The Outlook is Grim

Bill Gross should know a thing or two about prices being set "at the margin" in a gigantic, slow moving investment sector. The manager of the world's largest bond fund, along with his cohorts at Pimco, continue to argue that the removal of some subprime and Alt-A price-setters from the housing market is going to have an outsized impact.

He's been calling for rate cuts for what seems like years now (a smart thing to do if you manage a bond fund). In his latest monthly commentary, he continues to make the case for some relief from the Fed, though Ben Bernanke and Co. probably have their eyes on oil prices at the moment rather than home prices.

Last night on the evening news, the foreclosure story led the surging oil price story. By the looks of oil prices so far today and that weird spike to $68 late in the day yesterday, the order may be reversed in this evening's broadcast, continuing to "raise the bar for housing pain" before it gets any real sympathy from the Fed.

Long ago and far away there used to be an old “20% down” reality that morphed somehow into a subprime/Alt A cyberspace free-for-all (literally “free for all”). Talk about a second life! U.S. homeownership has expanded from 65% to 69% of households since the turn of the century, in part because it became so easy, and so cheap to finance a home ... They bought a house, began living the American dream by making money with someone else’s money, and expected to live happily ever after. Well, not so fast, at least for some of them, it seems. Home prices, as measured by the National Association of Realtors, have gone down by 2% nationally over the past 15 months and there’s fear in the air that it could get worse. It most assuredly will.

The problem with housing, however, is not the frequently heralded increase in subprime delinquencies or defaults.
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It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses.

That sharp move upward in the percentage of banks that are tightening their lending standards appears to have gotten the attention of the folks at Pimco too.

It is odd that there are continuing reports of some lenders, apparently not under any kind of supervision, who have not changed their qualifying requirements or mix of loan products much or, in some cases, at all. Who these lenders are escapes me at the moment, but there have been a few stories like this recently.

Bulls and bears argue over websites as to the percentage of all lending that subprime and alternative mortgage loans provide but while important, the argument obscures the critical conclusion that tighter lending standards and increased regulation will change the housing outlook for some years to come. As past marginal buyers are forced to sell their home to prevent foreclosures, so too will future marginal buyers be restricted from buying them. No one really knows the amount that homes must fall in order to balance supply and demand nor the time it will take to do so, but if one had to hazard a conclusion, it would have to be based in substantial part on affordability statistics that in turn depend on financing yields and home price levels in a series of different scenarios as outlined in Chart 2. The chart shows the amount that home prices or mortgage rates (or a combination of the two) need to decline in order to revert back to affordability levels in 2003, a year which might have been the last to be described as a “normal” year for home price appreciation. Since then, 10+ annual gains have been the rule whereas average historical estimates provided by Robert Shiller may have suggested something on the order of 4-5%. By that measure alone, homes are likely 15-20% overvalued (3 years x 5%+ annual overpricing). Chart 2, in addition suggests much the same thing. If mortgage rates don’t come down, home prices need to decline by 20% in order to reach prior affordability levels. If rates do come down, home prices will drop less.

Chart 2, while somewhat subjective and time dependent, introduces the critical connection between home prices and interest rates. PIMCO cares about housing and its fortunes, but primarily because of its influence on yields. And while the Fed may be willing to allow U.S. homeowners to suffer a little pain as indeed they have in recent quarters, a double-digit decline would risk consequences that few central banks would be willing to underwrite. So a forecast of home prices almost implicitly carries with it a forecast for interest rates. To prevent a double-digit decline in prices, PIMCO’s statistical chart suggests that mortgage rates must decline a minimum of 60 basis points and the sooner the better. The longer yields stay at current levels, the more downward pricing pressure will build as foreclosures/desperate sellers dominate price trends as opposed to prospective buyers. While the Fed, as pointed out in last month’s Investment Outlook must be cognizant of an array of asset prices in addition to housing, homes are the key to future equitization trends, and fundamental therefore to the outlook for consumption.

You may want to take this looming grim reality with a grain of salt or suggest as old worlders do that it’s not real at all if it can’t be touched or if it doesn’t touch you. Not so. Don’t take my word for it though. Investigate the Fed’s own study, written in September of 2005 (Monetary Policy and House Prices: A Cross-Country Study(.pdf)) covering housing cycles in aggregate and individually for 18 countries over the past 35 years. This study’s important conclusion for PIMCO and our clients is that if home prices in the U.S. have peaked, and are expected to stay below that peak on a real price basis for the next three years, then the Fed will cut rates and cut them significantly over the next few years in order to revigorate an anemic U.S. economy. Strong global growth (not part of this study’s assumptions) may temper historical parallels and provide a higher floor than would otherwise be the case. Nonetheless, prices for houses that I can see and touch every day outside my office are morphing with bond yields inside my computer screen to produce a reality show that speaks to an ongoing bond bull market of still undefined proportions.

It does look grim.