If you listen to the news media today, you might hear how housing prices have stabilized and that the worst for housing is over. For this entire year, the media has reported how February sales outpaced January’s while March’s topped February’s and so-on. Just this week, October sales came in 10% higher than September. Compared to previous months, it appears that housing has stabilized. But, what is left out of this reporting is how the housing market almost always sees this trend. The spring months outperform the winter months, and the sales peak in the summer. The chart below shows this annual trend for new home sales. As far as new homes, the month-to-month improved in 2009 until September, but the total sales are still below 2008’s depressed levels.
Existing home sales presents a little better picture from 2008 to 2009 starting in June of this year. This increased coincided with the $8,000 new homebuyer tax credit. Just this week, the National Association of Realtors (NAR) claimed sales rose 10% in October, but this was largely due to buyers jumping to take advantage of the tax credit, which was ultimately extended beyond the original expiration date of November 30th.
While these are encouraging signs of a possible bottom, I fear this is just the pleasant weather found in the eye of the hurricane. We could still face a massive amount of foreclosures over the coming two or three years that will put more pressure on real estate. I do believe the vast majority of the price declines are priced into the market, but I don’t see a rebound in prices for some time to come.
The reason I see more foreclosures in the future is due to the resetting of the Adjustable Rate Mortgage (ARM) market, particularly the Option ARM market. As you probably know, an ARM has a steady interest rate for the initial, trial period, usually 5 or 7 years. Then the interest rate adjusts according to the prevailing market rates. In this environment of low interest rates, this really isn’t a negative. In fact, many ARM holders will see lower payments at today’s interest rates once the mortgage adjusts. So long as interest rates in the various bond markets hold steady, these mortgages won’t be a problem.
However, the Option ARM market is a different story. An Option ARM is a different kind of mortgage. Known as the negative amortization loan or NEGAM loan, this mortgage allowed the home owner to pick a mortgage payment each month. Usually, four options existed: a payment based on a 15 year mortgage, a 30 year mortgage option, an interest only option, and a negative amortization option. The fourth option, the negative amortization, was the one most picked by homeowners. This payment allowed the homeowner to pay less than the interest due each month. Whatever interest was not paid is added to the principal. These homeowners are increasing the size of their mortgage each month. Even worse, the total amount of interest owed increases as well because the interest calculation is based on the principal amount.
These Option ARMs have a reset feature. Just as the traditional ARMs adjust after the initial fixed rate at 5 or 7 years, the Option ARMs adjust as well. These loans not only adjust the interest rate, but the banks require homeowners to begin paying down the principal. Even if interest rates remain low, these homeowners could see a substantial increase in their mortgage as they are required to pay the principal down. The jump in payments could be as high as 30%. Considering most of the homeowners who took these loans based their affordability on the negative amortization payment, this could result in many foreclosures. The ARM market is just as big as the subprime loan market, which started this housing fiasco. According to the chart below, the ARM resets begin in mass the summer of 2010 and won’t decline until the winter of 2012.
Even without factoring the ARMs, foreclosures stand to rise substantially. A “shadow inventory” of foreclosures will come to market sometime over the coming year. It is called shadow because the banks have yet to bring the homes to market. The banks are not pricing assets at market values (mark-to-market). If they did, they would be required to increase capital to improve their asset base. If a bank has a defaulted mortgage on its books, the bank may be better off not receiving the monthly mortgage payment than foreclosing and selling the property at a loss.
For example, say a bank has a mortgage on a home for $300,000. The monthly mortgage payment is $2,000. If the borrower defaults, the bank is losing $2,000 in revenue each month. But, the bank can still price the home on its balance sheet for $300,000. If they foreclose and sell the home for $240,000, the bank must recognize the $60,000 loss. So the banks want a stable market to bring these foreclosures to the market, and they want to do it as slow as possible. This gives them time to raise capital. Remember, the banks can borrow from the Federal Reserve at zero percent and either invest in Treasury bonds at 3% or loan to customers at 6% or more. This difference allows the banks to make tons of money. They just need time to earn enough to cover losses.
The banks could still be in trouble as the number of homes in the shadow inventory could be enormous. Estimates have ranged from 1.5 Million to 3.5 Million. One estimate even puts this number at 7 Million. What scares me is the 7 Million estimate – the equivalent of 2.5 years of supply – seems reasonable.
The chart above is from Amherst Securities. Amherst looked at all the homes either in foreclosure or behind on their mortgage (90 days late, 60 days late, and 30 days late). Amherst then estimates the probability that these loans will default based on historical cure rates. A cure rate means the loan is cured or the homeowner resumes paying the mortgage. Obviously, a home in foreclosure already has a 100% chance of coming to market as a foreclosed property whereas a 90 day late mortgage has a 99.2% chance of ending up as a foreclosure sale. Homes that are 60 days behind end up in foreclosure 95% of the time while 30 day defaults wind up in foreclosure 72% of the time. Based on these figures, Amherst believes 7 million homes are in jeopardy based on current defaults.
Along with the bankers reluctance to bring these homes to market, the government is attempting to stem the tide as well. Many states have issued moratoriums on foreclosures, and the federal government has a program to modify mortgages for distressed homeowners. Plus, the federal government created the housing tax credit to spur sales, and the Federal Reserve is printing money to buy Mortgage Backed Securities (MBS) to keep mortgage rates artificially low. However, these programs only kick the can down the road. Most state moratoriums are ending. The loan modification program has modified 400,000 mortgages with the temporary modification. To date, only 1,511 have become permanent. The other 399,000 benefitted from a five month trial period where the government determines if the homeowner can, in fact, afford the home. It appears most cannot. The Federal Reserve plans to stop its purchases of MBS in the first quarter of 2010, and the home buyer credit will probably continue for years to come in my opinion.
This great news completely ignores the troubles in the Commercial Real Estate market, which faces extreme difficulties over the next three years. While the the recent trends in housing have been positive, it could just be the eye of the hurricane.