How Will the Housing Crisis End?

We are continuously being barraged with mixed news concerning the housing crisis. One day we hear signs are pointing towards a bottom; the next, housing numbers came in much lower than expectations. So we raise this question: What indicators should we be looking at to truly signal a recovery in housing?

With this question in mind our analysis focused on creating the stages we believe would be necessary to facilitate a recovery. We were able to define 7 chronological stages which need to occur in order for the crisis to end. Additionally, the progress for each of the stages can be measured by several key indicators. The stages we outline below are meant to help to average investor better understand how a recovery will most likely unfold, and includes indicator that anyone with a basic internet connection will be able to easily access.

Our stages and key indicators to watch:

1. The number of defaults from subprime borrowers needs to drop substantially. This will help to stabilize growing inventory levels.

Key Indicator(s): RealtyTrac foreclosure data (monthly) & MBA foreclosure data (quarterly)

Subprime ARM mortgage resets continue to be the primary driver behind subprime foreclosures (July 2007-November 2009):

2. Banks need to lower lending standards for home mortgages. This will allow existing and new home sales to increase and prices to stabilize.

Key Indicator(s): Fed Senior Loan Officer Survey, mortgage rates (quarterly), Case Shiller Home price index (monthly), & New and Existing home sale prices

However, lending standards have tightened across all mortgage types according to the Senior Loan Officer Survey:

3. Once people are again able to buy homes we will see a reduction in inventory levels. When this occurs demand will rise for new constructions.

Key Indicator(s): New home sales data (monthly) & Existing home sales data (monthly)

But for now, increased foreclosures and tighter lending standards have caused new home sales to drop:

4. The rise in demand for new construction will first show up in building permits. The rise in building permits will lead to our next step...

Key Indicator(s): Building permits data (monthly)

But building permits have shown no signs of relief:

5. Very soon after the rise in building permits we will see an increase in housing starts.

Key Indicator(s): Housing starts data (monthly)

Currently, with permits being repressed, building starts are acting accordingly:

6. The increase in starts will lead to an increase in construction spending.

Key Indicator(s): Construction spending (monthly)

As you can see from this chart, this is not yet the case:

7. Finally, residential investment begins to rise and the housing crisis is over.

Key Indicator(s): Residential Investment via GDP release (quarterly)

Conclusion

Essentially, this crisis is occurring due to a substantial increase in the supply of houses through subprime foreclosures, and a decrease in demand to buy houses through harder to get mortgages. As more homes enter the market and less people are able to acquire mortgages to by them the price drops. Hence, the first major step in a recovery for the sector will be a slow-down in the number of foreclosures, which likely will not occur into the early parts of the second half of this year.

Secondly, and equally important banks need to reduce lending standards to allow qualified buyers to purchase new homes. These two actions combined will begin to reduce the inventory of homes on the market and stabilize price. Once the amount of inventory of homes for sale begins to drop, we will see demand for new constructions begin to rise. This will first show up in the building permits index, followed by housing starts, and finally private construction spending. All in all, this will not be a fast process, with the reduction in foreclosures and lowering of lending standards being the hardest hurdle to overcome.

Currently, the primary driver for subprime foreclosures are interest rate resets. When these borrowers we first given their mortgages they were given low teaser rates which would eventually reset into higher adjustable rates. Meaning some mortgage holders who were paying USD1,200 a month for their mortgage in November could be paying USD3,200 a month in December. For a lot of these borrowers it has been nearly impossible to pay the new amount and they have been forced to default.

On a positive note, based on available market information we should see the number of resets for adjustable rate subprime mortgages peak sometime in late spring/early summer. However, this means there are still a lot of resets in front of us which will prevent a sustainable recovery over the next few months. Are best estimates are indicating we should start to see the early signs of a recovery in 3Q08.

Investment Idea

Once a the market starts showing signs of a sustained recovery, we feel that US home builders could significantly benefit. US homebuilder stocks have been pounded since the housing crisis first began, and will be poised to make a recovery as demand for new homes eventually rises.

However, as we said this could take some time, but it will happen. In fact, we recently witnessed a rally in the sector when the market misinterpreted last month's housing data to imply we had reached a bottom. To us this means we aren't the only people looking at this trade. We had actually picked up a long position of iShares Dow Jones Home Contstruction ETF (ITB) at around 18 with the intent of holding for the long term. However, when the market rallied on what we felt wasn't substantial evidence for a recovery we sold the position at around 21. The ETF has since returned to trading at around 16, and we are considering re-purchasing for the long-term.

Performance of Home Builder ETFs

Comments

[apppro:]

Boy have I had enough! The housing crisis (among other things) will end, when all you pundents just shut the heck up.
Give it all a rest!

2008 Mar 26 07:55 AM

[flatman:]

The solution to the housing affordability problem, which isn't really mentioned, is not looser lending standards which is how we got into this problem but lower house prices which will happen as foreclosures rise.

2008 Mar 26 08:35 AM

[nukldrager:]

Interesting perspective Tom, thanks.

2008 Mar 26 08:49 AM

[pochovilla:]

This will be a slow and painful process. The recovery may take years to evolve. The can will be kicked to the new President who will have a set of unattractive choices to make. The fundamentals do not suggest a quick bounce out of this mess. I would expect volatility as reality struggles with the hope of a big bounce.

2008 Mar 26 08:53 AM

[JohnE:]

A well written article. Sometimes a very clearly written article can appear to state a bit of the obvious. This article might fall into that genre'.

2008 Mar 26 09:13 AM

[skifly05:]

Wow...rocket science. Easier money brings building permits, brings buildings, brings payment for materials for same...utterly brilliant. Why didn't I think of that. I thought there was a magic wand in there somewhere.

2008 Mar 26 09:55 AM

[dmvsmart:]

Buy foreclosure now,

2008 Mar 26 10:35 AM

[phdinsuntan...:]

well Malthus, the first stage in a recession is a fall in construction, the second is some fall in the value of banks that gave the loan using your savings, we are there, the third is that consumers have not money as the banks spent it in bank loans, we are almost there, and the next is a fall in aggregate demand and a respectable fall in employment and GDP, "hopefully" the second quarter. Then you can have reasonble adjustment in the currency, lets say 40 yen per dollar or 3,5 dollars per euro, and then, not before that, foreign investors will cam to buy your assets and rescue your economy, so by now short SRS, FNM and other funny assets still overvalued.

2008 Mar 26 10:56 AM

[Steven R. S...:]

You miss the point so far that it is amazing. Lowered Lending standards allowed what happened to happen. Liberal Lending is a root cause of the problem of the run up in Housing Prices.

Prices need to come down more for them to once again be Affordable. Bringing prices down another 25% to 40% will solve the problem. That and never allow another loan to be made to someone who cannot afford it.

And put all of the Appraisal Whores in prison for a year or two, that should cause some sobriety in theri field.

You would only need to put 30,000-40,000 of them in jail, along with the 50,000 or 60,000 unlicensed people they had in the field doing the appraisals.

2008 Mar 26 11:05 AM

[TM:]

Steven, I agree a lot of loans were given out that never should have been. However, right now a lot of people who should be getting loans can't... And that is a problem... Of course lower housing prices will help, but only if qualified people can borrow money to buy them, which they haven't been able to do.

2008 Mar 26 11:13 AM

[Hoganomics:]

I agree with TM... not sure affordability is the only issue, at least at the national level. I was considering buying a condo here in Boston area about six months ago, and while it didn't seem to be a great fit for my personal situation, the price on a monthly basis was not totally out of line with the monthly rent (like something on the order of 5-10% drop seemed reasonable).

That's how people consume residential real estate, on a monthly basis... The price runup on a national level over the past decade or so was due primarily to falling interest rates over a very long period, and interest rates are still stubbornly low, making affordability not that out of whack, at least not if/until rates revert to historical means. Can't speak for some other markets like the southwest though, but here in the northeast the problem seems to be availability of credit to people who can handle it, or fear that the market will continue to fall keeping people who should buy from doing so.

2008 Mar 26 11:29 AM

[jackooo:]

It works.

2008 Mar 26 11:55 AM

[goatfarmer:]

Well written, cogent article. Keep us updated with those permits and starts charts!

2008 Mar 26 11:58 AM

[jackooo:]

It works.

2008 Mar 26 11:59 AM

[jackooo:]

It works.

2008 Mar 26 12:00 PM

[Urbane Gori...:]

Good article... Very concise. In fact, I appreciate the reference to the "we've reached a bottom".."Ooops! We haven't reached a bottom.." Nice to see a clearly written article that doesn't fudge....

Thx jegan ;-)

2008 Mar 26 12:19 PM

[vaduz:]

good idea if and its a big if we see now further deterioration in the finance sector. there is just a lot of credit outstanding and the refinancing is getting ever harder

2008 Mar 26 12:35 PM

[daphne does...:]

>Of course lower housing prices will help, but only if qualified people can borrow money to buy them, which they haven't been able to do.

Yes of course! They haven't been able to get loans because they don't qualify--because prices is still way out of line.

2008 Mar 26 01:03 PM

[Greenleaf:]

The basic premise of this article is missing the point. The only thing that will kickstart this housing market will be for prices to come down to the historical Price/Income ratio. When the average wage earner in an area can afford the average priced home without resorting to toxic mortgages (which are gone for the most part), then and only then will the market become healthy again. It hasn't been healthy since 2000. That's it in a nutshell.

2008 Mar 26 05:32 PM

[damienhaas:]

Agree on the price must go back to sanity level before we can talk about housing recovery.

2008 Mar 26 07:06 PM

[Jane:]

I agree w/Stephen R Smith that loose lending standards is part of what caused this mess in the first place. Just continuing to pump air in an artificially/fraudulen... inflated bubble is not a solution to anything, except maybe to allow a few more greedy stupid people to grab a chair before the music stops AGAIN, as it surely will. The housing and credit industries need a good cleaning out. And Americans need to wake up to the idea of living within their means and not buying overpriced junk just because they are told by industry shills and wannabe investors that the price will "only ever go up."

2008 Mar 26 07:37 PM

[MikeHr:]

You made the comment, "Essentially, this crisis is occurring due to a substantial increase in the supply of houses through subprime foreclosures, and a decrease in demand to buy houses through harder to get mortgages." I would counter that by saying that prices were pushed to insanely un-affordable levels because of bad loan practices. Here in California, homes worth $150,000 to $250,000 were pushed up to $500,000. These are small 900 to 1200 square foot homes that were built 50+ years ago. Most would be better off being torn down and turned into housing more suited to today's world. Now those homes are plummeting in value from their previously inflated value. It will take time before they reach their real value, meaning we still have a ways to go on the downside,

2008 Mar 26 08:15 PM

[cfish:]

Nobody can time a bottom or a peak. Everytime I feel tempted to time the market, I remind myself how many geniuses failed at this task.

I like the sentiment idea that somebody mentioned before: when nobody wants to buy real estate because "all it does it lose money" we are near a bottom. Right now, we are still in the "there are a lot of great deals out there" stage - not quite there yet.

2008 Mar 26 08:22 PM

[User 168712:]

Houses will sell and mortgages will be granted when prices come down to a selling price that is rational. Take the average family's one week salary and use that to calculate a total mortgage amount and one will have what the "average" home should sell for. Until then, the average family will not be buying homes. If the government wants to do a bailout, then let the Feds mandate banks use this formal as a selling price for all forclosed REO homes and give government guarantees on these types of loans. The difference between what is owed on the home and what it is sold for is what the bank must eat. End of problem! Let the good times roll.

2008 Mar 26 10:41 PM

[slider:]

The Denver real estate crash in mid 1980's took 9 years before prices began to rebound. I was down 40 to 50 percent before market started to recover. Be patient, we have a long way to go!

2008 Mar 27 12:22 AM

[Expat:]

Cool! You, my friend, are stinking genius. House prices will go up when people start paying more for houses. Say, that concept could revolutionize the Dismal Science. Could this be applied to other areas of the economy? Would the price of cars rise if people start paying more for cars? It's possible. We need to do some tests. How about the price of socks? Would it work for socks? If people pay more for socks, will the price of socks rise? Gosh, the possibilities are endless.

Now that pesky part about mortgages. You mean, if we let people buy homes they can't afford with loans that are sure to fail, more people will buy houses? Holy cow! You ARE really, truly a stinking genius.

And when people start buying houses (and, wait for it, paying more than the old prices, leading to, get this, higher prices...god, why didn't i think of this?), and when the stock of available homes reaches the equilibrium level of supply and demand, and then when we need more new homes to meet demand, why then (you are going to be astonished...I was) the homebuilders will start making money again. It's so simple. And their share prices will go up.

Dude, are you running for public office. Anything? Dog catcher? Clerk of the County Court? You have my vote. We need you. America needs your ideas.

I am awed. Truly awed by your level of outright stinking geniousity!!!!!!!!!!! (extra exclamation points to express my true awe)

2008 Mar 27 02:51 AM

[Brandy:]

Japan is the business model here. They went through the exact same thing that we are now going through, only they did it in the 80's. Do your research on the internet...look up Japanese housing failure. From mid-late 80's their bubble broke. No appreciation in home values for 20, "count them 20 years". When they finally woke up to having to renegotiate all of their mortgages to "current market value" in the midst of all of the chaos, then and only then did their market begin to show appreciation. From 2006 to 2008 values grew a mere 2.6%. Been there, seen that, worn that t-shirt? If you are from Japan you have....they have to be sitting in their living rooms shaking their heads that we cannot learn from their mistakes. Oh, and by the way...Japan broke from "the world bank" as part of it's recovery. Wonder why???? Do your homework. Are the Fed's pockets deep enough as some have wondered??? ONLY if they can leverage which banks they are going to bail out...and that does nothing for people on the street OR their home values.

2008 Mar 27 08:43 AM

[Lilguy:]

Thank you for providing a process by which one can make some reasonable judgments about the state and futue of the housing market. This is far superior to pundits just offering an opinion or a single data point.

Thanks.

2008 Mar 27 11:24 AM

[dmvsmart.com:]

Wonderful article, keep up the good work

2008 Mar 28 12:53 PM

[ruleplayer:]

What about those of us who played by the rules got a good thirty year fixed mortgage and now are watching all their hard work go down the drain?

If we sell we will loose everything that we worked hard for because of the clandestine behavior of the majority of lenders. Having people in our situtaion renegotiate their morgates to current market value is genius. Let's see the presidency get behind something to help people who played by the rules and not the people who acted in a not so honest way.

2008 Apr 30 01:32 PM

[hedonist:]

Home prices fell about 6% in 2007 and are expected to tumble another 15% in 2008, 10% in 2009 and 5% in 2010, said Bostjancic. Unemployment, which climbed to its highest level in two years in December at 5%, will hit 5.8% by year end and 6% in 2009, predicts Bostjancic.

"Even if the bill wins final passage — far from a certainty — the most optimistic forecasts suggest it would help only about 400,000 of the estimated 3 million homeowners who will likely lose their homes in the next year." from MSNBC

“This is not the end, or even the beginning of the end, though it may be the end of the beginning.” Satyajit Das quoting a line from Sir Winston Churchill referring to the crisis.

2008 Jul 28 11:47 AM

[Charlie Str...:]

To see 9 reasons why home prices have further to fall, please read this article and my comment therein:

seekingalpha.com/artic...

2008 Jul 28 12:06 PM