What A Banana Republic And Monetary Policy Can Teach Us About The Future Of U.S. Housing

by: John Gilluly

Banana Republic is a political term first coined by the American short story writer O'Henry in his collection of stories, "Of Cabbages and Kings". He wrote it in Honduras in 1896-97 where he was hiding from bank embezzlement charges in the U.S. Central to the theme is his characterization of Oligarchy, in which all power effectively rests with a small number of people.

A banana republic has stratified social classes; a large, but poor working class; and a ruling plutocracy that comprises the elites of business, politics, and the military. A circuitous cycle is created in which the laws of the country and its economy primarily benefit a small group of people.

Democratic Americans are not accustomed to such a society, but it is common throughout the developing world (former colonial countries) and especially in the oil patch.

I'm mentioning this because one of the side-effects of the Fed's Quantitative Easing programs is a connection to the slow recovery in the domestic housing market. The enormous stock market wealth created by the Federal Reserve's stimulus programs (QE 1, 2, & 3) has brought unwanted competition into residential housing for home-buyers from investors and cash buyers.

Instead of affecting job or credit creation, the Federal Reserve's monetary policy has subsidized a subset of affluent Americans who've effectively absorbed - or rather, siphoned off - almost all the benefits of Quantitative Easing through the stock market, and funneled that into residential housing. Main Street has participated very little in this recovery, and the recovery is one of the slowest on record.

QE has sponsored a kind of carry trade, "a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return." (Financial Times Lexicon).

If the Federal Reserve was hoping to affect Main Street through QE, it is caught between a rock and a hard place; they have created a pool of funds for the affluent (the investing class) with little or no cross-pollination to Main Street. Fiscal policy is the only thing that might help create a balance, but that is hard to find in this dysfunctional government of late.

The last 5 years of stock-market returns have brought about a three-fold increase in corporate profits and a stratification of wealth in the U.S. which at least one economist considers a new Gilded Age, circa 1870s.

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In her recent article, The Rich Get Richer Through the Recovery, (by Annie Lowrey, NY Times, September 10, 2013), the author presents the research of prominent economists Emmanuel Saez and Thomas Piketty, UC Berkeley, presented in a white-paper Striking it Richer: The Evolution of Top Incomes in the United States, September 3, 2013. The source of their research is IRS records dating back to 1913, when the Federal Reserve Bank was first established.

Some highlights on the 2008-2013 economic recovery:

  • "The top 1 percent took-in more than one-fifth of the income earned by Americans, one of the highest levels on record since 1913.
  • "Even after the recession the country remains in a new Gilded Age, with income as concentrated as it was in the years that preceded the Depression of the 1930s.
  • "High stock prices, rising home values and surging corporate profits have buoyed the recovery-era incomes of the most affluent Americans, with the incomes of the rest still weighed down by high unemployment and stagnant wages for many blue- and white-collar workers.
  • "The income share of the top 1 percent of earners in 2012 returned to the same level as before both the Great Recession and the Great Depression.
  • "Richer households have disproportionately benefited from the boom in the stock market during the recovery, with the Dow Jones industrial average more than doubling in value since it bottomed out early in 2009.
  • "About half of households hold stock, directly or through vehicles like pension accounts. But the richest 10 percent of households own about 90 percent of the stock, expanding both their net worth and their incomes when they cash out or receive dividends.
  • "The economy remains depressed for most wage-earning families. With sustained, relatively high rates of unemployment, businesses are under no pressure to raise their employees' incomes because both workers and employers know that many people without jobs would be willing to work for less. The share of Americans working or looking for work is at its lowest in 35 years.
  • "In 2012, the incomes of the (bottom) 99% of Americans started growing again - if only by about 1 percent. But the total income of the top 1 percent surged nearly 20 percent that year. The incomes of the very richest, the 0.01 percent, shot up more than 32 percent.
  • "The top 1 percent of earners experienced a sharp drop in income during the recession, of about 36 percent, and a nearly equal rebound during the recovery of roughly 31 percent.
  • "The incomes of the other 99 percent plunged nearly 12 percent in the recession and have barely grown - a 0.4 percent uptick - since then. Thus, the 1 percent has captured about 95 percent of the income gains since the recession ended.
  • "...the concentration of income among top earners is unlikely to reverse without stark changes in the economy or in tax policy."

The steady decrease in interest-rate qualifications over the last 30 years has masked the concentration of wealth in the upper tier of American society. It's a fact that the middle and lower classes in our country borrow a lot; the wealthy, a little. The affluent have the discretionary income to buy things that the less-affluent must finance (e.g., cars, college educations, homes, etc.)

This becomes clearer when you look at the distribution of personal credit across income levels. The lower the income, the more a family turns to debt for discretionary spending.

The sources of private debt in the U.S. (from smallest to greatest) are: pay day advances; small-business loans; farm loans; automobile loans; tax-debt owed to IRS; student loans; home-equity lines of credit (HELOC) i.e., borrowing against your home; consumer credit cards; and mortgage debt.

Purchasing power for the bulk of Americans tripled from 1980 to 2013, but there has been no attendant rise in inflation-adjusted wages. Mortgage debt, student loans, and credit card debt dwarf all other forms of personal debt in the United States by a ratio of 18 to 1.

For decades, American families could borrow more for expenditures at cheaper rates of repayment, and thus more house (per month) with the same amount of money.

But that all ended in May, 2013, when Chairman Bernanke made his first comments about tapering the amount of Federal Reserve stimulus. Since then, bond yields have been rising and the housing market is fearful that interest rates will begin a long steady slog higher, maybe for decades.

As outlined in three previous articles (Important Lessons for Housing from the Government Crises of 2011 & 2013, Nov, 6, 2013; 4.5% Mortgage Rates for the Remainder of the Decade?, Sept. 10, 2013; and When Will the Builders Be a Buy Again?, July 26, 2013), interest-rate gyrations on the ten-year note have paralyzed fixed-income, REIT, and home builder investors; sending some companies down to 52 week lows.

A larger side effect of rising yields - not felt here in the states - is the effect on emerging market volatility. As I write, the emerging markets appear on the verge of another 10% dip into a jarring, short-term correction.

EEM vs. Ten Year Yield
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Rising yields bring up the question, who will be the available buyers for next year's new home construction in the United States? Those with the steadiest job-histories, the least amount of personal debt, plenty of assets, and high credit scores.

That's a good description of the investing-class who put discretionary income to work in the bull market and boosted their net worth.

The Great Recession has effectively run its course on two parallel tiers: those who have maintained their jobs throughout the downturn; and those who have not.

For workers seeking re-employment, many discover that "60% of previous ($)" is the new job offer they'll receive from the next company. The competition for white-collar employment is so intense that college grads and over-skilled workers compete for the same positions. It's a been a "spectator" recession for those who have maintained homes and employment; but a heart-breaking and humiliating one for those who've lost jobs and homes.

Only 50% of Americans today have any contact with the stock market - for example, through 401Ks, IRAs or pension funds - and in practical terms, just 10% of the population owns 90% of the stock. There's been little "trickle down" in wealth to expand the pool of available home buyers.

Who is not included in the home buyer pool? Individuals with poor credit histories (foreclosures, short sales, medical debts, job losses, etc); almost all students emerging from college ($1 TL in debt); and the 90% of our population that's least involved with the stock market.

In other words, the road ahead looks more like a Toll Brothers (NYSE:TOL) kind of housing market (Toll is a luxury home builder that caters to the wealthy). And in some respects, it's already happened. Home builders increasingly cater to higher-end buyers for whom financing, down payments, and amenities are not a problem. Goldman Sachs economists estimate that 60% of all homes sold in 2012-2013 were to cash buyers. These are homes being flipped to renters or bought for a profit.

There's also a new effort afoot to reform home finance in order to reduce risk. This is a hold-over from the financial crisis. It will effectively screen-out thousands of would-be buyers. You can't "save up" for a 20% down payment in a speculative housing market that's flying higher with mutual funds, small investors, cash purchasers, and foreign investment driving it. Price runs past the would-be buyer too quickly.

So first-time buyers turn to the GSEs or FHA for low down-payment loans, but each year there's increasingly-higher mortgage insurance premiums (tacked-on, up-front, in full, to the loan coast) in order to acquire these non-competitive government loans. The loans are expensive by any measure, but there are almost no private alternatives to them. Too, congress would like to phase out the GSEs, which would leave first-time buyers with practically nothing for financing.

It is interesting that the home ownership rate in California continues to fall and is at 20 year lows. There have been record CA home sales in the last year and 20%+ increases in home prices, but the foment hasn't affected the broader population. The buzz has been for a few, a very few.

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The only way for traditional buyers to consistently re-enter the new home market in the future will be growth in real wages, easier available credit, and a low-cost 5% down payment plan from private sources.

The chart below illustrates the buoying effect of cash buyers on home sales.

Chart source: Zero Hedge

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Toll Brothers reported preliminary fourth quarter 2013 revenues yesterday. Earnings increased 65% in dollars and 36% in units; contracts rose 23% in dollars and 6% in units; backlog increased 57% in dollars and 43% in units. FY 2013's Q4 net signed contracts per community were the highest for any Q4 since FY 2005.

Their fiscal year (FY) 2013 shows that interest-rates and rising home prices had no effect on Toll's sales or their buyers' comfort levels. Business is at 8 year highs; sales are brisk, and the future looks great (for them).

KB Homes (NYSE:KBH) commented in their recent report that first-time buyers were a lower percentage of their new homes sold, and touted the "new kind" of affluent buyer they were experiencing in coastal California.

If mortgage rates quickly rise to 5%, it will likely drive out the last of the remaining traditional first-time buyers and establish the new paradigm I'm describing. Ownership will be for the few. Renting will become the new norm. Home builder shares will drop precipitously, probably until they trade near book value (assets minus liabilities). The interest-rate cloud will hang over the sector like a Seattle drizzle.

Going forward, home builders will need to adjust their sights on a new kind of buyer for whom financing is no longer a problem; and build smaller homes for traditional buyers who seek financing. There will be fewer sales, but higher average selling prices. Fewer mortgages, but more cash sales.

Based on their massive accumulation of land in 2012-2013, I think the builders are done for now, and will spend the next year carefully metering-out their communities. If interest rates soar again here, there could be another 20% drop in the builders by the end of the year.

Disclosure: I am long [BRP]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional Disclosure: I remain long BRP as an investment position, but have exited the other home builders. I will be looking forward to a better entry point after interest rate concerns stabilize, and when the underlying fundamentals of the builders (sales, profits, etc) are not under such a cloud.