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January 01, 2009

Homes For The Holidays

Homes For The Holidays...Unfortunately, yeah, and plenty of 'em. It's an understatement to suggest residential real estate was either directly or tangentially very important to both economic and financial market outcomes in 2008. It has been the cornerstone of solvency, or lack thereof, in so many quarters of the financial sector. And as such, has had profound influence on the character of the US and really global credit cycle. It's been a while since we've checked in and all of us know that residential RE will continue to be a key macro economic health watch point as we move into the New Year. The current reconciliatory cycle drag that is residential real estate affecting financial sector balance sheets, household balance sheets (and P&L's for that matter), etc. is not about to dissipate in importance to macro economic outcomes in 2009.

You've seen what has happened recently as the Fed has gone into a good bit of hyper drive in terms of trying to financially engineer at least some type of stabilization in what continues to be a downhill journey for the asset class. They've allocated $600 billion to essentially buy agency debt (Fannie and Freddie paper) in the hopes of getting and keeping US conventional mortgage rates down. And so far that has indeed happened as post the establishment of this new Fed investment endeavor, conventional 30 year fixed mortgage rates dropped a good 100 basis points, plus or minus, in a matter of weeks. We'll spare you the graph, but in recent weeks we've seen new mortgage applications and refi apps spike meaningfully higher.

Mission accomplished by the Fed? We'll see, as we need to remember that a lot of folks with rate-locked in-process loans could only have taken advantage of these new lower mortgage rates by canceling the prior loan and writing a new one, probably with another mortgage vendor, which naturally would count as a "new" mortgage or refi app in recent data. Hence, there may be a bit of anomalistic higher counts in recent weeks due specifically to getting around prior rate lock issue, so we'll need to continue watching the data in the months ahead. Lastly, and you may know this already, China and a few foreign friends have been big sellers of government agency paper since the summer of this year. The $600 billion the Fed has already so generously provided is in part simply offsetting current foreign selling of US agency paper.

Additionally, the Fed followed up the $600 billion down payment, if you will, in trying to spark housing price stabilization/reacceleration with an announcement that they would like to put a program together (through wonderful taxpayer sponsored Fannie and Freddie) to provide 4.5% 30 year conventional loans to new home buyers. After all, it is the season of giving, no? Bottom line being, the Fed is starting to pull out all the stops to arrest home price contraction. Upping the ante in a big way relative to prior efforts. We expect the Obama regime to likewise address this issue, and perhaps forcefully. They've suggested rewriting existing mortgages, but that enters into the very dangerous and cornerstone area of contract law.

Key question for both our economic monitoring and investment decision-making ahead then becomes, can the US government decree/legislate/manipulate home prices higher, defying the natural laws of asset class supply and demand, as well as character and path of a generational credit cycle now in reconciliation? Defy? We doubt it. Temporarily arrest? The correct answer is, we're going to find out. Important in that, as we all know, the locus of initial US credit cycle trauma was the mortgage securities markets. Residential real estate was also the locus of consumer credit creation this decade and a current key driver of household net worth decline, certainly along with equities, influencing household financial well-being. Lastly, we need to remember the importance of investor psychology and bear markets as this applies to housing. Any even temporary stabilization in residential real estate would echo in positive psychological influence to the financial markets. All part of the ebb and flow of cycles in both financial markets and investor psychology.

A few macro overview observations about just where we are in the cycle itself. Cutting to the bottom line, at least in our minds, inventory and price remain the two largest cyclically unresolved outstanding fundamental issues for residential real estate at the moment. Once inventories at least get in line with historical precedent and prices stabilize, then we can begin to anticipate a better tone to mortgage credit markets, the housing industry itself, consumer well being and hopefully the macro economy. It's when housing stabilizes that the unprecedented stimulus being force fed into the system by the Fed/Treasury/Administration may begin to bite and gain traction. Let's get right to a few simple and self-explanatory views of life. The following is a four and one half decade view of median family home prices relative to median family income.

To get back to the average level for this ratio since 1963 (the red line in the chart), median home prices would need to drop roughly another 12% from current levels. And of course this assumes the cyclical correction stops at the historical average. Let's face it; we've already lived through a lot of price correction. The problem clearly is that other factors are weighing on residential real estate prices at the current time. Weak labor and wage growth, a coordinated global economic downturn of historical significance, and a credit market contraction of very meaningful magnitude is colliding with a housing reconciliation cycle, arguing the relationship above being arrested at the average of the last four and one half decades may be wishful thinking. Is the Fed essentially trying to speed up the reconciliatory process implied by the above relationship in manipulating the important plug factor in the real estate equation that is financing costs? Of course this is exactly what they are doing. Whether they will be successful is the unanswered question. And in good part that depends on the ability of inventory to clear as a result of the character of both price and financing costs.

Let's move right on to the also important issue of inventories. In the past we've shown you a lot of raw numbers when looking at this data. Time to stop that. Below is a look at the number of homes listed strictly as "for sale" properties (in other words this does not include second homes, rentals homes, etc.) at the current time. This go around we compare these per unit of inventory for sale numbers to the total US population to get a sense of historical perspective. We've heard "everybody's gotta live somewhere" a million times by those trying to bull up the residential real estate markets over prior years. And since the population is ever growing, comparing current nominal inventories to past cycles is misleading because of the dynamic of population growth. Oh yeah? Well now we're looking at the number of homes for sale relative to "everybody". Any questions?

As the chart tells us, when looking at per unit for sale residential homes on what is essentially a per capita basis, we're looking at a current level that is just shy of twice the historical average of the last four-plus decades. Yes indeed, everybody needs a place to live. It's just a good thing there are so many places to choose from at the moment relative to historical precedent, no?

The last chart characterizing current residential real estate inventories very much mirrors the directional pattern of what you see above. It's very simply the number of vacant single-family homes relative to all single-family homes. Bottom line? We've never seen anything like current levels. Residential real estate as an asset class cannot begin to fundamentally recover until inventory clears, and this is far from an "all clear" view of life. Seems a matter of relatively basic common sense, no?

House That Again?...Before concluding, a few last housing related anecdotes we hope are of interest. As per the comments above, we know that fundamentally housing prices and current residential real estate inventories remain open question mark issues. And the home building industry is more than aware. This is a very good thing in terms of cycle reconciliation. As of the latest data, housing starts rest near half century lows in nominal terms. Residential real estate construction has essentially collapsed. Existing inventories and price have been very strong drivers of this collapse in new activity. Years of demand were more than satiated in the prior mortgage credit cycle. The view of per unit starts is seen in the top clip of the following chart. In the bottom half we look at starts again as a percentage of the total US population. A new record historical low at recent levels. Clearly existing inventory remains the issue for real estate, not new inventory. As existing inventory clears, the asset class will heal. That process is well underway. The Fed just wants to speed things up a little with a big bit of financial engineering. Of course financial engineering has worked so well for them in the past, right?

Finally a very simple update of macro US homeowner equity as a percentage of the market value of real estate. You already know this ratio has been plunging for multiple decades now, plumbing new lows at an accelerating rate with each passing quarter over the last two to three years. The Fed has been quite kind to recently manipulate credit market mortgage costs downward, but only the real economy and real world residential real estate cycle can change the trajectory of what you see below. And this is the key to credit market collateral values, a sense of household financial well being, access to real estate based consumer credit, etc. Important? Yeah, we'd say so.

As we look at the chart above and contemplate what may be to come ahead, we again come back to the macro issue of deleveraging, running through the domestic and global economy. How do homeowners act to turn the trajectory of the relationship you see above upward in an otherwise very tough pricing environment? Deleveraging. Paying down mortgage debt. We're pretty convinced US financial sector deleveraging is well underway and more than discounted by the markets. Alternatively, we'd suggest household deleveraging is more just getting started in comparison and we believe has a long way to run. We expect this will be a major macro theme for 2009. Have the markets completely discounted this thought? We're simply not sure at this point. Residential real estate was incredibly important to economic and financial market outcomes in 2008. We expect exactly the same in 2009.

The message of the data above is clear, price and inventory cycle reconciliation is not yet finished. What is also clear is that the Fed/Treasury/Administration are stepping up their efforts as we walk into 2009 to truncate unfinished cycle reconciliation at almost all costs. Although we'll save this for a future discussion, we're not only focused on the importance of residential real estate in our current economic and financial market circumstances and how it will influence the financial sector, credit cycle dynamics and the real economy, but place incredible weight on the assured unintended consequences of Fed/Treasury/Administration efforts to truncate the natural cycle. The markets know what the Fed/Treasury/Administration are doing and are discounting these actions known actions in financial market prices. But it's the "at almost all costs" unintended consequences of this truncation attempt that may indeed be most important to 2009 investment decision making.

Market Observations
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