I have always been very interested in economics. The interpretation of the behavior of millions of individuals all making decisions simultaneously is fascinating. Macroeconomics is incredibly complex, but if we can glean some trends, above average returns in equities are possible. First, I will present my theory of how we have arrived at today's housing economy.
Las Vegas - circa 2004
I visit Vegas many times every year. I only live a few hours away, and the drive is quite pleasant. Sometime in 2004, I was having dinner at a PF Changs. I always go right to the bar since I hate waiting to eat, and I meet some real characters while dinning. On this particular evening, there were 3 young kids(anyone below 30 gets my kid moniker) eating and drinking next me. They were all boasting of there latest real estate deals and profits. As a former slum lord, Having bought and sold many rental properties, I was keenly interested in there discussions.
Not to my surprise, they were very willing to tell me about there recent killings in the Vegas real estate market. These young Turks were buying several new homes at the same time, then flipping within a few months for 50K profits per home. These guy were fun, and I enjoyed our conversations. I have found that ground level info on the economy is very valuable - our government should try this approach. On my drive back into the desert, I dismissed there claims as just some lying, and one upping each other.
Las Vegas - circa 2005 - 2006
I'm back in Vegas, at the same PF Changs. The bar is packed - in fact Vegas is packed and vibrant. I can't believe the amount of desert being scrapped for more boxes - this can not continue I scream! I am wrong. At the PF's bar, I meet more 20-30 somethings and everyone is talking real estate. Everyone is a flipper and dealer - Can everyone be lying? I start to investigate. I am surprised to find people buying more than one property at the same time. This was done years ago, before the computerized records age. Banks would know real time that people are lying on there mortgage applications - right? HM I guess not.
These new homes are not rentals. These buyers had very little cash, and their jobs were fairly low paying - they could not even qualify for one of these homes - but they were buying 2 or 3 at a time..... The tools used by our house flippers: ALT A, subprime, interest only, negative amortization, teaser rate loans, and basically ZERO due diligence from lenders. This was when I started buying puts on some of the home builders. I picked KB Homes as my target for a hedge against my long portfolio.
How could this happen? a Macro interpretation
I started to analyze this crazy home financing system. My theory is fairly simple. Too much liquidity chasing an ever shrinking yield. After the US depression in 2001-2002 the federal banks lowered the funds rate to 1% and kept it there. Wealthy investors were stumped. With short and long term risk free yields at pathetic low levels - cash was getting very hard to invest.
Investors were still hurt from the stock market crash, so these investor would not put their cash in equity markets. Then the US gave a large tax break to these wealthy investors, giving them even more cash per year to handle - what to do with all this cash? The combination of historic low yields, fear of equities, and a poorly targeted tax cut had created a HUGE increase in the demand for a stable return on all this cash.
Can you say SIV, or CMO? Where you have demand - supply will not be far behind. The larger banks and investment houses increased the creation of these SIV's with CMO and, CDO's to satisfy the large increase in demand for yield. 5-6% yield will do just fine in this now low yield environment. Banks would bundle 1000's of mortgages to create these new higher yielding financial vehicles.
To satisfy this large increase in supply of mortgages, lending standard had to fall - there is no other way to meet this new supply - much to the glee of my box flipping buddies back at the PF Chang bar in Vegas.....
Year of reckoning - 2008
Where is the US economy today? We are in a recession, and it may be a longer than average one. Housing is not the main issue - it is the credit collapsing due to the lending system finally falling apart. In conclusion, the US government has helped create the current housing bubble, and the current credit meltdown. As far as housing, my calculations show that home prices have already fallen back to base affordability levels. The measure to use is simple - the monthly mortgage amount for new homes adjusted for sq. footage versus monthly incomes.
Rates are close to historic lows, and the sq. footage of new homes are at historic highs, and incomes are still rising. Will home prices continue to fall? Probably. Lenders are still trying to raise capital, not lend, and US consumers do not wish to buy an asset that is still falling.
Future US economy 2008 - 2009: what's next?
I know many love to hate the home builders and related stocks. Many traders have made hefty profits shorting this industry over the past 6 months. The days of making easy money with these shorts are over in my opinion. We will get at least one US housing bailout package before the end of the year.
The US housing bailout could be as follows. 300-500B of lower level tranches of CMO debt to be purchased and held by the US government. Also the GSE's need to lend money - 5.5% 30 yr, to refinance the weaker loans with 2006-2007 vintages, and slow down the foreclosure process.
The third leg of the bailout would be the Federal government helping states and cities raise bond funds to purchase distressed homes in hard hit communities and take them off the market - maybe affordable housing. Even without a bailout, making additional money on shorting the home builders will be increasingly difficult.
To value any equity, one needs to look at 15 years of future cash flows discounted back into today dollar. Contrary to popular belief, There will be another housing up cycle.
This is an election year, and the politicians will be tripping over each other to show how much they care about us. If the US economy is a weak as I suspect, and as weak as all the bears on wall street think, then this above housing bailout will probably happen. And if the economy is really not as bad as we think - no bailout, but no more profits for shorts either way.
Baseline economic projection is a recession for most of 2008, followed by slow but steady recovery in 2009. I think the recession started in Dec. 2007.
Authors note: I first published this article on an equity web site called CAPS in Motley fools in Feb. of 2008.
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