September 28, 2005

View from Silicon Valley- Contrary Investor Real Estate Overview

Sorry for sending you ~387KB, but this commentary from "Contrary Investor" is particularly interesting and timely.  CI comments, again, on the credit cycle driving the real estate market (see also their September, 2004 comments http://www.contraryinvestor.com/mo.htm, as linked on our housing page http://www.viewfromsiliconvalley.com/id141.html).  You can go to CI's web site (http://www.contraryinvestor.com/ ) to sign up for a free monthly commentary.

The following was published September 27, 2005 (http://www.idorfman.com/09272005.htm)

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Now Everything Is Easy Because Of You…Our super friends at the Fed released their Flow of Funds document for 2Q 2005 last week.  Wonderful, as in our eyes this continues to give what we consider very important perspective about the character of the current US economy, US household circumstances, and ultimately has implications for the financial markets themselves in terms of longer term trends and themes.  In this discussion we’d like to quickly run through the broader dynamics of household real estate assets of the moment.  Why?  Do we really need to tell you?  We’re simply convinced that residential real estate price appreciation over the last half decade at least has been not only a strong protagonist in terms of helping to drive and sustain real world absolute dollar consumer spending, but has also been extremely important in terms of broader household financial complacency or emotional well being.  With a homeownership rate of near 70% in the US at present, arguably residential real estate is the single most important US household asset of the moment.  It’s the current symbol of US household wealth creation, having adopted that mantle some years back from equities.  And in a society where media plays an incredibly important role in shaping attitudes and thought, symbols are extremely important motivators of action and reaction, so to speak.  Let’s have a quick peek behind the symbol of current household "wealth building" that is US residential real estate.

To match time frames a bit, the following is simply an update of OFHEO (Office of Federal Housing Enterprise Oversight – the government agency regulator) year over year US home price change data.  This is the total shooting match in terms of nationwide prices.  As of 2Q, we hit a year over year rate of change number not seen in 26 years.  That’s how powerful residential home price acceleration has been as of late.  No wonder it’s the wealth creation symbol of the moment.
       

As always, we need to be mindful that not all is created equally in the world of US residential real estate.  At least over the last few decades, location has meant everything in terms of price.  To be honest, it’s really only the two coasts and the mountain states that have experienced incredible price acceleration over the last half decade.  The numbers are clear on this fact.  Is “everybody” getting rich with real estate?  Not really.

The Net Result…Remember, this is not a discussion suggesting that the world is about to come to an end in terms of residential real estate.  It’s simple perspective on where we have been in the past and where we stand at present with this most important of household assets.  In the table below, we’ve broken out the year over year change in household real estate holdings, total household net worth, and the year over year change in household mortgage liabilities since year-end 2000.  In our minds, this clearly tells us just how important the “bubble", if you choose to characterize it as such, in real estate values has been to the growth in household net worth over the last half decade.

On a gross basis, the change in household real estate values accounts for 86% of the growth in household net worth over the last five years.  Subtracting out the increase in mortgage liability, real estate has accounted for close to 45% of the total growth in net worth since 2000.  In percentage terms, residential only US mortgage debt outstanding since 2000 has shot up 70.7% in four and one half short years.  Household real estate holdings are up in value 61.7% over the similar period.  But net worth has advanced 19.5% in total.  And what we believe is important in looking at data from 2001 through 2004 is not just the absolute dollar growth in residential real estate values, but the sequential annual acceleration in dollar based growth that has occurred as the years have unfolded.  In our minds, it’s the acceleration that’s the important psychological issue from a consumer standpoint in terms of supporting consumer emotions of well-being or complacency at any point in time.  Although we clearly have no answers at present, what happens to the consumer psyche if the rate at which consumers are “getting rich” with their real estate holdings starts to slow? 

The only anecdote we have so far is what is currently happening in the UK.  As you surely know by now, the rate of change acceleration in UK residential real estate values over the last year or so has slowed dramatically, if not actually experienced an absolute price decline in specific areas of the country.  Simultaneous with this has been a rather dramatic fall off in the rate of change in UK retail sales, being one very important barometer of consumer sentiment.  We’ve also seen a recent month over month contraction in consumer credit in the UK as folks have actually paid down their bills.  Signs abound in the UK that consumers have reacted to this visible change in real estate price dynamics.  So what happens in the US if real estate price acceleration begins to taper off?  For now, that remains an open question, but we have to believe something similar to what is now happening in the UK is a good roadmap.  As a final comment, and we’ll be sure to address this further in a future discussion, the fall off in real estate price acceleration in the UK has as of yet not negatively affected their equity market.  We want to caution everyone that an inevitable change in the price trajectory of US residential real estate does not automatically portend an immediate decline in the US equity market, despite the fact that housing’s influence on US consumption has been so visible over the last few years.  Again, that’s a story to ponder and anticipate another day.

Compared To What?…Very quickly we have six graphic perspectives regarding US household residential real estate with which to leave you.  Again, all of this is historical data from the Fed Flow of Funds report.  As of 2Q 2005, residential real estate as a percentage of total household assets hit an all time high.  Simply put, residential real estate values are more important to US households today than ever before.  No huge surprise at all.
         

The following chart suggests to us the deep irony in the thought that residential real estate is creating real wealth here in the US.  It’s the long-term history of owner’s equity as a percent of the market value of household real estate.  We’ve colored in blue the period of 1994 to the present where point to point this measure has been completely flat.  It just so happens that over this period, the actual price of US homes as measured by the OFHEO data has risen almost 100%.  In other words, during a period of one of the greatest accelerations in price ever experienced in US residential real estate over a ten-year period, true owner’s equity as a percentage of market values did not increase at all.  Again, neither good nor bad.  What it says is that mortgage debt has grown in lockstep with market values of real estate.  So, just where’s the “wealth creation” that's supposedly the guarantee of the moment in residential real estate ownership?  It's one of the clearest signs we have that credit expansion has been primarily driving real estate values higher in aggregate over the last decade
        

As we have suggested many a time, the history of household debt levels of all kinds relative to GDP quite simply speak to the cold hard fact of an intergenerational change in personal attitudes toward the acceptance and application of financial leverage.  What you see below is nothing but another example of this phenomenon.  What is different in the current mini-cycle of the last half decade is the steepness of acceleration in the curve.  The acceleration since 2000 has been near vertical. 
       

What has also shown visibly meaningful vertical acceleration over the recent past is household real estate values as a percentage of disposable personal income.  Clearly US residential real estate price gains have meaningfully outpaced income growth over the past half-decade in relatively remarkable fashion.  The plug factor between these two rate of change variables is the current credit cycle, plain and simple.  Again, notice the steepness in rate of change acceleration over the last five years.  Unprecedented in the history of this data.
      

Although we really have no way of knowing just how the Fed calculates replacement cost for household real estate, they do publish data that allow us to compare the market value of household real estate  with its replacement cost.  A new high as of 2Q 2005 as you'd expect.  Again, does this mean real estate prices crash tomorrow?  Certainly not.  For a second, just think how high dotcom companies were capitalized relative to their replacement costs, so to speak, five short years ago.  As you know, anything can happen.
       

Finally, the last chart is both household residential real estate and household equity values as a percentage of total household net worth over time.  As you’d imagine, they usually move in opposite directional rhythm per the cyclical love affairs with each asset class.  It’s just that the last five years have been a bit more violent than not in terms of directional rate of change.  Clearly, residential real estate is almost twice as meaningful to households today as are personal equity holdings.  And that tells us that consumer choices and actions post an equity downturn may indeed be much different than what might transpire post a potential downturn or leveling off in residential real estate values.  But, of course, only time will tell whether a slowdown in the growth of real estate prices is to come.
        

For now, this data tells us the significance of real estate assets to US households at the moment.  Whether it is reflective of a massive imbalance and portends a downturn in prices is another question altogether.  Consumer psychology regarding asset classes runs in cycles.  That should be readily apparent to anyone watching the US financial and real estate markets over the past decade.  And at least over the last decade, we'd have to say that "manic-depressive" characterizes price movements per asset class perhaps more so in recent times than anything seen in the history of the last half century at least.  That's what the data and visual representations in the charts above are telling us.  As we've suggested in the past, we believe residential real estate price acceleration over the last half decade at least is merely a manifestation of a runaway domestic credit cycle.  Although a lot of folks are watching the homebuilding stocks for clues as to when the current housing cycle might end, we suggest keeping just as sharp an eye on the providers of mortgage credit.  The following table is simply an update detailing just who have been and continue to be the key providers of residential mortgage credit in the US and how their aggressiveness in terms of funding mortgage credit has changed since 2000.  Have a quick look.

It's absolutely clear that the GSE's (Fannie and Freddie) have curtailed balance sheet expansion in a big way over the last few years.  Given their accounting problems, it's really no wonder as to why.  It's also clear that the thrift institutions have experienced a significant drop off in mortgage investment activity in 2005.  Again, clearly explainable given the fact that the thrift institutions (Golden West, etc.) write primarily ARM product, whose costs have risen meaningfully with Fed interest rate increases throughout late 2004 to the present.  When covering this topic in the past, we have pointed out the increasing importance of the asset backed securities markets in current mortgage credit creation.  This sector of the market is on track for a record year at this point.  And this is residential mortgage credit creation that is occurring outside of the banking system proper.  Although the OCC (Office of the Comptroller of the Currency) is now set to hand down guidelines to the banks either later this year or in early 2006 regarding the curtailment of "risky" residential mortgage lending practices, the asset backed securities markets need have little concern.  Theirs is a world governed by the availability of capital, the cost of capital, maintaining a pool of willing buyers for mortgage paper, and loss experience.  On the first three counts, life has been wonderful over the past three+ years.  Never better.  And so far, loss experience has been minimal directly due to the incredible availability of capital to residential home buyers, with risk virtually being an afterthought in mortgage underwriting standards of the moment.  We suggest that it's the ABS issuers we need to keep an eye upon ahead.  As you can see above, the banks and thrifts have provided 39% of total mortgage credit YTD.  Clearly, stern guidelines from the OCC in upcoming months could put a crimp in their forward activities.  The important question being, can the ABS markets pick up any slack the banks might create in terms of potentially contracting mortgage related activity?  We'll see.  Longer term, the ABS markets will clearly be reactive and responsive to market conditions.  And given the bull market in both real estate prices and mortgage credit creation over the last half decade, market conditions could not have been better, hence attracting more and more capital to these securities as the years have passed.  But as the cyclical "weather" inevitably changes over time in real estate markets and the broader US economy, we believe the ABS markets will react swiftly and decisively to any potential negative changes in US residential real estate markets.  Perhaps much more quickly than would say the banks or GSE's.  Remember, when capital is needed least, there's always too much available.  When it's often needed the most, it's nowhere to be found.  Capital and liquidity are cowards over the long term. 

So just who are the stock market representations of residential mortgage origination conduits to the asset backed securities markets of the moment?  Folks like New Century.  Folks like Countrywide, just to name a few.  We'll end this little look at US household residential real estate circumstances with a few charts.  Messages from the collective vote of the equity market.  Listen up.  In all cases we're using the weekly charts to try to get a sense for longer term rhythm.

As you might know, New Century is virtually entirely devoted, as a company, to residential mortgage lending.  And it just so happens that these guys are big in subprime.  Just last week they stubbed their toes a bit by projecting lower results ahead than what had been previously expected by the markets.  Uh-oh.  There are a few messages in the chart below.  First, it's clear that even prior to the negative announcement last week, the stock had modestly broken an up trend line dating all the way back to early 2001.  Moreover, the head and shoulders pattern that has developed in this longer term view of life is unmistakable.  If the stock hits its 200 week moving average ahead, it will be the first time that's happened in four years.  New Century is telling us that trouble at the lower end of the mortgage credit pool has already been occurring for some time now.
         

New Century's very big and older brother in the residential mortgage origination game is Countrywide.  A stock that went from a split adjusted basis of about $2 in 2000 to what is a peak of $40 this year prior to backing off a bit.  The very well defined trading range of the moment has been intact for close to a year and one half now.  But what intrigues us the most is the decline in volume since peaking in late 2003/early 2004.  Unfortunately, temporary spikes up in volume since then have been on downside action.  Same deal with long term relative strength and the MACD indicator in terms of declining peaks for years now.  It appears that while interest in the stock has been waning, it has been able to hold its ground.  For how much longer assuming meaningful new buying interest does not develop?  We're going to find out.  As is clear, the stock could decline to $25 or thereabouts and still remain in a long term up trend.  
         

Although mutual funds are much different animals than are individual stocks, we can't help but show you the Fidelity Select Home Finance fund.  As opposed to being support, the 50 week  MA is now clearly resistance at this point.  But what stands out like a sore thumb is the almost classic head and shoulders formation in the price of the fund.  We'd consider a break of the neckline a very bad thing for the US residential mortgage finance industry.  We should not have long to find out where price goes ahead.
       

Finally, although we suggested that watching the homebuilders may not be the first telltale clue as to where the US real estate cycle heads moving forward (the credit providers just might be the important frontrunners), it's clear that the HGX (the Philly housing index) is currently sitting on a long term trend line of importance.  This trend line has contained the housing index since the equity rally of 2003 began.  Although not necessarily suggesting the end of the world, a trend line break would certainly be a noticeable dent in the US residential real estate battleship.
           

We're convinced that over the next twelve to eighteen months, the two most important sectors to watch in terms of trying to gauge the strength of the US economy are housing and retail.  We'll follow up Thursday with a peek at Flow of Funds data regarding the US consumer and a quick overview as to what are the current messages of the financial market with respect to retail.