Housing and Cognitive Dissonance on Wall Street

by: Michael Shulman

Cognitive dissonance is best defined as “an uncomfortable feeling caused by holding two contradictory ideas simultaneously.” The Street suffers from cognitive dissonance a good part of the time but is approaching new limits to scale with the bullish view of housing – or the lack of understanding what a broken housing market means for the economy and, over time, for equities.

Yes, housing is broken in the United States. It is not at a bottom; it is not in a depression or at recession levels; it is broken and this reality is having profound impacts on employment, feelings of consumer wealth, consumer spending, and the economy. And it will have greater impacts on the banks and corporate profits in the second of this year and in 2011.

There are reams of publicly available information – available to one and all, including analysts and money managers recommending and buying home building stocks – showing how badly broken the housing market is at this time. Rather than write a ten thousand word opus, a few highlights will do.

  • Historically, 63% of Americans own their own home. Under Clinton and Bush the Junior, that was pushed to 70%. This push was done through changes in credit standards. Those standards have been reversed and are now far tighter than when the push began. We are headed back down to 63% and possibly lower if the real world Great Recession continues longer than most expect. Historically, home buying has a linear relationship, over time, with national income and employment or unemployment. It is pretty simple -- people do not buy as many houses when they are unemployed or fear being unemployed. And real world unemployment of more than 20% - unemployed, the discouraged, the unwilling part timers and the permanent drop outs - is showing no signs of abating.
  • Analysts keep speaking about affordability – homes are cheap –but this is simply not true. Historically – before the fall in interest rates at the beginning of the millennia – the cost of a house was 3.2 times household income. The range from the sixties to the end of the last century was between 2.7 and 3.5 times typical household income. Last year it was 3.4. That makes the cost of a home high by historical standards. And assuming interest rates rise faster than incomes – a sure thing – affordability will continue to lag.
  • At the same time, we are less than one fourth through the foreclosure ramp created by the Great Recession – 1.5 million homes out of a 6-7 million homes that will be foreclosed in the next 24-30 months. Foreclosures are still at an all time high – and would be higher if not for state initiatives to slow down the process and the willingness of banks to slow the process so they do not have to write down losses. According to Sean Dobson of Amherst Securities, there are 12 million “at-risk households” due to a variety of factors such as the economy, the nature of their mortgages and so on. Of these 12 million, seven million are not making payments; the other five million have mortgages so much greater than the value of their homes they too will probably stop paying (remember between one fifth and one fourth of all home owners have mortgages greater than the value of their home). There are also several million mortgage resets coming in the next two years, peaking in the summer of 2012. Compare this to barely 1.5 million homes that have been foreclosed and liquidated and you begin to get a sense of the size of the problem. I use 6-7 million so people do not throw things at me during seminars and dinner parties. The actual number could be higher.
  • Six to seven million more foreclosures, plus some new homes starts – 350,000-500,00 a million a year -- plus sales of existing homes not in foreclosures means a gigantic inventory overhang that will suppress prices for several years. The current inventory is eleven months of sales; the historical norm is six months. Add the shadow inventory – foreclosed or soon to be foreclosed homes not yet listed – and this number more than doubles, by some estimates reaching twenty-seven months supply.
  • Home prices are set locally – where I live prices are stable and have been for a while. Nationally they have fallen by almost 30% since the beginning of the crash, more than 50% in some localities. According to Meredith Whitney and others, prices have at least another 15% to go before we see a national bottom. The supply of homes in parts of Nevada, Florida and California now equals fifteen years of demand. I do not see national prices stabilizing for more than quarter until mid-2012 at the earliest.
  • Federal support for housing is pulling back. Fed purchases of RMBS end today; the homebuyer tax credit, never politically popular, ends in a month; statutory caps on Fannie and Freddie’s balance sheet will hit before year end, probably just before the election, and there is better than a 50/50 chance they will not be raised; the FHA is in the red, is seeing historically high default rates and is going to have to ask Congress for more money, which will require further tightening of standards.
  • Interest rates are set to rise, reducing housing affordability. Ten year rates have risen sharply this year and will continue to climb, if not this year, next, through the simple math of bond market gravity and increasing demands by the US Treasury.

Bottom line: foreclosures will peak in 2012, home prices will stabilize nationally that year or early in 2013. Maybe – if the mortgage securitization market returns and national income begins to increase in 2011.

What does a broken housing market mean for the overall economy?

  • Historically, housing is the primary policy lever used by Uncle Sam to push the country out of a recession. During past recessions, the Fed has lowered interest rates to spur demand in housing – spurring construction and purchases of all sorts of goods and services. This is not an option – interest rates cannot get lower to spur demand.
  • The big banks are going to get hit. None of the major banks, and this is doubly true for Wells Fargo (NYSE:WFC), have reserved enough for the next wave of mortgage defaults, not to mention chronically high unemployment and slow or negative economic growth. They have been managing earnings quarter by quarter and actually reduced the amount they have been setting aside against future losses. These will come beginning in Q3 of this year – and when the banks get hit, they will take part of the market with them.
  • Between 2000 and 2007, more than 40% of all new jobs were in residential construction, the sector absorbing many new entrants into the workforce as the number of people employed in manufacturing stagnated and then shrank. These jobs are not returning anytime soon, depressing economic growth, and national income and consumer spending.
  • A home is the primary stash of wealth – and sense of wealth -- for the two thirds of Americans who own a home. Between 2002 and 2007, consumer spending was almost 100% driven by credit, not by gains in income, and a great deal of this credit came from the “house as piggy bank” – the home equity credit line. This cannot happen – and spending cannot increase until national income increases.

All of the data supporting this logic flow is and has been available to anyone who wants to look at it, read it, use it. Instead, the majority opinion on Wall Street is “housing has to come back.” Why? “Because the economy is coming back.” A philosopher would call this a tautology – a more common man would say this is standing logic on its head or perhaps the tail wagging the dog. Without an economic rebound, there can be no housing rebound. And without a housing rebound, led by the sell off of inventory and an increase in home values, there will not be a housing rebound.

And this is where cognitive dissonance comes in. Wall Street knows the truth about housing; it knows it wants the economy to grow – it has too, right? – and to avoid the unpleasantness of two conflicting ideas it is opting for what it wants – the economy to grow, the market to go up.

What does this mean for equities?

Slower economic growth means weaker corporate profits in many segments and pressure on the market itself: SPY.

A broken housing market means a miserable 2010-2012 for the home builders – all of them, including XHB, Lennar (NYSE:LEN), Pulte (NYSE:PHM), Beazer (NYSE:BZH), Hovnanian (NYSE:HOV), KB Home (NYSE:KBH), DR Horton (NYSE:DHI), NVR (NYSE:NVR), Meritage (NYSE:MTH), Ryland (NYSE:RYL), Standard Pacific (SPF) and Toll Brothers (NYSE:TOL).

And the continuing rise in defaults and foreclosures mans nasty surprises at the big banks, including XLF, Citigroup (NYSE:C), Bank of America (NYSE:BAC), Wells Fargo (WFC), JPMorgan (NYSE:JPM), PNC (NYSE:PNC), KeyCorp (NYSE:KEY) and SunTrust (NYSE:STI).

And pretty good business for home beneficiaries of home renovation and fix up projects – if you cannot sell it, and you are going to live there for a while, put up some fresh paint, build the porch, get a flat panel: Home Depot (NYSE:HD), Lowe's (NYSE:LOW), Sherwin-Williams (NYSE:SHW).