·                     New and existing home inventories surging.

·                     Adjustable rate mortgage holders to get pinched.

·                     Real estate now a big chunk of household net worth.

The party's over. I've penned a series of commentaries on the housing market, and since my last one in February 2006, conditions have deteriorated even further. The consumer, who rode the now-subsiding swell of easy money, could face shoals ahead.

One picture summing this up is the below chart of the S&P Homebuilding Index, highlighting the stunning 40% decline over the past year.

Homebuilders feel the pain

As of June, 2006.
Source: FactSet.


Affordability in free-fall
Statistics of every variety tell the same story. One of the more popular affordability indexes, the National Association of Home Builders (NAHB)/Wells Fargo Housing Opportunity Index, has just experienced its largest eight-month drop in history. The index measures the percentage of homes sold that are affordable to families earning the median income during a specific quarter. Given the previous parabolic increases in home prices, the big jump in mortgage rates—and income growth that's paled in comparison—this plunge is not unexpected.

Unprecedented decline in housing affordability

As of 1Q06. Estimates from Q202 to Q304.
Sources: NAHB and Ned Davis Research, Inc.


Little room for non-essentials
Also hitting the consumer is the combined effect of rising mortgage payments, still-high energy prices and other costs. Consequently, the share of our income now devoted to spending on "essentials" is at an all-time high of 55%.

Spending on essentials up sharply

As of 1Q06. Essential items include housing, other consumer debt service payments, energy, auto leases, medical care and food.
Sources: BCA Research and FactSet.


Loads of unsold homes
So, what happens when affordability bites the dust? Inventories of unsold homes begin to creep up. OK, creep is a big understatement. Take a look at the chart, below, showing the sizeable 30% swell in inventories of both existing and new homes. In fact, the past year's increase is the largest since the National Association of Realtors began tracking the data in 1983!

Home inventories swell

Sources: United States Department of Commerce and FactSet.


As pointed out in the June 26 Barron's, this has been an exceptionally long housing boom cycle. HSBC reports that increases of 100-150% in sales, housing starts, building permits and home-builder optimism from the bottom of a housing cycle to its peak are the norm, with advances tending to last four to five years. This one, strikingly, has carried 15 years, with gains in the aforementioned indicators ranging from 130% to 300%!

New home sales up, but …
The news is not universally ugly, but even the bright spots need dissecting. May's 4.6% gain in new home sales to an annual rate of 1.234 million, was ahead of expectations. Furthermore, readings for both April and March were revised downward.

But there's more to the story: Homebuilders are offering big incentives such as multi-year luxury car leases, cash payments toward closing costs, and free lifetime country club memberships to lure reluctant buyers.

Getting pinched in the ARM
My commentary in February honed in on the sub-prime borrower group of mortgage holders—those with checkered or no credit histories. Over the next two years, monthly payments on over $600 billion of sub-prime mortgages may rise by as much as 50% as two-year teaser rates on hybrid adjustable rate mortgages (ARMs) expire and interest payments hit their fully indexed levels. The size of these loans is unprecedented: currently, sub-prime loans outstanding account for more than 10% of the total U.S. mortgage debt of $8.5 trillion. "Affordability" products, including hybrid ARMs, interest only mortgages, "no doc" loans, option ARMs, negative-amortization loans, and piggyback mortgages, have been all the rage. Given the meaningful jump in short-term interest rates (with the discount rate now at 6%) and the decline in home equity, we have a real problem brewing.

But it's not just the sub-prime market that's set to feel the pinch—it's the ARM market in general. According to MacroMavens and Fannie Mae, there's estimated to be $1 trillion in ARM resetting this year and another $1.7 trillion in 2007. The typical ARM holder will see a monthly payment increase of about 25%, while for those in option ARMs, interest only, and negative-amortization loans, the resets could approach 60%!

Alan loved those ARMs!
Ironically, with all the attention and blame coming down on FOMC Chairman Ben Bernanke of late, I think more about Alan Greenspan when I consider how culpable the Federal Reserve has been in both juicing housing, and now pulling away the punch bowl. Recall the praise of ARMs by Greenspan during the latter years of his tenure—even as long-term rates were at 40-year record low levels (low long-term rates are typically associated with higher demand for fixed rate mortgages). You can see how unprecedented this demand for ARMs has been in light of mortgage rates in the chart below.

ARMs surged even when rates were low

As of June 2006.
Sources: Bloomberg and MacroMavens.


As housing goes, so goes household net worth
Finally, there's the ever important impact of housing on U.S. household net worth. You can see in the chart below that real estate holdings now account for 38% of net worth, up from only 24% six years ago. For now, net worth remains at an all-time high, helping to explain a still-strong consumer. But, what happens to the real estate market now stands to have a greater-than-ever impact on net worth statistics. Given that equity holdings represents another big piece, if we're right about continued market weakness net worth will be coming under increased pressure, suggesting a consumer-led economic slowdown is in the cards.

Real estate's growing slice of net worth pie

Source: FactSet.


The National Association of Realtors projects a 13% decline in new home sales in 2006, with the median home price increasing just 0.83%. Overall, the median home price in the United States has never declined in a calendar year since World War II. Maybe I'm out on a limb, but I think 2006 could break that streak.


The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of investment strategies mentioned may not be suitable for everyone. Each investor needs to review a investment transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. Past performance is not a guarantee of future results.

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