Here are six things you'll need to know for housing in 2010:
1. Data is Cloudy and not Always Reliable
For example, new home sales for November laid an egg, recording an 11.3% decline (compared to October) to an annual rate of 355,000, falling short of the consensus expectation of a 2% increase. The numbers aren't actually as bad as they look and we were not surprised to see the decline. During November, the nationwide tax credit was set to expire at the end of the month, and was not renewed until a week into the month. As a result, consumers likely pulled out of potential sales before finding out that it was extended. That issue, combined with changes in seasonality, makes the data somewhat unreliable.
On a side note, some of you may be confused as to why the existing home sales report was good and the new homes report was bad. The reason is that the data series are recorded differently, such that new home sales are a month ahead of existing. We are expecting the next existing report to be weaker because of the tax credit issues.
Other pieces of data that may throw off investors are inventory and foreclosures, which may be understating some problems. Banks, for instance, are not listing many of their repossessed properties on the market (known as "shadow inventory") which may be understating supply. Meanwhile, foreclosures are being delayed, and/or prevented by programs such as the White House's HAMP program. (More about this later)
2. The Tax Credit
The $8,000 nationwide tax credit has been a significant driver of sales, indicating that much of the current home demand is from government help rather than pure demand. We always knew it was a driver, but after seeing the changes take place in the new homes sales report, it seems apparent that the tax credit is even more influential than we realized. Much like Cash for Clunkers, housing market demand will likely subside after the program is finished. On April 30 when the tax credit expires (assuming it is not extended again), sales are likely to ebb.
The Home Affordable Modification Program initiated by the White House has been making an effort to stem foreclosures since May. There are currently more than 700,000 people enrolled in the three month trial period of the program, but as of the end of November just over 30,000 were enrolled in the full program. Crunching the data reveals that roughly 10% of trial participants are being converted into the full program. Those 700,000 borrowers have already been singled out as troubled, and if the vast majority are not being accepted into the program then there will be a large influx of homeowners being sent back to reality (i.e. foreclosure) after their three month trials are over. Consequentially, the latest foreclosure data is understating the amount of distressed borrowers. This may cause periodic increases in foreclosure filings until the economy improves or the program gains more traction.
The White House claims that it can enroll more than 3 million homeowners in the next three years. We seriously doubt those figures, but even if the program saves just 250,000 people in the next 2 years, that translates to 10,000 a month. That, along with delays from the trial programs, will turn the data more favorably.
4. Unemployment is the Key Driver of Foreclosures
What started as a subprime lending fiasco has turned into a recession problem. 33% of all foreclosures started in the third quarter were prime fixed-rate mortgages, the safest of all categories of loans. These loans also represented 44% of the foreclosure increases in the quarter, and represented 54% of the increase in delinquencies. Prime borrowers are foreclosing as a result of job losses, which also are raising the rates of foreclosure in all other foreclosure categories. Returning to employment growth could remove in the range of 100,000 default and foreclosure filings per month. In addition, employment growth obviously leads to improved consumer purchasing power which can help the demand side as well.
5. Option ARMs
Labeled by many as the next subprime, between $8 billion and $10 billion worth of these mortgages will reset per month in 2010. These loans give borrowers four payment options: a minimum payment, interest-only, 15-year amortizing, and 30-year amortizing. The problem is that a very large proportion of these borrowers are choosing minimum payments, which are payments even smaller than interest only. The catch is, when a borrower chooses minimum payment, the balance below interest is added to the loan outstanding. As a result, these borrowers can accrue balances of up to 125% of the size of the original loan before they are required to begin making full payments, and interest rates are recast.
Although little is known so far as to how bad the problem actually is, early studies show that upwards of 30% of these mortgages may go bust if they aren't somehow modified. If 40% of these mortgages were to go into foreclosure, our calculations show that it would add approximately 20,000 foreclosures per month. We think improving employment and HAMP to some extent will offset this effect. Nevertheless, these mortgages are likely to make 2010 a bumpy road, especially if it sends the financial sector into another rut.
6. Interest Rates
The Federal Reserve has definitely shown that it will keep borrowing rates low for the sake of the economy, but it will not stay that way forever. The Fed will eventually need to raise its prime borrowing rate to avoid inflation, while also winding down programs to add liquidity behind Fannie Mae (FNM) and Freddie Mac (FRE). These actions will eventually take mortgage rates well above 5% or even 6%, potentially adding hundreds of dollars to monthly payments.
It is tough to get a finger on housing trends at times with so many different factors convoluting the numbers. However, what is clear is that demand has improved significantly throughout the course of the year, as a result of much lower prices, and low mortgage rates, while the tax credit is certainly playing a role as well. These conditions are still in place for home sales to maintain momentum (despite the results of the aforementioned new home sales). So the question now then, is whether demand can outperform foreclosures.
We are worried about the effects of option ARMs and ongoing problems with Alt-A mortgages, but in the end those improvements made by an improving employment situation and eventually HAMP, combined with ongoing sales, will be enough to allow demand to absorb supply and lead to a firming of prices.
However, we do concede that the first half of 2010 could be bumpy with the introduction of option ARMs, the HAMP foreclosure delays, and the potential end of the tax credit. Concerning interest rates, we think Ben Bernanke has his eye on the ball, and will raise rates when the time is right. And, even if rates are raised early, higher mortgage rates could slightly dent home sales but prices are by far the more important factor.
We think HAMP will be a bit of a hindrance at first as trial borrowers are denied aid and thrown back into the fire. However, further down the road as the program gains traction it should help to soothe the foreclosure numbers, possibly by tens of thousands of homes per month.
Meanwhile, employment trends have recently begun to turn more positive, with only 11,000 jobs reportedly being lost in November. Although many are skeptical of the number, it does appear that employment can turn the corner within the next several months. Turning job losses into job gains can significantly reduce the foreclosure pipeline while also giving homebuyers more power. Therefore, the housing market may struggle to improve significantly in the first half of this year, but should be in the clear in the second half of the year.