Is the Housing Sector a Drag on the US Economy?
The S&P/Case-Shiller 20 City Index rose at a 13.8% annual rate in November. This proves that the US housing market continues to recover, right? The headlines in most news stories and economic commentaries indicate that the housing market is continuing to improve and with it the US economy. But if you dig into the numbers a bit, the reality in the housing market is a good bit more subtle than the headlines suggest.
Indeed, it can be argued that the US housing sector has not really recovered significantly and remains a major drag on US economic growth. Back in November 2012, I predicted that housing would be a drag on the US economy and could even drag us back into recession. The reason? The failure by Congress and federal regulators to restructure under water borrowers would eventually become a dead weight, limiting growth and job creation, as well as home price appreciation, as it did from the 1920s through until the early 1970s.
For example, in the second paragraph of the S&P press release it states:
For the month of November, the two Composites declined 0.1%. After nine consecutive months of gains, this marks the first decrease since November 2012. Nine out of 20 cities recorded positive monthly returns; of these nine, Boston and Cleveland were the only cities not in the Sun Belt. Minneapolis and San Diego remained relatively flat. After declining last month, Dallas edged up to set a new index high. Denver is 0.6% off of its highest level due to two consecutive months of declines.
There are a couple of key things to remember when you are looking at the Case-Shiller Indices. First and foremost, the price gains seen a year ago reflected the sale of foreclosed homes, what we call “REO” in the housing business for “real estate owned.” If you take REO sales out of the numbers, then the real increase in home price appreciation or “HPA” was something more like 6-7%. Second, the hottest housing markets are pulling the average higher while most other markets are slowing or even going down.
“November was a good month for home prices,” says David M. Blitzer, Chairman of the Index Committee at S&P Dow Jones Indices. “Despite the slight decline, the 10-City and 20-City Composites showed their best November performance since 2005. Prices typically weaken as we move closer to the winter. Las Vegas, Los Angeles and Phoenix stand out as they have posted 20 or more consecutive monthly gains.”
This week, Jeff Macke wrote an excellent analysis for Yahoo Finance showing the sharp divergence between different US housing markets. Specifically, while about 20% of all US homes remain under water, the numbers for some states are much higher. He noted:
December’s headline data from RealtyTrac showed the national rate slipping to 18% of homes being underwater or having negative equity (which simply means a homeowner owes more than the property is believed to be worth), but at the bottom of the scale, there are still 9.3 million “deeply underwater” homes that are in the hole by twenty five percent or more. In fact, six states that are at least ten points above the national average of 18%, including Nevada (38%), Florida (34%), Illinois (32%), Michigan (31%), Missouri (28%), and Ohio (28%).
“Normal real estate overhangs are created by people moving and dying,” notes a veteran real estate attorney who lives in Florida. “In Florida, for example, the mortality rate is said by realtors to generate, on its own, a normal turnover rate of about 4-6% per annum of the total housing stock. If 2% get wrecked for whatever reasons and 4% are built, that means about 7% or so of housing needs to sell each year, just to keep prices stable. That's a HUGE amount--and since we have not hit the mark, that's why Florida prices are stuck and sometimes still sinking.”
The attorney notes that when "in-migration" to Florida stops (we close the borders to capital flight and retirees cannot sell homes elsewhere--for whatever reason--to move here), the impact is to push Florida real estate down, even when "normal" turnover begins to get covered elsewhere. This is one reason why the State of Florida seems to LOVE developers who defraud people into buying homes. It may be crooked, but it increases sales, thus Florida’s civil fraud laws and enforcement are among the weakest in the nation.
Even in some of the better performing states, the degree of home price appreciation has still not nearly caught up with peak prices seen during the housing boom. In a report this week in the Los Angeles Times, Andrew Khouri noted that despite a nearly 30% YOY increase in HPA in the Bay area, home prices are still well-below the peaks seen during the housing bubble, leading to a dearth of supply for home buyers:
Home prices in the tech-flush Bay Area continued to post strong annual gains, although at a slower pace than earlier in 2013. The median has held at about the same level since summer. Over the year, prices jumped 23.9% to $548,500 in December. Although home prices have risen more than 20% year-over-year for 14 straight months, the median price is still far below the $665,000 peak during the housing bubble. Besides slowing price appreciation, there were other signs the market is normalizing. Distressed sales and investor purchases both declined over the year.
The lack of supply in markets like the Bay area are actually pushing prices higher because of the lack of available homes for sale, but not enough to get back to pre-crisis levels.
Another factor that analysts and investors need to remember about housing prices and the various price indices used to track HPA is that these are lagging indicators. My friend Sam Khater and his colleagues at CoreLogic produce an excellent blog on the housing market (http://www.corelogic.com/blog/). He noted several months ago that home prices in the lower end of the market have been slowing for months, a leading telltale of change in what is a lagging indicator. Think of home prices as a large herd of animals, with the more attractive homes still moving up, while the inferior homes are slowing or even falling in value. Sam noted in a recent email exchange about the deceleration in HPA:
As for the slowdown, irrespective of methodology home prices have always a lagging indicator behind other real estate metrics. Furthermore it’s also lagging in our data (and Case Shiller) because we use a 3 month moving average of closed sales in the public record. So it takes a while for price accelerations/decelerations to show up, but we can see it in some sub-segments of price continuum, like lower end prices which have clearly decelerated.
So what are the takeaways from this analysis? First, a large part of the improvement in US home prices seen over the past several years is due to the closing of the gap between REO sales and voluntary retail sales. Now that the REO trade is basically done, the rate of increase in HPA is likely to fall as well – all things being equal.
Second, the fact that many homes remain under water vs. the mortgage debt on the property is constraining supply, another near-term positive for home prices, but a negative for the US economy. Indeed, it can be argued that the still large percentage of homes that lack at least 20% positive equity – the minimum required for a voluntary sale without forcing the debtor to write a check at the closing – is a major obstacle to the Fed’s efforts to reflate the housing sector via low interest rates and “quantitative easing.”
Finally, the clear deceleration of home prices, especially at the low end, suggests that the summer of 2013 was really the peak in US HPA, as analysts such as Michelle Meyer at Bank America Merrill Lynch have reported. While many analysts continue to predict that home prices as measured by Case-Shiller and other lagging indicators will continue to rise, any increases in these averages will be a function of a few top-performing markets as opposed to a broad increase in HPA for the US as a whole. Real estate, as the old saying goes, is a local market.
But aside from the outlook for HPA, the key issue for investors and policy makers is how to clear the huge, abnormal overhang of underwater homes that is weighing down transaction volumes and the US economy. If a third of all US homes cannot trade due to being underwater or not sufficiently above water to clear the mortgage and closing costs for the seller, then the US economy is going to suffer – and it is suffering now, despite what you hear in the big media. Reduced labor mobility is just one of the drags on US economic growth.
The underwater component of the US housing stock reported in the statistics is 18% of total or 9.3 million mortgages. Add another ~ 5-10 million homes below the 20% equity threshold that allows them to trade without the seller writing a check or a total of 35-40% of all US homes. That is a huge number and equals somewhere between 10 and 20 years of new home construction. Free immigration might absorb some of that, but without forgiveness of taxation, we'd need a huge inflation cycle in housing to take that monkey off the back of the US economy.
The last time we had a national calamity in housing like the current 1/3 overhang of underwater and barely above water mortgages was the Great Depression. It took until the 1970s arrival of the REIT and tax shelter craze that finally allowed states like Florida to clear the overhang of the land bust of 1927. As we’ve noted before in ZH, everything and everyone in real estate finance simply "froze" in fear from 1929-41. The Second World War disrupted normal economics for another decade. It took until the 1950s and 1960s for growth to get to a point where "inflation" pushed housing up enough to free Florida and other states from the deflationary vise that started to hit it in the late 1920s.
The Fed has tried to deal with the overhang of housing by stoking up inflation via QE, but that has clearly not worked. The appalling volume numbers for bank mortgage lending bear grim testament to the failure of QE when it comes to housing and credit creation. The other alternative is restructuring, but the Fed and most of the banking sector have stubbornly resisted this idea. We need Congress to respond by changing uniform bankruptcy law and tax law. Nobody else has the Constitutional power to do what's needed. Specifically, we need to remove the prohibition on federal judges restructuring mortgage loans in bankruptcy and extend the tax holiday for mortgage debt forgiveness for another five years. But given that Congress and the Fed are in the pockets of the large banks and institutional debt investors, the chances of this happening are just about zero.
So to answer the question, has the US housing market recovered? Well, sort of, but not enough to make a positive impact on growth and employment. Net, net, the US housing sector remains a net drag on the US economy. This will not change in the near term unless a miracle occurs and the small minded men who inhabit Congress will take a lesson from the 1930s and start to aggressively restructure the millions of mortgages that remain hopelessly under water. The incentive to do the right thing is very simple. If we wait long enough, those under water home loans sitting inside mortgage backed securities and on the balance sheets of US banks will turn into defaults.
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