes and personal balance sheets, and a new frugality and it is hard to see demand in 2013 or 2014 climbing past 50% of demand in 2006. Even if the FHA does not go bust - which it will, requiring another Treasury bailout.

You will notice I am not using specific point estimates - that is an analyst's game. I am a stock picker and options guy - mostly on the short side. And I make recommendations based not on absolute values but change - the relative movement of a stock or segment against other segments, the market and Wall Street expectations.

I recently had lunch with a very smart - truly - Wall Street type economist who mostly follows Uncle Sam and his cousins for institutional clients - and he is very good at what he does. He has been doing this for thirty years and I made this argument. He disagreed, I laid on the New York Times reported estimate of thirteen million vacant, unlisted dwellings and he laughed, waving his hand - and then stopped himself. "You know, I own two places that are vacant, I will sell but have not listed because prices are too low. My old place at the beach and my mother's place in Miami." Not investment properties - just properties waiting for a market comeback.

He also predicted the economy would bottom in Q4. We were having lunch at the Palm and as we left he looked around - it was a Thursday, second busiest day of the week - and noticed something. "I have never seen this place so empty." I punched him lightly in the arm and said, "can't wait for that recovery pal."

So, what to short?

Short term, traders are beginning to get weary of waiting for a rebound and short interest in many homebuilders is increasing driven this week by the sharp rise in mortgage rates. So, pick a publicly held homebuilder and take a look at the chart. Toll Brothers (TOL) and KB Homes (KBH) have weak balance sheets the shorts like. Longer term - two to eight quarters - play almost any of them or buy puts on the homebuilding index, the XHB.

Their suppliers have been crushed - Louisiana Pacific (LPX) and Masco (MAS) are the two big names. Check them out also - short interest is increasing and Masco's net cash - cash plus liquid securities plus accounts payable (assuming they will be paid) minus accounts receivable - wouldn't fill my gas tank for too long.

Comments

[Mad Hedge F...:]

You have my vote. That great sucking sound you hear is the air going out of the housing recovery- punctured by the collapse of the bond market and the spike in interest rates. Interest rates on 30 year fixed rate mortgages gapped up from 5.03% to 5.29% in just one day, up from the 4.50% low two months ago. This underlines what a difficult position the government is now in. While all the stimulus spending is great, the need for epic financing is triggering a collapse of the dollar and the bond market. The resulting soaring interest rates are bound to snuff out any recovery. Obama is truly caught between the Scylla and the Charybdis. (non antiquities scholars see Homer’s Ulysses).

Jun 02 10:01 AM

[History Buf...:]

Michael,

As your anecdote from the restaurant illustrates, smarts is not a substitute for observation. You knew the housing stats and he didn't. Once you pointed it out to him and he noticed how empty the restaurant was, he had an "aha!" moment.

If you see something, and you hear something, and you smell something, you don't have to be smart to figure out something is there!

I've given up trying to short this market. With all the hocus-pocus and government money and stupid money sloshing around, I'm long precious metals with a toe in the water for oil. Sooner or later the bull will hit the fan, the tide waters will recede again, and we'll see who's not wearing their knickers.

Jun 02 10:20 AM

[HardwoodFlo...:]

I'm not in agreement with many of your statements but do agree with your sentiment. The reality is that the housing of the future does not include the "Wall Street" builders. It is back to the future in housing, small "mom and pop" shops building to suit for "real" customers who have construction loans in hand.

The big builders created this mess by assuring wall street that they could do a better job than the "mom and pop" shops because they had in-house economists and market researchers who would prevent them from over building a market- well we all know how that turned out.

Moreover, the days of the Mc Mansion are a thing of the past. People will be building for what they need, not what they perceive they need. This will affect the big builders in this way. It cost a big builder relatively the same amount of money to build a 3,000 square foot home as it did a 5,000 square foot home. But they still got $200 a square foot so their price per unit went up turbo charging their revenues. This will not be the future so they will have to sell more units at less margin to carry over head and in a compressed market this will have a compounded effect as margins are narrower and market is smaller.

Jun 02 10:42 AM

[HardwoodFlo...:]

On the supply side I think your right on MASCO but wrong on LP. The reason is that so much lumber, plywood, OSB production has been stripped from the market that these companies like Weyerhaeuser are super charged for the recovery. CME lumber is up 15% in the last week because so much production has been stripped out.

MASCO has a stupid business plan and the products are garbage. People will be more design oriented in the future and that's not good for MASCO. Also- I think Shaw, Mohawk, Armstrong are not positioned well for the next housing market. They are set up for the old market just like MASCO was.

Jun 02 10:47 AM

[FLbuilder:]

You are right to be bearish on the new home builders.

However you cant say that TOL has a bad balance sheet. How do you support that argument. Out of all the public homebuilders, they have propbably one of the top 3 balance sheets. How many of the builders have as much cash as debt on there balance sheet. MDC, TOL, and NVR.

Pleaese dont make uneducated comments because they diminish an otherwise accurate article.

Jun 02 11:31 AM

[Vito Boscaino:]

As a real estate professional I agree completely with the assessment here. The market is very soft, and in fact has gotten softer in the last couple of months. Job losses create further job losses, and this trickle down impact is just starting to be seen in late payment rates and defaults. Banks are trying to hide repo's anywhere they can as a means to try to put the best light on what must be horrendous capital structures for many of these institutions. With financing costs begin to increase (a logical outcome since the Fed can only manipulate the markets so long to try to artifically depress rates) buyers will face further pressure and sales rates will continue to decline. This is definitely a snowball still working it's way down the mountain, certain to turn into a much worse avalanche before this situation starts to settle down and trun around.

Jun 02 11:31 AM

[HardwoodFlo...:]

Correction on CME lumber. Last week it was at $175 today $207. That's a 20% climb. Production is at it's lowest levels since the 1930s.

Jun 02 12:04 PM

[Tobin's Q:]

RE: your basketball team. Beware the fallacy of intervention. It leads down a dangerous and costly road.

Jun 02 01:02 PM

[OptimizedPrime:]

Your poor friend. A super-star expert when it comes to Other People's Money but dumb as trailer trash with a subprime when it comes to his own money.

If he wasn't self-delusional, he would know the following about his other houses:

1. NOW IS THE BEST TIME TO SELL. Prices are low, but they are going lower. Remember when you stayed in CSCO when it was 50 because you thought it would go back to 80 "soon". Never did. Never will. Never. It went to 20 and stayed there. Sell now before all-out panic takes over.

2. PRICES ARE NEVER "COMING BACK". Bubbles do not re-inflate. We're never going to see the the prices we saw in the past. Prices will come down to 50-60% off peak and stay there FOREVER inflation adjusted*.

* Praying for inflation to take care of your underwater loan? Think again. First, we're in the most deflationary environment the world has ever seen. Second, inflation would be an act of war (seriously) against our nuclear-armed creditors; third, even the HINT of inflation will absolutely SLAUGHTER the housing market since it will drive interest rates through the roof.

Surely your friend is smart, but even the smartest can suffer from self-delusion.


OP

Jun 02 01:03 PM

[Mad Hedge F...:]

Here is the better play. Those fortunate few who took my advice to go long lumber futures (www.madhedgefundtrader... ) can now go out and build a bonfire to celebrate. Since then the homebuilder’s favorite commodity has rocketed by 35% to $200. The biggest producers, Weyerhaeuser (WY), Rayonier (RYN), or Louisiana Pacific (LPX) have also done well. The last gap up was prompted by more mustard seeds that the housing market may have hit bottom. The enormous subsidies offered to first time buyers is also helping eat into inventories. After seeing similar Chinese inspired moves in copper, crude, and coal, this is further proof of the beginning of a much broader, long term bull market in commodities.

Jun 02 04:33 PM

[Dan in mpls:]

I think China et al know their US bonds are going south. I do believe we wil have inflation that will double the price of housing in 10 years give or take. It is the only way out.

Jun 03 12:15 AM

[twaite90:]

I do not know why people here are so negative about housing. CA is booming. Ask any real estate agent in california, they will tell you, housing is up, passed the bottom already.

Jun 03 03:00 AM

[Daniel Herkes:]

They are selling foreclosures.


On Jun 03 03:00 AM twaite90 wrote:

> I do not know why people here are so negative about housing. CA is
> booming. Ask any real estate agent in california, they will tell
> you, housing is up, passed the bottom already.

Jun 03 05:35 AM

[Wez:]

Haaa, keep dreaming buddy. "Ask any real estate agent..." now that's a great source of unbiased information.... Btw, I have a real estate license, CA is a disaster.


On Jun 03 03:00 AM twaite90 wrote:

> I do not know why people here are so negative about housing. CA is
> booming. Ask any real estate agent in california, they will tell
> you, housing is up, passed the bottom already.

Jun 03 10:16 AM

[crawlars:]

Of course that is what is said. Do not out too much faith in the transaction-dependent.


On Jun 03 03:00 AM twaite90 wrote:

> I do not know why people here are so negative about housing. CA is
> booming. Ask any real estate agent in california, they will tell
> you, housing is up, passed the bottom already.

Jun 03 11:36 AM

[Dave T:]

Hate to say it but you are delusional! Most of my friends are RE agents and life is hell for them. I got my RE license 2 years ago and I'm keeping it in the file cabinet for now. Ca is not booming and won't be for years to come. If any RE agent says the bottom has passed already, they are lying!!


On Jun 03 03:00 AM twaite90 wrote:

> I do not know why people here are so negative about housing. CA is
> booming. Ask any real estate agent in california, they will tell
> you, housing is up, passed the bottom already.

Jun 03 12:14 PM

[joof:]

I know 2 well established veteran and competent CA real estate agents ( not newbies that got their licenses at the tail end of the boom) that had their best years ever last year, and are doing even better this year. They are making up in volume what they lost in price

Data (not self serving anecdote) say that in better CA real estate markets resale supply is less than 5 months, in some cases as low as 3 months, sales. This is different than FL and NV and AZ. Multiple bids on well located entry or first move up houses have become the norm. Many sell for better than list. Affordablity is at a generational high

Check Data quick if you don't believe me

More foreclosure are hitting the market, but sales rates thus far this year are keeping up. After the summer.....who knows?

Jun 03 04:44 PM

[twaite90:]

I am trying to buy a house either REO or SS with listing price without success for a month. If the condition of house is good, 10% above listing price and multi-offers is normal, though I do not chase up. The home price is going up for sure.


On Jun 03 12:14 PM Dave T wrote:

> Hate to say it but you are delusional! Most of my friends are RE
> agents and life is hell for them. I got my RE license 2 years ago
> and I'm keeping it in the file cabinet for now. Ca is not booming
> and won't be for years to come. If any RE agent says the bottom has
> passed already, they are lying!!

Jun 03 11:15 PM

[Tom Armistead:]

FLbuilder is correct on TOL's balance sheet, they have plenty of cash, as does KBH. Masco has a lot of debt and needs a housing recovery to continue as a viable company.

The short positions on the homebuilders are huge. With those that hold substantial cash, the likelihood of a liquidity crunch and forced sale of assets is nil, the tangible book values provide margin of security, and the chances of making a killing by going short are not good. The chances of getting caught in a short squeeze are much better.

I would suggest puts over shorting the stock, if you think homebuilders are going lower. That would limit your losses in a short squeeze.

Jun 06 12:10 PM

[Ricard:]

Great article, well reasoned, and firmly grounded. Thanks for sharing.


To twaite90:

Asking a real estate agent about the real estate situation is like asking someone selling their 20 year old beater of a car how it's running - 'Great, never been better! $2,000 and it's all yours! Make that $1,000!'

On Jun 03 03:00 AM twaite90 wrote:

> I do not know why people here are so negative about housing. CA is
> booming. Ask any real estate agent in california, they will tell
> you, housing is up, passed the bottom already.

Jun 07 03:30 PM