Amazingly, we've just heard the first bubble warnings about homebuilder stocks, which have inflated over the past year on hopes for a housing-market recovery. For instance, shares of Toll Brothers (TOL) and Lennar (LEN) have more than doubled, and Pulte (PHM) is nearly a three-bagger.
Even after Wednesday's downdraft amid worse-than expected new-home sales numbers, I suspect that call is premature, but it still worth measuring, for the following reason. While the adverse credit environment I flagged in June hasn't spoiled the party (thankfully), it could occur via post-election tampering with the tax code.
The White House and Senate races aren't over, of course. There's still a chance that pollsters might be oversampling Democrats, or that Republican presidential nominee Mitt Romney and running mate Paul Ryan can turn things around during the four presidential and vice-presidential debates beginning next week. But recent polling numbers and Intrade results signal that a status-quo Obama re-election is increasingly likely, along with a maintained Democratic Senate majority. If we couple this with President Obama's positioning to force GOP concessions in order to avoid the "fiscal cliff," we may see the investment significance become more evident.
Most notably, Senate Republicans have begun to signal resignation toward agreeing to higher taxes during the lame-duck session, which is to begin in mid-November. They may rationalize this as being necessary to avoid the greater evil of devastating across-the-board defense cuts to be triggered on Jan. 2, 2013. This adds new importance to the question of whether House Republicans might lose enough seats in November to perceive their majority as being at risk in 2014. That, in turn, might diminish their own resistance to a tax hike during the lame-duck session.
According to my partner and fellow Real Money contributor Jim Lucier, the net of these forces is that "tax expenditures" -- such as the mortgage interest deduction (MID) -- may be put at risk far earlier than expected. This could occur well before Congress begins deliberations over comprehensive tax reform. Depending on how any such move might play out, this could test the nascent housing recovery, or even put secular downward pressures on high-end housing. That's the particular province of Toll Brothers, but also the ambition of others, such as Lennar and Pulte.
Part of the backdrop has constituted MID-curbing proposals from President Obama, Mitt Romney and the Simpson-Bowles deficit reduction commission. Obama, in his fiscal 2013 budget, proposed to cap MID deductibility at 28% for individuals making $200,000 per year or more and couples earning $250,000 or more, while Romney has discussed denying deductibility for second homes. Simpson-Bowles, meanwhile, recommends capped deductibility of a mortgage at $500,000 (down from $1 million) and conversion of the current deduction to a 12% tax credit.
What isn't new, of course, is that the housing lobby remains focused and powerful. It's armed with well-honed arguments that, according to its data, the incidence of tax relief from the MID goes overwhelmingly to middle-income households with children -- those earning less than $200,000. It even throws in the pitch that MID is actually progressive, given that these cohorts pay 40% of taxes, yet get 70% of the relief.
These assessments are refuted by others, who turn things around to argue that 75% of the relief goes to those earning more than $100,000, and that the provision is regressive because the benefit grows for those with bigger mortgages in higher tax brackets. Meanwhile, observers note that the MID, which has been in existence since 1913 -- and has been arguably made more valuable by the ending of deductions for consumer interest in the 1986 Tax Reform Act (TRA) -- has really served to incentivize Americans to leverage up and buy bigger houses. Given the additional fact that Canada, Australia and other countries have no MID yet sport higher homeownership rates, and given also the lingering ill will toward banks and a new focus on renting, the backdrop for housing-related tax reforms seems propitious indeed.
So is now a good time to make a change? If so, what form might that take?
The bigger-is-better/easy-money paradigm that created the housing bubble and helped to precipitate the Great Recession has proven to be a decidedly mixed bag for middle- and upper-middle-income homeowners. In many markets, prices and sales of more expensive homes haven't recovered as quickly as those being bought out of foreclosure or at short sale by lower-end or first-time homeowners. Meanwhile, with Fannie-Freddie and FHA loans representing the only games in most towns, the prolonging of lender-policy risk from emerging Basel standards and Dodd-Frank mandates has been negative but not yet paralyzing.
But let's say there's a compounding notional cutback in the MID for underwater or economically stressed borrowers who are holding back McMansions from the market. This could have the effect of, shall we say, handing these would-be sellers an anvil. Where would the pool of new buyers come from? What good are the slashed, near-zero-interest-rate-policy mortgage rates that Federal Reserve Chairman Bernanke has tried to engineer via "Quantitative Easing Infinity" if few can afford to buy, and if lenders remain uncertain whether they can afford to lend?
The good news is that some clarity on the regulatory front should emerge by next spring -- and I'm betting on moderation of proposed rules on all virtually all counts. Meanwhile, even if Congress were to adopt a MID haircut before year-end (a two-in-five prospect, I'd initially wager), it would likely be phased in only gradually, much as was phase-out of the consumer-interest deduction in the late 1980s. This might even help to clear pent-up shadow inventory among the McMansions, as would-be mover-uppers could be incentivized to buy while a tax incentive still exists in full force.
Nevertheless, a question arises on the potentially declining number of Americans who might be able to afford a loan, and the higher after-tax costs of near-million-dollar homes, going forward. With fewer buyers will come lower prices -- and that could, perhaps, create downward pressures among lesser-valued properties, as well. This could affect the entire housing chain -- banks, home improvement retail, mortgage insurers and homebuilders alike.
I'd bet that housing-related demand will revert to an upward climb, with or without the full MID in the future, just as consumer spending did after the phase-out of credit-card interest and consumer-loan deductibility in the late 1980s. But that transition could be a bear, suggesting that it makes sense to keep an eye toward Washington as winter approaches.