Friday, August 21, 2009

Is There a Hidden Structural Impediment to a Housing Recovery?

I was reading one of my favorite daily newsletters when I came across some interesting insight from Mark Hanson of The Field Check Group. If you are not familiar with Mark’s work, I highly recommend checking out his mortgage and housing blog. Throughout the housing crisis Mark has offered ground level data and analysis that is head and shoulders above just about anything else out there. For those of you who are wondering, he is still incredibly bearish on the housing market, mostly because of the continuing supply overhang and what he sees as a coming foreclosure tsunami as more interest rates are due to reset on a plethora of exotic mortgage products.

In any case, here is the commentary that led me to some new thoughts about the potential for a housing recovery:

[W]ithout exotic financing, buyers can’t reach out of their affordability bands like they could from 2002-2007. Investors won’t reach out of their rental return band in order to chase a bid. This dynamic has isolated millions of houses above the median income/rent ratios in cities across the nation and will lead to significant house price compression.

The point he is making is that without the ability to secure high LTV loans with low teaser rates, aspirational home buyers will not be able to buy the more expensive houses they were able to during the bubble. I would argue that from a long term point of view this is a very good thing. From a societal perspective we don’t want people living in houses that they cannot afford. As the bursting of the housing bubble has illustrated so dramatically, foreclosures and short sales are terrible for home prices and can rip neighborhoods apart. The problem, of course, is that in the short run the marginal buyer will be forced to buy a cheaper house and the excess supply of more expensive homes will sit on the market. This dynamic may only prolong the recovery process and in the short run push prices down even further.

I don’t have access to Hanson’s full piece and I don’t know if he addresses this specifically, but what if there is a larger problem than just that? What if the availability of cheap financing, low down payments and loose lending standards led to the construction of far too many houses in the price range that the majority of buyers have fallen out of? In that case there could be a structural imbalance between the number of homes built for a certain price range and the number buyers who can afford these “reach” houses. Let me use an example with completely arbitrary numbers to explain my point further. My disclaimer is that this is certainly an oversimplification and should be viewed as more of a thought experiment than a data-backed analysis.

To make things easy, let’s assume there are just three general price ranges for houses: Under $300K, $300K-$1M and $1M+. Now let’s assume that before the easy lending period that started after the tech bubble, 40% of new homes catered to the under $300K group, 50% were built for the middle class, and 10% were built for the richest crowd. But, what if, as a result of the housing bubble, we saw a cyclical shift towards more expensive houses? Now, “expensive” is a little tough to define. There are so many factors that go into the value of a house that it is not easy to single out specific items that separate a middle class house from lower income dwelling. Plus, a house is only worth what people are willing to pay for it. A given house could have 18 bedrooms and an Olympic sized swimming pool, but if it is right next to a sewage treatment plant it is not going to be worth very much. Finally, it’s all relative. What can be categorized as a middle class home in Tulsa, Oklahoma is very different on a nominal basis from one in Beverly Hills, California.

Having said all that I think it is fair to assume that the size, amount of land, and quality of the construction and fixtures have a large impact on the type of buyer a specific house is meant to attract. So, if we take those three variables as pretty good indicators of value, my question is what if during the boom we built far too many houses that fit in the middle class category? An increased focus on bigger houses does make sense from a builder’s perceptive because in general the larger the project the higher the profit. Using my prior percentages, what if during the bubble 25% of houses were built for the $300K and under buyers, 60% were built for the $300K-$1M group and 15% were constructed to tap into the market for the growing rich class? In that case, my thesis (which I don’t have the data to prove or disprove) is that recently tightened lending standards combined with rising unemployment and increased consumer frugality has significantly eroded the number of buyers who can buy houses that were created for the $300K-$1M group. Furthermore, as a result of the overbuilding in that portion of the market during the bubble, the demand for these houses (from people who could have afforded them even at the bubble price) that have a certain size, amount of land, and construction quality is well below supply.

The logical response to the case I have presented, is so what? In an efficient market you would see people shift from the $1M plus group down the $300K-$1M class to soak up supply and also the lack of supply in the under $300K sector (due to the cyclical under-building) would push the prices of those houses up in response to the increased demand. This mechanism then could offset any price declines in the higher groups. My response to this is not necessarily. For one, I think a lot of the people in the under $300K group are now going to be renters for a long while. Those people who probably never should have bought a house in the first place based on their income probably aren’t coming back into the owner’s market any time soon.

Second, I would argue that the number of people falling back into the under $300K group is far larger than the number of people falling from the $1M+ group into the $300K-$1M group. This makes sense intuitively. If you think of income distribution like a pyramid, there are many fewer people at the top of the pyramid where it is narrow than there are at the wider bottom. In other words, there are far more middle class people than rich people. So, in theory, that leaves a flood of buyers interested in the $300K and under houses, about the same number of very wealthy people who demand $1M+ houses (as the data presented in the Zero Hedge piece linked below shows that the rich are much less affected by recessions and home price declines because their assets are more diversified), and a huge void in the middle. Kind of like the dreaded erosion of the middle class in the US or, far worse, the complete lack of a middle class in emerging market countries.

What are the implications if this is true? Honestly, I am not sure. In fact, the reason I am proposing this scenario is to get feedback from people. Maybe I will even email Mark Hanson to see if he has any valuable input on this conundrum. The overall impact on housing prices of this theoretical imbalance has a lot to do with the magnitude of price declines in the middle and upper end houses versus the potential offsetting increase in the price of the under-supplied lower end. Specifically, a problem could arise as a result of the disproportionate indebtedness of the middle class consumer. Take a look at these charts from this great analysis by Tyler Durden at Zero Hedge:

This data clearly shows that the middle class as defined by income is by far the most levered group. If these middle class people are not able to become home buyers (or return to the market after a foreclosure) even in the under $300K group due to the amount of debt they have accumulated, they will become renters and the previously mentioned offsetting increase in value of the lower end homes might not occur and even worse, the $300K-$1M housing market will be decimated even further. Yes, if there are supply restraints rents would eventually rise and help push up the value of the under $300K houses, but that dynamic could take a long time to play out (due to existing rental agreements delaying increases and the lack of transactions as a result of there being a renter in the house) and in the meantime the $300K-$1M homes will just sit idly on the market until the prices drop enough to clear. If that is how it plays out it is logical to assume that there could be another large fall in the drop of the middle end houses, a process that could undermine a recovery and since this represents (in my example) the majority of houses on the market, could have an oversized impact on national housing prices.

Obviously, some of the declines could be temporary and as the housing market shifts back towards some kind of equilibrium, prices will inevitably start to rise again. But this could require a multi-year structural rebalancing in which more and more people are forced to walk away from their homes due to being (maybe only temporarily) underwater on their mortgages. In any case it appears that the combination of continued foreclosures and imbalances like the one I have discussed may make the bottom of the housing market more elusive. Therefore, my suggestion, whether my analysis captures the supply dynamics perfectly or not, is to beware of those who say we have already reached a bottom in the housing market. There may be more subtle forces at work than you read about in the popular press.

(Picture courtesy of