2 Black Swans That Could Crush The Housing Market

by: Dave Kranzler


Legislation to eliminate FNM/FRE hits Congress.

Shifting the risk of mortgage loss to the private sector would increase mortgage rates.

The first time buyer cohort is in decline.

I have been forecasting that the housing market is going to re-enter the bear market trend that began in mid-2005. The enormous amount of Fed/Government stimulus, combined with a temporary surge in investor buying, created a short bounce/bubble in the housing market. As I have detailed in several previous articles, the underlying supply/demand fundamentals are deteriorating and this alone will throw the housing market back into its bear market. However, two potential black swans have appeared which could severely damage the housing market.

First, yesterday before the market closed it was announced that a bipartisan Bill, with input from President Obama, would be introduced to the Senate that would eliminate Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). The Bill would require that homebuyers put at least 5% down. In my view, the key provision of the Bill would shift the credit risk of mortgages from the Government to the private mortgage market by requiring that private lenders would be on the hook for the first 10% of any mortgage losses.

Mortgage rates are very narrowly spread over the 10-yr Treasury because the Government insures against the risk of loss on every mortgage purchased by Government Sponsored Entities, or GSEs. This covers about 97% of all mortgages, with Fannie and Freddie responsible for about two-thirds of all mortgages underwritten. If banks and other private-market mortgage lenders are required to bear the risk of the first 10% of any losses on mortgages underwritten, they will require a much higher rate of interest to compensate them for the risk of loss. This alone will cause mortgage rates to spike higher and increase the cost of buying and owning a home.

As we have seen recently in the news, the biggest mortgage banks like Wells Fargo (NYSE:WFC), JPMorgan (NYSE:JPM) and Bank of America (NYSE:BAC) have been significantly reducing their mortgage underwriting departments. It is my view that the inability to lay off the complete risk of any mortgages underwritten and sold to Fannie/Freddie will further reduce the amount of capital that the big banks commit to the primary (purchase) mortgage market. This will further increase the rates that the private market will require to underwrite mortgages - over and above the increased risk exposure - as it will require significantly higher rates as risk-compensation to induce private money into the market

I do expect that higher rates will stimulate institutional investor money to fill some of the capital void left by the partial withdrawal of capital by the big banks. However, any private sector capital with significant risk exposure to mortgage losses will require much higher rates as compensation for that risk than is being reflected by current Government guaranteed mortgage rates. The higher cost of mortgages from the passage of any legislation that essentially eliminates much of the Government guarantee behind mortgages will thus increase the overall cost of buying a home and therefore could significantly reduce homebuyer demand.

The second potential black swan not being priced into the market value of homebuilder stocks is the quiet dissipation of the first-time buyer segment of the market. The first time buyer segment of the market has historically averaged about 40% of total homebuyer demand. In 2013, that percentage slipped to 38% (per the previous link). However, in the latest existing home sale numbers released by the National Association of Realtors, the first time buyer share of the market had plunged to just 27%. While the investor buyer cohort has been making up for some of this lost volume, as I have detailed in previous articles the investor buyer segment is a shorter-term dynamic and the volume of purchases by the investment buyer has been starting to decline.

Although the recent increase in prices is one factor that has caused the first time buyer to fade, in my view the primary reason for the decline in this segment of the homebuyer market is the inability to find jobs that will support the purchase of a home. Per the latest employment report from the Bureau of Labor Statistics, the labor force participation rate for Americans in their 20s hit a record low 2013 of 75.5% (source link, edit in red is mine):

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If people in their 20s are not working, how can they possibly go out and buy homes? And if the first time buyer segment of the market drops away, who will buy homes from the potential 'move-up' buyers looking to sell their first home and upgrade? In other words, the declining number of people taking/finding jobs out of college significantly reduces the total size of the demand side of the housing market. This will likely create a multiplier effect as the decline of the first time buyer will damage the health of the 'move up' market, as the move up buyer heavily relies on the health of the first time buyer market.

Based on my potential black swan analysis above, I thus believe the housing market faces serious risks that are not priced into the valuations of homebuilder stocks. Since closing at 536 on February 27, the Dow Jones Home Construction Index (DJUSHB) has dropped 7% through today's (Wednesday, Mar 12) trading. In the same period of time, the S&P 500 has been flat. To me this is the market's signal that it is going to start pricing in the highly elevated risks embedded in the housing market that are not being discussed by Wall Street analysts or the financial media.

I continue to recommend selling out of homebuilder stock positions. I also believe that aggressive traders can make a lot of money shorting the homebuilders. My favorite short plays right now are DR Horton (NYSE:DHI), KB Home (NYSE:KBH) and Ryland (NYSE:RYL). I am short those names and have recently added to my positions. As an example of smart money selling out of this sector, consider that DHI insiders have been unloading their shares. In the last twelve months, DHI insiders sold shares vs. bought shares at a ratio of 90:1. In just the last three months, there have been 4 sellers of over 142,000 shares and zero buyers. For me this reaffirms my thesis that a new bear market in housing is here and the homebuilder stocks are overvalued.

Disclosure: I am short DHI, KBH, RYL. 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.