Housing Headwinds Begin

 | Jun 27, 2013 | 5:00 PM EDT
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Housing prices and transactions have rebounded over the past year in stunning fashion, reversing from contraction into expansion, and they are now on a new bubble trajectory. The year-over-year average national rates of appreciation, according to the S&P/Case-Shiller home price indices, have advanced by about 12% in the past year.

Rates of appreciation in the southern half of California, Phoenix and Las Vegas are 20% to 25% on average. The 10-year rolling national average rate of appreciation at the most recent bubble peak in 2006 was 12.5%. The sustainable and historical multi-decade average is about 5.5%. The current trajectory for home values has been engineered by way of cheap debt capital from the Fed, coupled with inventory restrictions from the banks.

After the recent surge in Treasury yields and mortgage rates, which was caused by the Fed indicating its interest in removing support for mortgages and Treasuries, the cheap capital driver is now gone. In the span of about a month, mortgage rates have shot from six-month highs to two-year highs. This rate of increase, which has taken par 30-year fixed conventional conforming mortgage rates from roughly 3.5% to 4.5%, and which has caught consumers interested in buying a home unprepared, will almost certainly cause price appreciation and a decrease in transaction volume.

We had all better hope that it does anyway, because if it doesn't, a new bubble in home prices very soon is inevitable.

The next issue for housing is the dearth of inventory. Next week, the Federal Housing Finance Agency will officially implement its plan to allow defaulted mortgagors to refinance and keep their homes. I wrote about this issue in two back-to-back columns in March, "Stealth Bailout Buries Banking Default Reality" and "FHFA's Loan Changes Good for Housing, Banking, Stocks." I suggest reviewing them again to get a brief understanding of the magnitude of the issue.

I still don't know the mechanics of how the money centers are going to proceed with this, but I will reiterate some issues I discussed previously.

One of the keys to making the Streamlined Modification Initiative viable as an alternative to foreclosure is that the rates and payments that result from the restructure of the defaulted loan must be substantially lower than the rates and payments the defaulted mortgagor had.

Most of the inventory of eligible defaulted mortgages is concentrated in the money centers: JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C). Most of those loans originated between 2002 and 2007, with average loan rates between 6.5% and 7.5%. 

It's important to note here that non-GSE loans, those not financed through a program sponsored by Fannie Mae, Freddie Mac or the FHA, are not eligible for the streamlined initiative.

For those who are eligible, though, now that mortgage rates are rising, the reduction in monthly payments associated with the new loans is being reduced. It is probable that in order for the program to self-finance, the cost of restructuring the loans that the new rates offered to the defaulted mortgagors will be about 1.5 percentage points above rates for new home purchases. This would put them in the 6% par range today, and thus not much below the rate on the defaulted loan. Even at that rate, though, it is possible that there will be a reduction in payments of some kind.

The important issue for investors to be aware of is that the beginning this program also starts the foreclosure process.

Defaulted mortgagors who either refuse to participate or cannot make the payments on the new loan will not have their loans simply returned to the bank's nonperforming portfolio. The bank will have to send the loan through the recovery process, which requires foreclosure.

That could cause a surge of properties to come to market, reversing the inventory dearth and creating a glut.  

Investors in the stocks of companies in the residential real estate space -- homebuilders, builder suppliers and mortgage lenders -- should watch this issue closely. The best proxies for these groups are Toll Brothers (TOL), Whirlpool (WHR) and Bank of America.

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