The Fed And The Housing Squeeze

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Includes: CLAW, DHI, HOML, ITB, NAIL, NVR, PHM, PKB, TOL, XHB
by: Douglas Adams

Summary

The March FOMC minutes acknowledged the Committee's beginning task of working out the logistics of ending monetary accommodation for the economy in all its current forms.

Ending monetary accommodation includes closing out its reinvestment programs for both MBS and Treasury securities purchased in the wake of the Great Recession of 2007.

The Fed's reinvestment program alone for MBS averaged about $26 billion a month through 2016. This month, that total will fall to $18 billion and decline further in 2017.

The current decline has more to do with the decline in refinances and mortgage originations than any change in Fed policy. What is the impact on the housing market?

The Federal Reserve, the biggest player in the mortgage-backed security (MBS) market, is buying a good deal less agency debt this side of the US election. This is hardly earth-shattering news, given the uptick in long-term interest rates since the US election in November. The average 30-year fixed mortgage came to 3.58% for the 10-months leading up to the election. The benchmark jumped to 3.77% through the end of November and jumped again to 4.20% in December, where it remains through the end of March.

The impact of rising mortgage rates not only slows the pace of mortgage originations as home buyers that have to use the credit markets to finance their purchases start pulling out the market. It also means refinancing existing debt slows in lockstep. When refinancing of existing mortgages slows, so too does the rate which MBS mature because less principal is now flowing back to investors in the form of loan pre-payments. The impact on the Fed's portfolio is already being felt. The Fed's Open Market Trading Desk plans to acquire $18 billion MBS as a part of its repurchase program for maturing MBS on the Fed's balance sheet through the 30-day period ending 12 April. The purchase is the lowest total since the period of 12 June through 11 July 2014 and well below the average $28.15 billion 30-day purchase level for the period. The decline of purchases means less liquidity flowing back into the credit markets for home buyers to tap to finance their purchases. It also means the home financing credit markets are tightening due to the upward drift of interest rates and declining demand for mortgages and refinancing in the credit market. The trend will continue for the foreseeable future.

This presents an interesting dilemma for Fed policy makers moving forward. The Fed is now in the midst of a short-term interest rate hike cycle, having completed the first of three projected rate hikes for the year. The cycle continues to be data dependent, a well-worn criterion. Yet now another continuing agenda item is on the table. Since the Fed's MBS program began in December of 2008, the program has amassed a staggering $1.769 trillion in agency debt that now resides on its balance sheet through the week ending 6 April. Even when the Fed did finally stop actively adding to its portfolio, reinvestment of maturing securities, both Treasuries and MBS, continued unabated. While the Fed discontinued actively adding to its MBS pile, the balance sheet line nevertheless continues to grow, albeit at levels much reduced from the January 2009 through December 2014 period. In the last six months alone, the Fed's MBS portfolio has grown by roughly $26 billion or about 1.5% for the period.

That said, with the publication of the Fed's March Open Market Committee meeting minutes, Committee discussions will now include dealing with the logistics of both withdrawing these last remnants of accommodation and actually shrinking its balance sheet. The details about when, how much and how fast are still to be sketched out. While nearly all the participants to the discussion agree with the premise that the US economy is at or nearing maximum employment - a not insignificant assessment in the strength and durability of the recovery process thus far - an equal number readily recognize that the economy had not achieved the Committee's inflation target of 2% on a sustained basis. Headline PCE inflation hit 2.1% through the end of February for its highest post since March 2012. Meanwhile, core PCE inflation - a good indicator of future headline inflation - remained largely unchanged through the end of the 4th quarter at 1.7%. While opinions on the subject differed, the Committee's consensus view appeared to gravitate toward a gradual rather than a sudden removal of existing accommodation for the very good reason of avoiding a sudden surge in volatility around rising rates that overwhelm the ability of markets to readily absorb. At the fore of the Committee's thinking is sidestepping a replay of the taper tantrum of 2013 that saw interest rates soar while bond markets and currency valuations sank across the emerging markets space on the announcement. The calamity stayed the Fed's hand for another year before it finally was able to end its purchase program to its conclusion in December of 2014.

Of course, when the Fed backs away from its current role of primary market maker, some other buyer(s) will have to step up to the plate to keep market liquidity flowing. While much of the MBS in the Fed's portfolio in theory matures well past 2040, most analysts believe a large chunk of the total will likely be paid earlier through refinancing activity and accelerated premium paydowns. One advantage that appears to be working in the Fed's favor: while term premiums across the developed world will most certainly be rising over the course to time, the Fed will be the first central bank out of the block with its program of shrinking its balance sheet to more historical dimensions. The Banks of Japan, England and the European Central Bank are still actively buying assets, therefore, pumping large quantities of liquidity into their respective, and indirectly into the global financial system.

The question now arises: what will be the impact on housing with the Fed plotting its hoped-for orderly retreat from the MBS market?

This year's season is all but shaping up to be one of the toughest market for both buyers and sellers in at least a decade, with the perfect storm of rising interest rates and declining inventories offering up strong headwinds in many markets across the country. Existing homes sales fell 3.7% in February to an annualized rate of 5.48 million units, driven by a 13.7% decline in home sales in the Northeast market. While rising interest rates are beginning to be felt in both monthly refinance and mortgage origination tallies, falling inventory stocks of listed homes continue to be the primary story behind recent sale declines. National inventory levels are now down to 3.8 months in February, down just under 12% year over year (YOY). The lack of inventory across many markets of the country continues to create a strong seller's market as home prices continue to rise. The median US existing home selling price rose 7.7% YOY to $228,400 as more houses were sold at prices higher than the median price, pulling overall market prices up during the month. The average existing home selling price also rose by 5.8% during the month, responding to the same market pull.

Affordability indices are the most stretched in Western markets where the median home sold for $336,600 during the month of February. The median family income during the month came to $74,300, while the qualifying income came to $64,656 (25% housing expenses to gross monthly income with a 20% down payment). The difference came to a scant 14.9%. On a YOY basis, affordability fell by 8.378% during the month. Wage growth for all employees on private nonfarm payrolls rose by 2.67% over the same period. For non-supervisory and production employees, wage growth over the period was a bit less at 2.34%. On the other side of the price spectrum, the median existing single family home price in the Southern market listed at $173,600. The median household income for the month came to $70,831, while the qualifying income came to $33,504 for a difference of 111.4%. YOY, affordability fell just under 8%.

In another data series, the S&P Case Shiller Home Price Index, a 20-city index calculated on a three-month rolling average, saw existing home prices increase 5.70% YOY - the highest post since July 2014. Seattle (up 11.24%), Portland (up 9.61%), and Denver (up 9.17%) continue to lead the country as building, zoning, land prices and land availability issues continue to drive prices ever higher. More affordable cities in the Index in terms of annual price growth include New York metro area (up 3.15%), Cleveland (up 3.80%), and Washington DC (up 3.90%) for the month. Even at the low end of the Index, annualized existing home price growth exceeds wage growth by an ever-widening margin.

New home prices are proportionately higher. The median sales price of a new home in 2016 came to $315,500, up 6.44% from the median selling price in 2015 as home builders continue to cater to the higher end of the market. The average price for 2016 came to $370,800, up from $360,600 for a gain of just under 3%. Because of the price differential between existing and new home prices, the annualized rate of 592,000 new home sold in February is a fraction of the 1.389 million new homes sold in July of 2005. The median price for all of 2016 has been exceeded on a monthly basis five times since April 2016 in a data series stretching back to January 1963. Unsurprisingly, inventory of new homes across the country is not the problem as with existing home stocks. At 5.4 months, the new home inventory is close to equilibrium between supply and demand. The constraint here is largely one of price rather than availability.

Despite headwinds already blowing briskly, home builders continue to attract both investor attention and funding through the 1st quarter. High-end builder Toll Brothers (NYSE:TOL) is up just under 14% through the end of the period. This is a strong market showing, given inventory of high-end homes continue to outpace demand in many markets across the country. Through the first three months of Toll's fiscal year ending in January, net income came to $70.4 million on revenues of $920.7 million, down 4% from net income of $73.2 million on revenues of $928.6 million YOY, driven by increasing revenue and marketing costs over the period. Still, the net value of contracts signed on 1,522 homes came to $1.24 billion, up from 1,250 homes and $1.09 billion net value YOY. Backlog through the end of January increased to $4.35 billion on 5,145 homes compared to $3.66 billion on 4,251 homes YOY. Toll's backlog through the end of October was $3.98 billion on 4,685 homes. Toll has a good-sized long-term debt-to-equity ratio of 89.27%, while its price-to-book ratio is low at 1.05%. The company's return on equity is also low at 9.04%, while its return on assets computes to 4.03%. The average price of a home was $773,700 through the three months ending in January with the average selling price in 2016 coming to $873,500. The up/down ratio of the stock is strongly to the downside at 0.44% through Friday's market close (7 April).

NVR (NYSE:NVR) is more regional home builder whose activities stretch from New York to the north to Florida to the south and from Pennsylvania on the east to Indiana in the Midwest. The stock is up just under 24% through the end of the 1st quarter. NVR posts a long-term debt-to-equity ratio half that of Toll Brothers and a price-to-book ratio of almost five times that of Toll. Gross homebuilding revenues through the end of 2016 totaled $5.71 billion, up 12.71% on 2015 revenues of $5.065 billion. NVR's strongest revenue and profit centers in its homebuilding segment are in the southeastern states of North and South Carolina, Florida and Tennessee and in the mid-eastern states of New York, Ohio, Western Pennsylvania, Indiana and Illinois. Gross revenue in the Southeastern sector rose 23.39% through the end of 2016 YOY and 17.49% in the Mideastern sector of operations. Gross profits followed a similar path, increasing 21.71% in the Southeast and 20.63% in the Mideastern states. New orders and the average sales price of those new orders increased 11% and 2% respectively in 2016 YOY. Backlog units and dollars through the end of 2016 totaled 6,884 units and $2.704 billion as compared to 6,229 units and $2.375 billion YOY. NVR's cancellation ticked up in 2016 to 16% from 15% in both 2015 and 2014. The average selling price of a new home across all operating segments was $381,200, with a range of $439,600 (Mid-Atlantic) on the high end and $292,400 (Southeast) on the low end. The up/down ratio of the stock is strongly to the upside at 1.39% for the highest post of the group, through Friday's market close (7 April).

PulteGroup (NYSE:PHM) competes directly with NVR throughout much of the northeast, south and southeast with the addition of Arizona, Nevada, New Mexico, Washington. In the Midwest, PHM includes the states of Kentucky, Michigan, Minnesota and Missouri. PHM has a similar long-term debt-to-equity profile as Toll Brothers at 74.24% as well as closely comparable price-to-book and price-to-sales ratios. Gross home sale revenues rose 29% through the end of 2016 YOY, while earnings before taxes rose 13.66% over the period. New orders in 2016 came to 20,326 for a dollar value of $7.753 billion. On the volume side, this represents a 13% increase in new orders between the two years and a 23% increase on the dollar side of the equation. Backlog inventory through the end of 2016 came to 7,422 units, up 10% YOY with a market value of $2.942 billion, up 20% YOY. The high-priced western market supplied 26% of the company's before tax income posting a 33% growth through the end of 2016 YOY. The relatively low-priced Midwestern states provided 14% to total gross income and a 31% income growth for the year. The average home price across all sectors came to $373,000, with a range of $491,000 on the high end (Northeast) and a low of $277,000 on the low end (Texas). The company's up/down ratio is also strongly tilted to the downside at 0.30% (7 April).

While D.R. Horton (NYSE:DHI) is a national player with operations spread across the country, just under 64% of the company's revenue comes from five states in the Southeast (Alabama, Florida, Georgia, Mississippi and Tennessee). The other half derives from the south-central states of Louisiana, Oklahoma, and Texas. The net sale of homes increased 9% through 2016 with the net value increasing 12% over the same period. Horton's backlog inventory grew by 8% in 2016 YOY, while the value of its backlog book increased by 9% for the period. Horton's long-term debt-to-equity ratio is the lowest of the four home builders at 41.03%, while its price-to-book, return-on-equity and return-on-asset ratios are the highest of the group; 1.66%, 48.16% and 28.30%, respectively. The stock is up just over 21% through the end of the 1st quarter. The company exposure to the lower-cost sectors of the country where much of its total revenue derives places its average home price significantly lower across its operation segments at $299,600 in 2016 with a range of $502,200 (West) on the high end to $230,100 (Southwest) on the low end. Horton's up/down ratio is also decidedly to the upside at 1.31% (7 April).

This brief sketch of homebuilders competing in the US market presents a decidedly mixed picture of the strong headwinds already starting to blow across the economic landscape. The perfect storm of rising interest rates and rising home prices mixed together with falling inventory stock across many markets poses significant challenges for homebuilders at all price levels. That new home prices over the years have consistently occupied the upper levels of the price spectrum means fewer buyers at lower income levels will be able to either afford and/or qualify for funding from the credit markets to finance such purchases. With the Federal Reserve fully intent at moving forward with the daunting task of shrinking their balance sheet first through the discontinuation of its reinvestment program and eventually eliminating their current MBS pile of $1.769 trillion over the course of time, the impact on liquidity in the mortgage market will likely be singular. While few details have emerged as to the logistics of the Fed's play in this regard, the most likely pullback scenario will be gradual. The last thing the Fed wants to do is to disrupt the mortgage market and create a negative feedback loop into the broader economy. That said, the task of pulling back from its current status as prime market maker, not to mention finding a private sector replacement, will not be easy by any shot. The outlook for home builders remains quite cloudy moving forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.