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Heads - I Win, Tails - You Lose

UNEDITED!

Several housing indicators were released over the past week that confirmed the housing market remained robust in October. During the beginning of the month several homebuilders reported that activity remained strong during the quarter and backlogs were at record levels. Housing starts jumped 6.4% in October to a 2.027 million unit rate. Not only was this better than the 1.96 million rate economists forecasted, but the fastest pace this year. But since housing finished 2003 at the strongest levels in about 20 years, the year-over-year growth was only 2.2%. Permits also increased in October to 2.018 million. Existing home sales were also stronger than expected in October, but off slightly from September. The 6.75 million unit rate was the fourth highest rate since the National Association of Realtors started the series in 1968, with the only higher levels occurring this year. New home sales picked up slightly in October and were the third highest total ever. The combined number of houses sold dropped slightly from September, but was up 5.9% from last year.

Homebuyers continue to use adjustable rate mortgages at record levels. The percent of applications that were for ARMs has remained over 30% for 32 consecutive weeks. That is twice as long as in 1994 when rates moved up. The major difference between when buyers chose ARMs then and now, was in 1994 it was after rates rose. Ten-year Treasury yields moved from about 5.5% to 7.5% before the percent of ARMs was more than 30%. This time, ARMs have soared in popularity as ten-year rates have hovered around 4.0%.

The strong housing market has kept home builder confidence at the highest level since the late 1990s. In October, the Association of Home Builders/Wells Fargo Housing Market Index was unchanged from September at 71. The last time it was higher was October 2003. The component that measures current sales increased two points to 79, which is the highest level since January 2000. The indicator for future sales dropped by two points to 80, obviously indicating expectations remain strong.

This optimism was shared by at least one California man, Igor Doncov, who purchased four houses in Las Vegas from Del Webb, a division of Pulte Homes. It appears that Doncov attempted to profit from the hot Las Vegas real estate market by purchasing four homes for over $1.5 million. Unfortunately, his timing was not very good. If you recall, last month Pulte announced that it was lowering the prices on its homes. This announcement made it impossible for him to resale the houses and "created an instant loss of over $100,000." Reselling the houses was Doncov's only strategy, since the mortgage payments for the four houses totaled $15,000 per month was a little steep for his "a little" more than $30,000 annual salary. At the end of June, Las Vegas home prices had increased 45% from the prior year. If prices had increased even one-fourth that rate, Doncov would have made roughly five times his yearly salary. And if not, mail back the keys or sue. If you are shaking your head, you can read the story here; Man sues after Pulte price reductions.

The million dollar question remains, "what will happen to real estate when interest rates rise?" The Bank of England might have provided a glimpse of an answer. The Bank of England started raising rates last November for a total of 125 basis points to 4.75%. This week, it said that the housing market is experiencing a "significant slowdown." Additionally, Bloomberg reported that HBOC Plc, the largest home loan provider in the UK, said that prices fell 1.1% in October. This was the largest decline in four years.

Greenspan sent a shockwave though the market last Friday by telling those that have not hedged for higher interest rates are "desirous of losing money." This comes after telling homebuyers that they should use adjustable rate mortgage just a few months ago. I doubt homeowners have hedged their adjustable rate mortgages. The common justification for choosing an ARM is that the buyer will only live there for five years or less. The problem with this logic is that the person buying the house in five years needs to be able to afford the monthly payment at the then current interest rate, which is very likely to be higher. If the rates are higher then the payment will be higher if the price remains constant. This cuts down on the number of buyers for the property since it will require a buyer with a larger income than previously. This would not be significant in isolation, but a substantial amount of the housing market is now subject to this dynamic. Plus there is a group of homeowners that have the heads I win, tails you lose mentality. While this represents a very small number of homeowners (hopefully), the low down-payment mortgages have left a large number of homeowners with very little "skin in the game."

Have a happy and safe Thanksgiving.

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