Does New Data Really Suggest A Housing Market Bottom

Date Published: 8/12/09

Hyllandresearch.com

Does new data really suggest a housing market bottom? Abstract: New data released by the National Association of Realtors is being hailed as a sign of the bottom in the housing market. However we believe that the data suggests tough times to come, with implications that will effect the general market, particularly the mortgage industry.

Data released this morning by the National Association of Realtors is being reported as positive news and, in part, was responsible for sending shares of home builders and REIT's substantially higher today. Here are the takeaway points: • • • •

Total state existing-home sales, rose 3.8 percent. 129 out of 155 metropolitan statistical areas reported lower median home prices. The national median existing single-family price was $174,100, which is 15.6 percent below the second quarter of 2008. Distressed sales – foreclosures and short sales – accounted for 36 percent of transactions in the second quarter.

The entire press release can be viewed here: http://www.realtor.org/press_room/news_releases/2009/08/2nd_helped The report generated cheerful stories and sound bytes by the main stream media and insiders: • CNBC: “Existing-Home Sales Rise, Helped by Lower Prices” • NAR Economist: “2nd Quarter Existing-Home Sales Rise in Most States, Helped by Affordable Metro Prices” However, not everyone is turning bullish on the housing market quite yet. Recently a report by Duetsche Bank suggests that by 2011 48% of the mortgages in the US could be 'underwater'. The report has received a lot of press, mostly in disagreement. We wonder, could their estimate be plausible? What economic fundamentals could cause this report, released after many have called a bottom to this recession and housing market, to become true? Are rising home sales congruent with an all around improvement of the housing market? A recent report out of the New York Federal Reserve Bank discusses how the biggest factor in the mortgage market is not home sales, credit ratings or DTI (debt to income) ratio, but is instead home prices. The report, titled: “Below the Line: Estimates of Negative Equity among Nonprime Mortgage Borrowers” can be found here on our scrid page.

Evidence presented in this report shows how, with recent numbers like today's released by the NAR, Duetsche Bank may not be far off in its estimates. In their report, Andrew Haughwout and Ebiere Okah of the New York Federal Reserve find a surprising link between home equity and default risk. Traditional measures used to determine mortgage risk such as credit rating, debt-to-income ratio, loan-to-value ratio proved to inadequately explain the rise in defaults in mortgages. Instead, home prices and negative equity were the economic fundamentals that deteriorated with mortgage performance. The report finds that borrowers with negative equity are twice as likely to become delinquent or default on their mortgages. Where negative equity is defined as having property value below the balance that exists on the mortgage. Studies are cited within the report which find that negative equity adds 7 percentage points to default probability for owner-occupants adds between 15 and 20 percentage points for investors. The report concludes by issuing a warning. “Many borrowers are very near zero equity. Relativly small changes in house prices from this point forward can therefore have large influences on both incidence of negative equity and risk of default”. The data released today showed the largest drop in home prices since the index was created in 1979! And futures contracts on the composite index tells us that the market expects further decline in home prices. The CME group lists futures on the S&P/Case-Schiller Index and they point to housing prices continuing to decline through May 2011.

Data is based on prices from August 13th 2009.

This paints a dreary picture for those who hold mortgage assets, many of which are banks that are already in tough shape. Using these numbers, the report out of the Fed estimates the number of borrowers who will be in negative equity will increase substantially.

The depreciation in home prices is broadly based.

Figure courtesy of fhfa.gov.

Don't be mislead by the key for the picture above. “Less than 1%” for this graph means negative for EVERY STATE except Alaska (+4.8%), North Dakota and South Dakota ( both +.6%). This includes -22% for Florida and California, -31% for Nevada and so on. Clearly no improvement is in sight. Although the increased sales we have seen in the housing market may be beneficial for home builders, it comes at a substantial cost for those who have invested in mortgages. As home prices continue to plunge, defaults will continue to increase. It is only a matter of time until mortgage investors can not handle the increased default rates. We forecast that this cost for investors in mortgages will produce stronger downward pressure on the general market than increased home sales numbers will push up the market. On top of this, other factors such as the still increasing unemployment rate also increase default rates on these mortgages and effect the number of buyers of homes. The report out of the federal reserve expects that 61% of subprime mortgages will be at negative equity should prices depreciate as currently expected by the futures contracts. That is roughly another 2 million home owners into negative equity. Another 2 million that are, at least, 7% more likely to default.

How to Invest in Real Estate There are several ways for investors to play the real estate markets. As mentioned earlier in this article, there are futures contracts that trade the S&P/Case-Schiller home price index, however they trade at very low liquidity, and futures may be beyond the average retail trader. However it is the purest play for a bet on declining home prices. There are also ETF's that track the Dow Jones real estate index. The index is not however a play on home prices (as evident by its run up since March), however if our predictions of a second dip in the housing markets due to continuing decline in home prices come true, then ETF's such as IYR will take a hit. There are several ways to play a downtrend in the housing market. An investor could short the IYR, (or URE which is the 2x ETF) or buy SRS (2x inverse fund). A riskier play is shorting certain homebuilders. The big names are Toll Brothers (TOL), Beazer Homes (BZH) and DR Horton (DHI) to name a few. Many banks are also effected by the performance of mortgage securities. Should defaults continue to increase, banks will face increased pressure. Although government involvement and recent changes to accounting rules in the financial sector makes us uncertain on how bank stock prices will be effected by increased mortgage defaults and decline in the the value of their mortgage investments. Recently, the drop in market volatility has made option prices very attractive as well, as IV (implied volatility) is near 52 week lows for several areas of the market. If a downturn were to occur, and volatility return to the market, buying puts on ETF's such as IYR and certain homebuilders like TOL will offer investors the best return, but at an increased risk compared to simply shorting the stock. Specifically, we are keeping our eye on the Sept 24 puts on TOL, which at close today, trade at only 46% IV at a price of 1.65. The drop in IV also presents some good spread trades, which we will cover in further detail in a future article.

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