Is the housing market turning around?

After a few months of recording slightly optimistic economic indicators, the US economy hit a bump last week with release of existing home sales, new home sales and durable goods orders. In August, existing home sales went down by 2.75%, new home sales missed expectation by 16,000, median existing homes sales prices went down by 3% to $177,700 and median new home prices went down by 9.5% to $195,200. While people are still debating that the worst is behind us and we would continue to see rally in these numbers, I think it is very important to take a deep breath and look at the biggest asset class (mortgages) of the US in the context of fundamental economic indicators and the impact of the government intervention.

In my opinion, we still haven’t reached the turn around on the pathway. I don’t know if the journey will be short, but as a pilot will say the journey is going to be bumpy and we should keep our seat belts fastened. The fundamental factors that I think will impact the housing prices are- unemployment, credit availability, mortgage rate, inventory and foreclosures.

As is widely expected, we will see the unemployment going up to double digits (10-11%) from current 9.7%. Most of the firms are restructuring and trying to stay afloat by cutting costs. This unemployment is also going to be sticky and especially the jobs lost in the financial services and automobile sectors. As of August 2009, we have had more than 5 million jobs lost in this recession (unemployment 9.7%). In past recessions, on average, this number was 2.5 million (average unemployment 7%). In past recessions, it took around 2-3 years to create the lost jobs. In this one, we can easily see that it will take more than 5 years. Given the unprecedented unemployment and the sticky nature of it, I don’t see enough people having growth in their income to propel the demand for houses.

As microeconomics suggests, demand and supply meet each other in the markets to determine the price. In the case of housing, usually the equilibrium is achieved with 6-7 months of inventory. Higher inventory means an increase in supply and given that the demand hasn’t changed, the price will go down. In the current market we have more than 9 months of inventory. This is publicly known and the government is trying everything to sop the extra inventory. Two most prominent steps taken by government are: i) a tax credit up to $8000 for first time home buyer and ii) a plan to purchase mortgage backed securities to keep the mortgage rate low (increases affordability). So the most pertinent questions are how long will the government keep running these programs and do we have only 9 months of inventory?

Tax credit for first home buyer ends on 1st December 2009 and the mortgage purchase plan ends in the first quarter of 2010. If these plans truly end on the above mentioned dates, I can confidently say housing prices will hit a new bottom. As a student of depression, Ben Bernanke knows that when a country is coming out of recession, the price depreciation of any asset class is not good and that of the biggest asset class of the US, not at all. So I believe that these plans will be extended but will these plans be good enough to bring down 9 months of inventory to 6-7 months of inventory? This is where market has lot of noise and disagreements. Many experts believe that banks are holding 1-1.5 million houses in foreclosed and other lenders are waiting for prices to firm up before they enter the market. Based on the recent reports published by Laurie Goodman of Amherst Securities Group, there is more than 7 million of shadow inventory ready to enter the market and this is around 16 months of inventory. This will put a huge pressure on the housing market and despite the government’s attempt to stimulate the demand, the demand will never be able to match such a big supply and prices will come under tremendous pressure.

Based on what we have talked about so far, the path forward for the government is pretty clear: continue with incentives to encourage people to purchase homes (not refinance), keep mortgage rates low by continuing to buy the mortgage based securities, provide other subsidies to promote home ownership till the industry manages to regain its health. These steps will serve as the seat belt and Fed needs to implement them tightly and boldly to alleviate the pain we will face in the bumpy ride and to make sure the injuries don’t become fatal.