One question that I hear most from the people I meet during my travels around the U.S. is whether the deflation of the housing market has run its course. Housing is a very relevant and widely sought necessity, thus the state of the housing market is second only to the weather in terms of popularity as a topic of casual banter. The short answer to the question, however, is no.
While observed prices in many real estate markets are close to the bottom in percentage terms when compared with the peaks of 2005, this does not mean that “normal” volumes of transactions are likely to come back soon. Yes, markets like Arizona and Florida have tightened in some areas, but to use the Wall Street metaphor, this is a stock picker’s market. There are several negative overhangs still affecting behavior in the housing markets — factors are unlikely to change quickly because the numbers are so big and long term in nature.
I recently got a look at the latest presentation from Josh Rosner at Graham Fisher & Co. Rosner makes some downright scary predictions about the end of the U.S. real estate market as we know it. The changes in household formation by age is enough to make me bearish. During the past decade, did we really see up to 4 million households drop from the 35-45 age group of the market? Yes. Guess what that does for housing prices? Nothing good.
Even more profound than the decline in the number of households in the 35-45 age group is the drop in overall homeownership rates for all age groups, clear evidence of the structural changes in the real estate market and household composition that my fishing partner Rosner has been talking about for years.
The homeownership rate fell in the first quarter to the lowest level in 15 years, according to the U.S. Census Bureau. This is more than just post-bubble fallout, though, but rather is a shift in long-term demographics going back to World War II.
Rosner notes that homeownership rates peaked in 2004 and have been falling ever since, in part because more than one third of the pre-crisis market was driven by investors. “A home without equity is just a rental with debt,” observes Rosner, who also notes that Wall Street equities have replaced home prices as the key indicator of economic health among policymakers.
STRESSED OUT LENDERS
Inside the banking sector, the situation facing lenders is equally dire. Real estate owned, or REO, is just starting to liquidate, meaning that banks could be facing years more of above-normal administrative and credit costs associated with real estate. My rule of thumb is that whatever a bank is showing you in terms of REO on its balance sheet is probably half or less of the reality.
One of the most striking indicators of operational stress in the lending sector is the still-high rate of loan losses inside most banks. While charge-offs have fallen back from the crisis levels of 2008 and 2009, visible loss rates are still running two times the levels seen in the mid-1990s prior to the start of the mortgage bubble. Yes, loan losses have dropped to the lowest levels in four years — back to 2008 — but the visible level of loan charge-offs remains high compared to long-term averages.
Another indication of the stress being felt by U.S. banks is the steadily rising levels of expenses related to mortgage related activities. The efficiency ratio for all U.S. banks, which measures the portion of operating revenue taken by overhead costs, is now more than 64% for the entire industry, up roughly 10 points in the past six quarters. With operating income constrained by low interest rates and rising expenses related to foreclosures, many lenders are pinched and this does not make banks easier on credit. Quite to the contrary, banks view deteriorating operating leverage with alarm and generally cut front office headcount in response.
While much of the banking sector and the holders of residential mortgage-backed securities managed to charge-off the worst portions of portfolios, there is still a good deal more loss to be taken on bad loans, REO and litigation. As we’ve noted in these pages, Bank of America and Bank of New York are still trying to settle some of the put-back claims arising from RMBS created by Countywide Financial.
But these put-back claims are just a subset of the tens of billions of dollars in remaining claims against this one lender and securities dealer. The Merrill Lynch unit of Bank America, for example, still faces tens of billions in claims by investors arising from losses on collateralized debt obligations. Lenders like Ally Financial and JPMorgan Chase still face further pain from legacy mortgage exposures related to subprime RMBS from ResCap and Bear Stearns, respectively.