Friday, February 16, 2007

Housing Bust Continues

The chart below shows housing construction starts in the US since 1960. The latest data for January 2007 were reported yesterday, down 14.3% to 1.408 million units started on an annualized basis. There had previously been some talk of construction stabilizing as better weather in November and December slightly boosted seasonally adjusted numbers. But the bust is now back on.Previous boom-bust cycles lasted about 6-8 years as measured trough to trough, meaning the average construction boom lasted about 3-4 years. However, the latest boom started back in 1991 and lasted 15 years. Notice also that during the bust leg starts bottomed out consistently at around 800.000 units/year and that we are still far above that level.

Given the length of the boom that just ended, many more houses were built this time, overshooting the "natural" housing demand that comes from new household formation. In the end, the market was driven by speculators who bought overpriced houses expecting to flip them for a quick profit (to whom?) - a bubble. Notice how the number of new houses sold jumped abruptly in 2002-05 (chart below).
But many of those houses are now sitting empty and are just adding to inventory. A record 2.7% of houses in the US are now vacant and for sale only - that's 2.1 million houses (chart below).
Keep in mind that inventory will keep rising for a while longer because builders still have a near record number of houses being completed from projects that started 12-24 months ago (chart below). The very latest number released yesterday showed a seasonally adjusted 1.88 million completions in January on an annualized basis - still very high.
Seen together, the relatively small drop in average house prices so far (chart below) and the record number of empty houses for sale mean that owners are still "sitting" on their properties hoping for a turn. Well, hope dies last, because...

...it is apparent from all of the above that the trough of the housing cycle is still ahead of us. Given the previous excess, this time the bust will be deeper and longer, lasting until the excess inventory of unsold houses is worked off. This can happen in two ways: (a) builders will severely curtail new construction, far below the 800.000 unit/year "normal" trough and (b) house prices will drop significantly to attract new buyers. Either way, the economy will be severely affected:

If condition (a) predominates, unemployment will rise sharply because housing creates jobs in many fields besides construction (materials, shipping, retail, housing services). If (b), then the financial/banking side of the economy will be hit hardest with mortgage delinquencies and defaults rising sharply as lower prices causes home equity to evaporate and even turn negative.

So far we have seen both (a) and (b) happening in relatively modest ways: builders have reduced housing starts but are still running far above trough levels and finance has been hit hard only in the sub-prime category which accounts for ~14% of all existing mortgages. The ABX group of indexes just made new lows yesterday, signifying that the cost of such risky mortgage loans is now completely prohibitive. Interestingly, it is not only the BBB/BBB- tranches that are getting hammered: the weakness has spread into the A rated tranches as well, pointing to higher lending costs beyond the sub-prime area.

Tighter lending conditions obviously removes marginal demand from the housing market at a time when supply is high and expanding. It won't be long before average prices also reflect this new housing market reality, if only for a very simple reason: all those vacant homes for sale incur mortgage payments, taxes, insurance, etc. while their owners have to live somewhere else, incurring another set of expenses. They can't re-finance either, because lending conditions are tighter and prices are not rising to create excess equity. At some point the weakest owners will be forced to throw in the towel and either default or sell at a distressed price, bringing down overall house values. Renting out this excess inventory is not really an attractive option, since rents are currently far below carry costs (chart below). In any case, a move towards renting and away from ownership removes even more marginal buying demand.

Bottom line: we are still quite far from seeing the trough and things will get much more challenging for all involved, including Goldilocks. I believe her la-di-da attitude towards credit risk is dangerously short-sighted.

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