So we’ve covered why demand for housing has been weak.
But the more important determinant of housing prices over the near- to intermediate term will be on the supply side. There are still over 2 million houses in the foreclosure pipeline. The combination of loans in foreclosure and loans 30 days+ delinquent is nearly 13%. While down from the highs, this is still a huge amount of supply pressure. Mortgage servicers have been exceedingly careful about the process of foreclosure in the wake of the revelations about robo-signing and other improper foreclosure practices. The regulatory scrutiny caused by the robo-signing ordeal has exacerbated the supply problem. Given the backlogs, servicers simply do not have the resources to work through all these foreclosures. Therefore, the pipeline has swelled, foreclosures are taking much longer, and the correction cycle has been extended much longer than should have been the case. The market has not been allowed to clear yet.
In addition, estimates say anywhere from 23% to 30% of total mortgages are underwater (the principal balance of the loan exceeds the home value). My belief is that the loan servicers, in anticipation of more widespread strategic defaults (homeowners simply stop paying their mortgage even though they have the resources to do so), will increasingly call the borrowers and offer to write down their principal balances. It is unclear what effect this will have on homeowner behavior and housing prices. But it is not hard to imagine a scenario whereby a herd mentality takes over and borrowers increasingly try to stick it to the banks.
It is pretty clear to me that the true clearing price for residential real estate in many regions is lower based on a lot of supply and not enough demand. The most likely scenario going forward is that inventories will continue to be slowly cleared, causing additional pressure on prices. Meanwhile, more and more homeowners will find themselves underwater, forcing the banks to be more aggressive about writing balances down. This whole process could lead to another meaningful downward adjustment in prices. However, it is more likely that the Fed increases its role in supporting the housing market. I believe the Fed is super-focused on housing, and this is why I believe a QE3 could be coming before long. Housing is just far too important to our economy right now. It affects consumer sentiment, consumer behavior, savings rates, and the job market. And as we all know, consumer spending represents 70% of our economy.
I guess my point is that higher interest rates are only one of a number of factors that could potentially pressure housing prices more in the near future. There are other factors that have been inhibiting demand and increasing supply. For sure, a rise in mortgage rates would not be a welcome development for homeowners, prospective buyers or the Fed. And the Fed’s focus on housing is just another reason why we view sharply higher interest rates as unlikely any time soon.
But lower housing prices, while very important, are just one consequence of higher interest rates (which could be the result of a debt downgrade). There are almost too many to count. A sign at my mechanic’s garage reads, “Poor planning on your part does not require panic on our part.” Unfortunately, my mechanic may not have considered the actions of Congress when composing his sign. Whatever may have happened to this point, let’s heed Admiral Rickover’s admonition for, “...prudent men will reject these tranquilizers and prefer to face the facts so that they can plan intelligently.”
Our portfolios remain defensively positioned.
Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.