SERIOUS MONEY: BEN BERNANKE, the chairman of the Federal Reserve, recently engaged in a bout of self-delusion, as he patted himself and his colleagues on the back for the success of their latest round of quantitative easing (QE2). The programme's success is supposedly apparent from the surge in stock prices since Bernanke first raised the possibility of QE2 last autumn, even though one of the stated aims of the ultra-accommodative monetary policy was to keep long-term interest rates in check.
Indeed, the chairman previously declared that “lower mortgage rates will make housing more affordable and allow more homeowners to refinance”. Unfortunately, subsequent events have not materialised as intended; mortgage rates have increased and house prices have resumed their decline. Even more troubling is the fact that housing market fundamentals can best be described as awful, and a further double-digit percentage point drop in prices is a distinct possibility.
Perhaps the most challenging issue facing the housing market is the level of excess inventory. The supply of both new and existing homes is roughly eight months at current selling rates, as compared with the five to six months that is believed to represent an approximate equilibrium between supply and demand.
However, these statistics only paint part of the picture, as there is a large “shadow” inventory that includes mortgaged homes at high risk of default. An assessment of the true picture suggests the inventory overhang could be a two-year supply.
More than 9 per cent of all home loans are already delinquent and the figure could easily move higher as the year progresses given the substantial number of adjustable-rate mortgages that are due to reset during the latter half of 2011. The dollar amount of loans due to reset could average $35 billion (€25 billion) each month from mid-summer through the end of the year as compared with a $25 billion monthly average for all of 2010.
Many of these mortgage holders will not be able to refinance in time and avoid the punitive uplift in mortgage servicing costs upon reset, simply because refinancing is not an option available to the substantial number of households that already owe more than the value of their home. Indeed, more than one in five homeowners is already in negative equity and since roughly one in eight mortgage holders devotes more than half of household income to service mortgage debt, the number of homes at risk of default is certain to grow upon loan reset.
An increase in delinquencies fuelled by mortgage resets will only add to the burgeoning pipeline of homeowners that face foreclosure filings and potential repossession. Almost three million properties received foreclosure filings last year, and though the figure represented only a modest increase on the previous year, the figure would have been higher, but for the controversy concerning foreclosure documentation and procedures that led to the temporary suspension of foreclosure activity by several lenders.
Government intervention has already slowed the foreclosure process and though the measures helped to stabilise prices in the short-term, the measures alongside the current halt to foreclosure activity only delay market normalisation. Indeed, since the vast majority of troubled mortgage holders ultimately lose their homes and the properties subsequently repossessed are typically sold at a 20 to 25 per cent discount to comparable new homes, lengthening the foreclosure process simply adds to market uncertainty.
It is clear the potential size of the supply overhang represents a formidable market challenge, but the demand outlook is also disappointing. Although the National Association of Realtors notes that its Housing Affordability Index is close to an all-time high, it is noteworthy that lenders including the Federal Housing Administration and Fannie Mae continue to tighten credit standards.
The irresponsible lending practices that led to so-called “ninja” and “no-doc” loans during the bubble years are now a thing of the past and standards from loan documentation to required down-payments are now extremely conservative. Furthermore, the standards applied in the appraisal of property values have also been tightened considerably, such that the appraisal value often falls well below the asking price. This means that the potential buyer must either secure the additional funds to meet the difference or convince the seller to lower the asking price.
The obvious imbalance between supply and demand means prices are likely to decline further in order to remove the inventory overhang. Although Bernanke may believe the increase in stock prices in recent months will subsequently boost personal consumption via the so-called wealth effect, the truth is that rising equity values have little impact on middle-class balance sheets. Indeed, roughly two-thirds of the gross wealth of middle-class households is invested in their homes with stocks directly or indirectly held accounting for just 7 per cent of their total assets.
The message is clear – America’s beleaguered housing market deserves close attention in the months ahead.
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