Homebuilders Rally, but Beware Fed Friction

 | Jun 15, 2012 | 3:30 PM EDT  | Comments
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Homebuilding stocks were up sharply Thursday, stoking hopes that the group might resume its climb that began after many had reached record lows last summer.   Fresh evidence suggests ample reasons to be bullish.

Nevertheless, as with just about everything touched by Washington these days, there is a wall of related policy-risk worries still to climb that even now may not be fully built. There is a poorly-chronicled new threat to mortgage lenders from the Fed and other regulators relating to emerging new international capital standards that may force the bankers to continue wearing leg weights, even as layup opportunities multiply.

While there may have been other catalysts for the June 14 rally, one I'd point to is a bullish new forecast and analysis freshly released by Harvard's Joint Center for Housing Studies predicting that "2012 will mark the beginning of a true housing market recovery."

The report followed weeks of great news about a boom in multi-family housing construction and -- partially boosted by the rising rents that helped drive this move -- a separate report that median asking prices among home sellers in May hit the highest level in 2-1/2 years.

Both these reports could presage another positive reading from the National Association of Home Builders/Wells Fargo Housing Market Index (HMI), which a month ago reported the strongest pick-up in builder confidence since 2007.

The Harvard report is a worthy read, in no small part because it delivers the good news along with the bad. As the authors note, there is a backlog of 2 million homes in foreclosure. After the mortgage servicing settlement of late winter, this backlog is finally expected to begin clearing, but even amid budding recoveries in key states, these sales still threaten to depress prices.

Another 11 million homeowners owe more on their mortgages than their homes are worth, "which dampens both sales of new homes and investment in existing units," the report continued. Nevertheless, the authors noted a dividend from parallel rental markets. Those markets, while already recovering, have yet to benefit fully from the Echo-Boom Generation. As soon as the economy recovers, more of this cohort will be able to move out of mom's house and strike out on their own, initially adding even more demand for rentals. But as rental prices continue to rise, the relative cost of buying will decline. 

Meanwhile, the maturation of Echo Boomers and aging of likely-homeowning Baby Boomers led the Harvard authors to predict a near doubling in 2007-11 household formation rates to 1 million new units a year. Add the fact that 86% or more of 18-34 years olds still aspire to homeownership and one can easily buy into an upbeat view for the homebuilding industry, retail hardlines like Home Depot (HD) and Lowe's (LOW) and the housing sector writ large.

But to do this you have to first move beyond the chicken-egg argument of whether the U.S. economy is weak because of housing or housing has made the economy weak. The Harvard authors have largely done this, noting that "housing should make a stronger contribution to economic growth in 2012 than it has in years."   You also have to immunize yourself from seductive stories about what mass refi-enabling legislation or reforms from Washington might be able to do. As I've written before, they're not going to happen.

As the Harvard authors conclude: "The greatest potential for recovery in the for-sale market lies in its historic affordability for well-positioned homebuyers. But the availability of mortgage financing for young buyers with limited cash, other debts and less than stellar credit is far from certain."

"With key mortgage lending regulations still undefined," they noted, "it remains to be seen to what extent and under what terms lenders will make credit available to lower-income and lower-wealth borrowers."

This reference was likely to the CFPB's evolving Qualified Mortgage (QM) standard, which lenders fear might provide less than a safe harbor protecting them from suitability-related lawsuits regarding borrowers' ability to pay and the separate but related Qualified Residential Mortgage (QRM) standard expected to determine what kinds of mortgages can escape higher capital charges for banks or risk-retention requirements regarding mortgage securitizations.  

I think the housing sector has had 15 months to adjust to these concerns, which hopefully won't prove as tangible or disruptive as feared. The final QRM standard, for example, is expected to back away from an initially-proposed 20% minimum down payment and even tougher debt-to-income and debt delinquency disqualifiers.  Nevertheless, related uncertainty could freeze lenders in the interim.

More importantly, the list of regulatory worries grew even longer last week when, in the context of proposing a new standardized approach to bank capital risk weightings under Basel III, the Fed and other regulators threatened to make banks hold capital for mortgages and other off balance sheet transactions as if they were on balance sheet (at least for 90 to 180 days). A top banking analyst estimates that these provisions and their related rep and warrant implications could force mortgage leader Wells Fargo (WFC) to either increase its capital by 10% or significantly decrease the bank's level of securitizations.

According to one former top regulator and industry lobbyist, who has recently joined the mortgage business, "Basel is a huge concern, but the hope is we can get the rule changed." As with the QRM (if not the QM), I'd bet that will prove the case.

Still, one has to marvel that yet another great uncertainty has been heaped upon lenders so late into the re-regulation cycle, when the politicians want them to lend so badly. All of which suggests that homebuilding stocks may be better suited for those with a medium-term investment horizon.

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