Time to Move Out

 | Feb 19, 2014 | 5:00 PM EST
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The prime driver of the U.S. economy is debt. The debt that has the most immediate impact on economic activity is consumer debt.

Personal consumption makes up roughly 70% of economic activity and is funded by consumer's access to debt and willingness to take it on. Economic expansions and continued growth are predicated on both access and willingness. Demand for goods and services is the measure of the potential for consumers to increase their consumption. This is determined by their willingness to access credit to take on debt that is available to them.

There have traditionally been two categories of consumer debt that are most important for determining immediate economic prospects: installment and revolving. The majority of installment consumer debt is in mortgages and auto loans. Revolving debt is in credit cards.

Within the last decade, though, student loans have arisen as a new factor that must be accounted for in determining demand for consumption. There is now more outstanding student debt than there is of either credit card debt or second trust mortgages in the U.S., respectively at about $1.2 trillion, $1 trillion and $900 billion.

The massive increase in student debt, which has tripled in the past decade, and the income required to service it, is causing access to other credit necessary for the economy to grow to not be there. But that's just one component of the lack of available credit.

The primary issue is that available consumer credit is already largely used. Since the financial crisis of 2008 underwriting guidelines and credit scoring algorithms have become stricter.

Ten years ago, credit scores were not negatively impacted until the use of available revolving credit exceeded 70%. That's now down to about 30% and by the time consumers have exceeded the 70% level, their scores are greatly impacted. Most consumers don't know this though.

The new qualified mortgage rules that went into effect in January have codified strict limits on credit scores and, more importantly, debt-to-income ratios that must be met by applicants in order to be approved for a mortgage.

Mortgagors are required to have total debt-to-income ratios that do not exceed 43%. That means that all of their debts, including a mortgage, cannot absorb more than 43% of their gross income.

Even though this figure is well above what was the old standard of 36% (which was the rule a decade ago), it is well below the 70% range that was allowed during most of the real estate bubble years. Since 2008, lenders have not had a hard rule they must follow but the industry largely used a 50% debt-to-income ratio as a limit. The problem with that is that most people are already at or near those limits, just by taking into account housing and auto payments, and before even factoring in revolving and student debts.

On average, the only age groups that have available credit within the new guidelines for taking on a mortgage are the current 35-year-olds to 64-year-olds, according to figures published by the Bureau of Labor Statistics. These statistics do not yet account for the fact that this is the same demographic responsible for the large increase in student loans over the past decade.

Those who are younger than 35 and older than 64 years of age are already living beyond the new credit guidelines. The problem here is that the driving force behind consumer debt and, thus, economic activity are first-time home buyers.

With the younger demographic not having access to credit to get a mortgage, because they are tapped out paying for autos, credit cards, and student loans, they are also not forming families. I wrote about this last August in the column Household Formation Is Cratering, and it has only gotten worse since then.

Household formation is now contracting at an average annual rate of 205,000. This is the first time in the post-World War II environment that this has occurred in the U.S. The totality of all of this is that the lack of access to new credit is hindering the economy's ability to grow.

Although there are multiple implications of this that I will address in future columns, the most important for investors now is that the stocks of the homebuilders are reflecting expectations for sales and revenue for this year that are not probable.

After dropping last year -- following the run-up in mortgage rates -- all of the builders have been steadily climbing again on optimism for this year that appears to already be fully accounted for in their prices. I would sell them all at this point: DR Horton (DHI), Ryland Group (RYL), Toll Brothers (TOL), PulteGroup (PHM), Beazer Homes (BZH), Hovnanian Enterprises (HOV), KB Home (KBH), and Lennar (LEN).

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