Reasons to Hesitate on Housing

 | Nov 21, 2012 | 10:00 AM EST
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Shares of homebuilders (Lennar (LEN), DR Horton (DHI), Toll Brothers (TOL), Hovnanian (HOV), KB Home (KBH) and PulteGroup (PHM)) outperformed on Tuesday. The group had declined with the market after Election Day, but it bounced back amid this week's optimism about a housing recovery. The home-improvement retailers -- Home Depot (HD), Lowe's (LOW) -- also caught a lift.

I agree with Stephanie Link's call that there are many ways to play U.S. housing at this stage, including key banks leveraged to the sector (such as Wells Fargo (WFC) and SunTrust (STI)). But here are some points that you might want to consider before jumping on board. I see a potentially neutral-to-positive Washington overlay emerging for housing, provided we don't go over the fiscal cliff. But there could be a lot of back and forth in months ahead.

One step backward, for instance, was the Federal Housing Administration's announcement on Friday, Nov. 16, that its depleted secondary reserve fund will compel a 10-basis-point increase in annual insurance premiums and could even require a taxpayer bailout. This could initially raise the average cost per borrower by only about $13 per month. But for some peoples, an additional $150 a year could matter, and as noted by The Wall Street Journal's Nick Timiraos, House Republicans will now have fresh ammunition to try to pass legislation reducing income eligibility and loan levels next year.

The threat of throttling a source of more than 30% of all recent mortgage finance is significant. Meanwhile, as I've been predicting since mid-October, the FHA news will also likely douse any residual hopes of Congress' passing Menendez-Boxer legislation to further streamline refinancings for underwater borrowers via the Fannie-Freddie-related HARP 2.0 program. And as for Sen. Diane Feinstein's (D-Calif.) White House-backed proposal to use the FHA to create a new refi opportunity for borrowers whose loans aren't backed by Fannie and Freddie, forgetaboutit.

We can also probably forget any hopes that President Obama might recess-appoint a replacement later this year for Federal Housing Finance Agency acting director Edward DeMarco. That individual might issue a quick green light for principal forgiveness via the GSEs, the thinking has gone, if not the equivalent of an administratively-advanced HARP 2.1. But despite related concerns about prepayments that have created volatility in mortgage debt markets (i.e., the "DeMarco trade" ), the expectation in Washington is that Obama will likely nominate a "permanent" DeMarco replacement to undergo Senate confirmation, which could take several months into the new year.

Conversely, to go the recess appointment route, as Obama did with Consumer Financial Protection Bureau Director Richard Cordray, might be unnecessarily provocative at a time when the White House needs to be forging consensus and starting a debate about housing finance reform that could last through its entire second term.

Meanwhile, also seen doubtful has been the notion of an immediate green light for principal forgiveness upon a new director's entry. That, too, might take a little time, given staff misgivings and the fact that a related plan is no longer in the queue.

Yet one step forward could be the also-now-expected follow-through of Cordray with a long-anticipated qualified-mortgage rule, perhaps just after Thanksgiving. That standard, mandated by the Dodd-Frank Act, will govern the degree of legal insulation granted to mortgage originators and investors who underwrite or purchase loans that meet strict "vanilla loan" criteria to ensure a borrower's ability to pay on future mortgages.

The housing community has long worried that Cordray might adopt only a "rebuttable presumption of compliance" for low-interest, 30-year fixed-rate loans with ample documentation, no negative amortization, no balloon payments and strict debt-to-income/credit-score and other underwriting standards, and that would leave lenders highly vulnerable to "suitability" lawsuits. But Cordray has recently signaled that he will compromise with a tiered approach offering a more insulating "safe harbor" for the safest prime loans.

As complex as this issue is, if Cordray follows through with such a moderated final rule, the news will signal not only that regulators have finally begun to clear the decks of unresolved Dodd-Frank mandates that have frozen lenders in their tracks, but that they are also on a moderating course. Assuming that a broader committee of regulators follows up by next spring with a related "qualified residential mortgage" standard governing whether securitizing lenders would be forced to meet a 5% risk retention rule, this would provide more assurance of a private mortgage market's return to take up the slack created as FHA premiums and Fannie-Freddie guarantee fees are strategically raised to reduce their market share.

In other words, we'd finally get back to running the housing finance engine on all cylinders. And all the gnashing of teeth about proposals to goose refis and mitigate foreclosures aside, the biggest prize would be the return of good old fashioned purchase money, the life's blood of a sustainably healthy housing market.

All of which brings us to the tiebreaker: the fiscal cliff.

Investors should not read too much into the firmer tone of the market since last Friday's White House meeting between Obama and congressional leaders (which arguably may have just reflected relief that lawmakers will be out of commission for a week as they recess for the Thanksgiving holiday). Neither side agreed to anything except a two-stage process. Democrats doubled down on demands for higher upper-income tax rates by year-end, and Republicans insisted that new revenue be considered only in tandem with entitlement cuts and in the context of comprehensive tax reform.

My colleagues and I predict an ultimate agreement, but only after the Republicans gag at being forced to break their tax pledge. Along the way, Democrats will likely be forced to accept less than the triumphant solution they thought they had won a mandate for on Nov. 6. And investors could potentially face a TARP-like moment, perhaps as a negotiated late compromise initially fails on the House floor.

In other words, another dramatic holiday-time show is coming from Washington, one that could involve tradeoffs including a haircut to the mortgage interest deduction (MID).

Obviously, if this turns into a dust-up, investors might get a chance to buy the housing names even cheaper. Or they may want to stay away indefinitely in the event the cliff is breached and disagreement prevails long enough to prompt another recession. Tweaks to the MID might not be as devastating as industry lobbyists predict but could nevertheless cause indigestion-- and arrest improving home valuations -- as we figure that out.

On the other hand, if the cliff is successfully navigated by year-end, and the MID is largely retained (perhaps with its value somewhat diminished by a cap on overall deductions), this would be an unmistakably good thing. A possible upsurge in U.S. equity prices would almost assuredly lift housing-related boats. And in lifting the economy just as policy-related concerns abate, it could potentially shift the sector's recovery into an even higher gear.



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