US mortgage carnage

[Kimosabi]

I might just book a flight to the US of A and pick myself up some houses...

Strong Aussie Dollar, plus no Credit Crunch here yet, sounds like a fantastic idea...

 

[Freeballinginawetsuit]

http://www.telegraph.co.uk/news/main.jhtml?xml=/news/2007/04/06/wdetroit06.xml

Attached is the latter part of the article...........first part irrelevant.


Lenders typically offer loans at attractive "teaser" interest rates which after two or three years leaps, doubling repayments in many cases.
Tens of thousands of such deals are due to move out of the fixed phase over the next 12 months, creating alarm that house prices in the broader market, which have mainly levelled off, will fall sharply.
Brokers have been repeatedly accused of failing to tell clients the full truth and of hiding their own high costs.
Dozens of lending companies have gone bust or been bought up, while some states, such as Ohio, are now considering bailing out mortgage defaulters with cheap loans. Congress is discussing a nationwide rescue plan and debating tighter regulations.
Sub-prime mortgages are typically sold among ethnic minority communities by brokers of the same background, and often over the telephone.
Jose Cortez, a 57-year-old Mexico-born Chicago caretaker, was cold-called by a Spanish-speaking agent from a company in California. He was offered a loan that would consolidate his credit card and car hire purchase debts and also refinance his mortgage.
"A week after we first spoke he sent someone round at about 10.45 pm and said we had to do this quickly because tomorrow you won't have the deal," said Mr Cortez.
He didn't read a bundle of documents all in English, his second language. He was expecting to borrow another $30,000 but the sum transformed into $70,000, including a $10,000 broker's fee. He already owed $290,000 from his first mortgage, on a salary of $36,000. His monthly repayments now equal his salary.


It has been quoted on this thread that SPL's are akin to a variable rate loan with the 12 month kicker........ in AUS. Seems to me that this article indicates that SPL's are the 'Cash Converters' of credit with a like minded clientele.

Nothing would surprise me in the US, least of all a responsable credit system and a well informed client base.

The attached article is comical

 

[numbercruncher]

I might just book a flight to the US of A and pick myself up some houses...

Sounds to good to be true, and unfortunately these things often are, gotta be some catch, Maybe its virtually Impossible to get tenants, High Rates etc etc ?

 

[YChromozome]

Sounds to good to be true, and unfortunately these things often are, gotta be some catch, Maybe its virtually Impossible to get tenants, High Rates etc etc ?

The problem in Detroit is the decline of the motor industry. So unemployment must be high.

But surely if you buy the properties @ 7k or even 30k you don't need to charge much rent to get a tidy return. Just have to find out what unemployment benefits are worth. (oh, and give them something to do during the day so they don't wreck the place).

What say we start ThinCorp (thin on capital - high on debt). Anyone want to come aboard? We just need to spend a few dollars up front to improve social infrastructure, to help reduce crime and vandalism (might do some advertising and glossy brochures too). Then we can invest in all these investment properties. 15% yield, "guaranteed" return.

 

[Kimosabi]

The problem in Detroit is the decline of the motor industry. So unemployment must be high.

But surely if you buy the properties @ 7k or even 30k you don't need to charge much rent to get a tidy return. Just have to find out what unemployment benefits are worth. (oh, and give them something to do during the day so they don't wreck the place).

What say we start ThinCorp (thin on capital - high on debt). Anyone want to come aboard? We just need to spend a few dollars up front to improve social infrastructure, to help reduce crime and vandalism (might do some advertising and glossy brochures too). Then we can invest in all these investment properties. 15% yield, "guaranteed" return.

That's a great idea, got to get all that money out of retirees somehow...

 

[Kimosabi]

Market Woes Move to Alt-A: American Home Lowers Earnings Forecast

"Michael Strauss, American Home's Chairman and Chief Executive Officer, commented, "During March, conditions in the secondary mortgage and mortgage securities markets changed sharply.

In particular, these markets were characterized by far few buyers offering materially lower prices, both for loan pools and for "AA", "A", "BBB" and residual mortgage securities. These changes had a significant, adverse impact on our Company's first quarter results, reducing our gain on sale revenue and causing mark-to- market losses in our portfolio.

http://www.housingwire.com/2007/04/...alt-a-american-home-lowers-earnings-forecast/http://market-ticker.denninger.net/2007/04/here-we-go-first-earnings-guidance-ahm.html

These guys aren't even a sub-prime.

They are getting hit from both ends, Rising Delinquencies and having difficulties getting more money to make more loans.

 

[Uncle Festivus]

The nations largest residential builder sales orders down approx 40%, another may report a loss. The carnage not contained yet I don't think.
~~~~~~~~~~~~~~~~~~~~~

BOSTON (MarketWatch) -- D.R. Horton Inc. said Tuesday its cancellation rate remains elevated and that it hasn't seen a rebound in market activity that's typically associated with the spring home-selling season.
D.R. Horton said second-quarter cancellations were basically unchanged from the previous quarter at 32%. For the three months ended March 31, the Ft. Worth, Texas-based company said net sales orders dropped 37% from a year earlier to 9,983 homes.

Donald Horton, chief executive at the nation's largest builder of residential homes, in a prepared statement said the spring sales period "has not gotten off to its usual strong start." The assessment is the latest piece of evidence that the hoped-for housing recovery is still on hold.

Last week, another big home builder, Ryland Group Inc., said it expected to post a quarterly loss. Like others in the industry, it's booking land charges as home prices in many areas of the country pull back.

 

[Kimosabi]

IMF warns subprime woes may spread, dollar falls
Tuesday April 10, 9:40 pm ET
By Herbert Lash


NEW YORK (Reuters) - Fallout in the U.S. subprime mortgage market could spread to related markets, the International Monetary Fund warned on Tuesday, as nagging worries about housing helped weaken the dollar.

Shares of real estate investment trust American Home Mortgage Investment Corp. (NYSE:AHM - News) tumbled for a second day on

Tuesday after the REIT slashed its profit forecast last week.

The company's shares fell on investor concern that problems in subprime mortgages may be spreading to higher-quality housing loans, a view the IMF also gave credence to.

The IMF said in its semi-annual Global Financial Stability Report that a decline in the subprime market was more rapid than expected at this point in the overall housing downturn.

Looser underwriting standards may have gone beyond the subprime sector into portions of "Alt-A" mortgages, the next-riskiest area, the IMF said. In addition, there could be losses in other consumer credit markets, including credit card and subprime auto loan asset-backed securities, it said.

"Financial supervisors need to identify the potential for spillovers from the cooling of the housing market and continue ensuring that mortgage underwriting standards are maintained," the IMF said.

At least 20 lenders in the subprime mortgage sector, which serves borrowers with poor credit histories at high interest rates, have gone out of business as default rates have jumped.

The crisis has triggered broader concerns that the fallout may spread to mainstream lenders and damage the U.S. economy.

Homebuilders continue to report an industry slowdown. D.R. Horton Inc. (NYSE:DHI - News), the largest U.S. homebuilder, said on Tuesday orders for new homes tumbled 37 percent in the last quarter.

D.R. Horton also said selling this spring has been slower than usual, suggesting the industry has yet to hit bottom.

Chairman Donald Horton said conditions remain tough in most markets because of high inventories of unsold new and existing homes. The housing market downturn has hit homebuilders and related sectors hard, and tightened loan policies due to the subprime mortgage crisis have exacerbated the industry's pain.

D.R. Horton's net sales orders in its quarter ending March 31 fell to 9,983 homes from 15,771 a year earlier. The dollar value of orders sank 41 percent to $2.6 billion, it said.

The biggest decline for orders was in California, where they fell 59 percent to 1,107 homes, and the biggest dip in dollar value of orders also was in the state, falling about 57 percent to $533.5 million.

Subprime lender New Century Financial Corp. (Other OTC:NEWC.PK - News) urged a federal bankruptcy judge to speed up the auction and sale of its main lending business while it still has value.

New Century wants to sell its loan origination business by early May, and sees an "exigent and immediate need" to set up bidding procedures, according to a late Monday filing with the U.S. bankruptcy court in Wilmington, Delaware.

The Irvine, California-based company previously said it planned to sell major assets within 45 days of its April 2 bankruptcy filing, or around May 17.

New Century asked U.S. Bankruptcy Judge Kevin Carey to schedule an April 17 hearing to set up bidding procedures, and a May 15 hearing to approve a successful bid.

The company previously agreed to sell its loan servicing unit to hedge fund Carrington Capital Management LLC for $133 million, down from an original $139 million.

Subprime lender Accredited Home Lenders Holding Co. (NasdaqGS:LEND - News) said on Tuesday it had hired Squar, Milner, Peterson, Miranda & Williamson LLP as its independent auditor, replacing Grant Thornton, which resigned from the role last week.

After Accredited shares surged 8.8 percent to $10.04 in electronic, pre-market trading, shares pared gains and were off 7 cents to $9.16 in late afternoon trading.

Shares of American Home Mortgage fell $2.32, or 10.6 percent, to $19.60 in late afternoon trade on the New York Stock Exchange.
(Additional reporting by Jonathan Stempel, Ben Klayman, Lesley Wroughton and Christian Plumb)

http://au.us.biz.yahoo.com/rb/070410/usa_subprime.html?.v=1

 

[Uncle Festivus]

When they start off a story saying "the first time in x years" you know it's not your ordinary real estate bust.

~~~~~~~~~~~~~~~~

WASHINGTON (MarketWatch) -- U.S. home prices will probably fall this year for the first time in at least 38 years, the National Association of Realtors said Wednesday.
In its monthly housing outlook, the real estate industry group said tighter lending standards will cut into home sales even further than it had been projecting, driving prices lower.
Median sales prices of existing homes are now projected to fall 0.7% in 2007 before a modest 1.6% gain in 2008, the realtors said.
Since the realtors began tracking prices of single-family existing homes in 1968, the smallest price gain was 2.0% in 2006. The average gain has been 6.5%.
After adjusting for inflation, real home prices will probably decline for three straight years from 2006 through 2008.
Meanwhile, the median sales price of new homes is expected to rise 0.4% in 2007 and 2% in 2008.
"Tighter lending standards will dampen home sales a bit, but by less than a couple of percentage points from initial projections," said David Lereah, chief economist for the realtors, in a statement. "We still forecast 2007 to be the fourth highest year on record for existing-home sales, and housing remains a great long-term investment." :screwy:
Lereah urged people who are "uncomfortable" with the terms of their mortgage to refinance quickly before rates rise.
"Simply stated, a loan with the lowest monthly payment probably isn't in your best interests -- borrowers need to understand worst-case scenarios," Lereah said. "If you're in a mortgage you aren't comfortable with, now is an excellent time to refinance, if you can, with historically low rates on safer conventional loans."
Lereah's new forecast:

• Existing home sales down 2.2% to 6.338 million in 2007 from 6.478 million in 2006. A month ago, Lereah was forecasting a 0.9% decline. Sales fell 8.5% in 2006.
• New-home sales down 14.1% to 904,000 in 2007 from 1.053 million in 2006. A month ago, Lereah was forecasting a 10.4% decline. Sales fell 17.9% in 2006.
• Housing starts down 18.4% to 1.47 million in 2007 from 1.80 million in 2006. A month ago, Lereah was forecasting a 16.7% decline. Starts fell 12.9% in 2006.
• Spending on residential construction down 13.6% to $503 billion from $582 billion in 2006. A month ago, Lereah was forecasting a 12.8% decline. Spending fell 4.2% in 2006.

 

[Wysiwyg]

I can see that gradually the USA financial markets are having less of a stranglehold over the world and other financial institutions are having a say in the state of the world economically.Being the biggest consumer on the planet makes the USA economy vulnerable.

 

[Shane Baker]

"Being the biggest consumer on the planet makes the USA economy vulnerable"

Also makes those economies that supply the goods vulnerable to any downturn in US consumer purchasing power.

 

[Kimosabi]

50!

http://ml-implode.com/

55 Today

 

[Uncle Festivus]

The US subprime mortgage crisis hit General Electric on Friday, wiping $373m from the industrial conglomerate’s first quarter profits and prompting its executives to warn of an incipient “bubble” in global credit markets.

 

[Kimosabi]

Nothing like irresponsible lending to the irresponsible to end the party...

 

[Kimosabi]

Well the Mortgage Implode-o-meter just clicked through 60 mortgage lenders that have gone broke in the US.

http://ml-implode.com/

Luckily for us in Australia, no mortgage lenders have be so irresponsibly as to lend money to those who couldn't afford to repay the debt for overpriced houses...

 

[wayneL]

Well the Mortgage Implode-o-meter just clicked through 60 mortgage lenders that have gone broke in the US.

http://ml-implode.com/

Luckily for us in Australia, no mortgage lenders have be so irresponsibly as to lend money to those who couldn't afford to repay the debt for overpriced houses...

Lucky it's all been contained to that sector then hey?

 

[Kimosabi]

hello,

so 60 lenders have gone bust and what has it done?

they have to fill pages with something

thankyou

robokimbosabibots

 

[Kimosabi]

This is a pretty good analysys of the Current US Housing/Credit Markets

I had to split the article into three posts to fit it on here.

Part 1

U.S. Credit PerspectivesMark Kiesel | May 2007

Still Renting

One question my friends and colleagues have asked me repeatedly over the past six months is: Are you still renting? Yes! I sold my house over a year ago and continue to rent. Back in late 2005, I became anxious about my investment in the “American Dream,” after spending a considerable amount of time and effort researching several factors that I felt would influence housing prices. At the time, I was nervous about housing and ended up selling my house in early 2006 after owning for eight years, and then, upon closing, published For Sale, our U.S. Credit Perspectives, June 2006 publication. A year ago, I suspected housing prices were set to take a sharp turn for the worse and more “For Sale” signs were coming.

Based on the current outlook for housing, I will likely be renting for one to two more years. While many factors that influence housing prices have turned negative, I suspect we have not yet hit bottom. In fact, housing prices should head lower throughout the rest of this year and next year as well. Why? Housing inventories remain high, delinquencies and foreclosures are set to rise as homes purchased over the past few years by speculators and individuals with teaser-rate and adjustable-rate mortgages come back on to the market, affordability is low, and sentiment and risk appetite has shifted negatively. Most importantly, the availability of credit is set to take a turn for the worse as lenders tighten credit standards.

This is all great news for renters and buyers who are patient. Over time, housing prices and interest rates should decline, resulting in improved affordability. This adjustment, however, will take time and occur over a period of years, not months. Housing is illiquid and prices are sticky. As a result, potential buyers should exercise patience and not jump back into the housing market too early. A year ago, I described the state of the U.S. housing market as “the next NASDAQ bubble.” The NASDAQ took over 2 ½ years to go from peak to trough. I suspect that housing prices could display a similar pattern, and we are still over a year away from the bottom. Given these risks, I prefer renting versus owning, and an investment strategy which favors defense versus offense.

Unwinding the Housing Bubble

Housing was an asset bubble influenced by bullish sentiment, robust risk appetite and speculation, lack of fundamental analysis, cheap money, inflated appraisals and easy lending standards. These factors helped to drive housing prices up to new levels and the unwinding of these conditions is expected to drive housing prices down. Never before have we witnessed so many people lever-up real estate with so little money down or “skin in the game.” This growth in mortgage debt and risk appetite helped fuel consumer spending and corporate profits. As such, the unwinding of this bubble will have broad consequences for the overall economy.

As the housing bubble unwinds, what are the implications for the overall economy and credit spreads? The U.S. economy will likely experience sub-par economic growth for the next year as declining housing prices lead to weaker consumer spending, slower corporate profit growth, a decline in business investment and less job creation. This environment favors reducing credit risk, especially to cyclical industries and lower-quality sectors of the market. As lending standards tighten and risk appetite turns more conservative, housing prices are likely to face a further leg down.

What’s the big picture? Declining housing prices will lead to a pullback in job creation and a sharp slowdown in corporate profit growth, causing the Fed to lower short-term interest rates by the end of this year. Despite lower short-term rates, mortgage rates may not follow downward, because more cautious lenders will charge higher spreads relative to Treasuries. In addition, credit spreads should widen as consumers rein in their risk appetite for housing and investors turn more cautious on the outlook for the U.S. economy. We will now turn to an analysis of the supply and demand factors influencing housing. These factors should help to illuminate the future path of housing prices over the next year.

Inventory

On the supply side, the inventory of new and existing homes available for sale remains near all-time highs (Chart 1). The homebuilder industry helped contribute to today’s record inventories through its bullish sentiment and aggressive land purchases over the past several years. Unfortunately, homebuilders have little incentive to stop building once they have purchased land for development. In hindsight, homebuilders bought too many lots over the past few years, expecting that the run-up in land prices would continue for several more years. Given that undeveloped land is less valuable than developed land, homebuilders went through the process of getting zoning approvals on their land and started the build-out process in order to monetize their investments.

Even when prices appeared to have peaked over a year ago, homebuilders continued to commit to new developments and communities. Meanwhile, even in the face of large discounts and concessions, housing order rates have fallen more precipitously than most expected, resulting in inventories remaining stubbornly high. Undeveloped land cannot be monetized without a completed home. The cost of carry, including completion guarantees, provides strong incentives for builders to keep building. Unfortunately, housing is like a supertanker, which takes time to slow down. In addition, homebuilders have little incentive to stop building when a home is incomplete, even if economic conditions soften. All of these factors help to ensure that once projects are started, they are completed, and also help to explain why homebuilders’ inventories have remained elevated despite aggressive incentives such as –10% to –15% price discounts.

The housing market faces potential new supply from other sources as well. First, a large portion of incremental housing demand over the past several years has come from speculators and investors. With housing prices now falling in most of the markets where speculative activity was strongest, yesterday’s marginal buyer is becoming today’s marginal seller. Not surprisingly, the inventories in highly speculative regions such as Florida, California, Phoenix and Las Vegas, have risen sharply. In some of these over-heated markets, supply represents several years of demand. Not surprisingly, homeowner vacancies are soaring (Chart 2). This trend may even accelerate as recent speculators with low initial equity, and negative future equity, choose to walk away from paying monthly mortgage payments on a losing investment, especially factoring in the cost of 4-5% real estate commissions.

Another source of new supply will likely come from rising delinquencies which will eventually turn into more foreclosures. A growing segment of recent homebuyers have bought homes using teaser-rate, adjustable-rate, and no-money-down or low-money-down mortgages. As adjustable-rate mortgages reset upward, the housing market will likely see increased foreclosures involving individuals who can’t afford the new reset rate on their mortgage. The total inventory of homes in foreclosure has risen to 437,041 homes, a +39% increase over the past year.1 The problem is not only in the subprime category, as delinquencies for both prime and subprime loans are rising (Chart 3).

 

[Kimosabi]

Part 2

In fact, the market’s primary focus on subprime ignores a major issue, which is that Alt-A and prime borrowers will also face “sticker shock” when adjustable-rate mortgages reset upward. Lehman Brothers estimates $421 billion of ARMs will reset in 2007 ($308 billion subprime and $113 billion prime) and $542 billion of ARMs will reset in 2008 ($349 billion subprime and $193 billion prime).2 Clearly, this is not just a subprime issue, but rather an ARM reset issue as both subprime and prime borrowers potentially are forced to put homes back on the market with almost $1 trillion of ARMs resetting over the next two years. What impact will this have on housing? According to a study published last month by First American CoreLogic, a total of 1.1 million foreclosures with losses of about $112 billion will occur over a period of six years or more with roughly 500,000 homes going into foreclosure over the next two years.

Rising foreclosures will result in homes coming back on the market not only at a time when current inventories are near record levels, but also when pent-up demand for housing is low. Easy lending standards and innovations in the mortgage market over the past several years brought forward future housing demand. People who would have qualified for a mortgage in the future were given a mortgage today. Why? Lenders, hungry for yield, relaxed their underwriting standards and provided cheap money. Naturally, consumers took the bait, and levered-up with record low down payments. In fact, 46% of homes purchased in the U.S. last year had less than a 5% down payment.4 Over time, homeowners with little capital at risk and negative home equity will likely walk away from homes under water. For all these reasons, housing inventories are likely to remain high over the next few years.

Affordability and Risk Appetite

On the demand side, housing affordability remains near 20-year lows due to a sharp run-up in housing prices (Chart 4). While mortgage rates have come down slightly over the past few quarters, housing remains unaffordable for a large group of new potential buyers. This buyers’ strike will continue until prices fall and/or mortgage rates decline. Given that homebuilders can’t control the absolute level of mortgage rates, we should expect buying incentives to remain elevated over the next several quarters. Given the strong incentives for buying a new home, owners of existing homes who are forced to sell will likely be forced to lower their asking prices.

We know from the NASDAQ bubble that once risk appetite changes, prices can shift violently in the other direction. Housing is different from equities because it is much less liquid; therefore price adjustments take more time. In a down housing market, the gap between buyers and sellers widens, and volumes fall. Buyers pull back and sellers take time to realize their listing prices are too high. Eventually, housing prices in entire neighborhoods will get reset downward by the weakest hand. Just as prices went up and everyone in the neighborhood applauded the newest neighbor who bought at the top, prices will likely start to fall as financially-stretched home owners and speculators sell, and are forced out of the market. As this process unfolds, risk appetite for housing should take a sharp turn for the worse. This year’s weak start to the traditionally strong spring selling season suggests we have indeed entered the “buyer’s strike” phase of the cycle.

Credit Availability, Lending Standards and Appraisals

A major headwind for housing in the near future will be more restrictive credit availability. Lenders are already increasingly asking for income verification and higher down payments. Countrywide changed their no down-payment lending policy last month, and is now requiring homeowners to have at least a 5% stake in their homes.5 Other lenders are following Countrywide’s lead, which will result in a smaller pool of potential homebuyers. The threat of increased government regulation and restrictive legislation is likely to cause lenders to reduce offerings of no-documentation loans, and to ensure that adjustable-rate borrowers can qualify at the higher reset rate. This trend will tighten credit availability for potential homebuyers.

As delinquencies and foreclosures rise, lenders will also suffer losses. This should reduce their willingness to take risk and cause credit spreads to widen, particularly for riskier borrowers. As lending standards tighten, less credit will be granted. And, credit that is granted will likely be offered at higher interest rates. In the long run, this will be a positive for the housing market, as only buyers who can afford to buy a house will buy one. However, in the short run, tighter lending standards will cause a reduction in demand for housing, and could cause the home ownership rate to fall. Given the significant increase in projected foreclosures mentioned above, an extended period of credit tightening could materialize.

As we discussed in Credit Innovation and Opportunity, our December 2006 U.S. Credit Perspectives, the mortgage industry’s ability to develop new products that kept initial monthly payments low enabled consumers to buy homes they could not otherwise afford, and was a major factor in driving the home ownership rate up 5% in the last 10 years to today’s level of 69%. With rising delinquencies and foreclosures, the downside of credit innovation will surface and may be met face-to-face with increased regulation. Innovation in the mortgage market, which has provided a huge lift to consumers and housing prices through growth in non-traditional products (Chart 5), is clearly at risk. Consumers will likely shift away from exotic mortgages, resulting in less overall stimulus for the housing market, particularly given the lack of pent-up demand for housing.

Lenders are not the only players in the real estate market who are turning more cautious. Real estate appraisers will also become more conservative in their evaluations of property. Some appraisers, who in hindsight probably inflated appraisals over the past several years, helped contribute to the housing bubble on the way up by helping to get marginal buyers and mortgages approved in order to “make the deal work.” Given heightened regulatory oversight, appraisers will turn more realistic.

As lending standards tighten (Chart 6) and appraisals become more conservative, the pool of potential homebuyers will shrink. Why? A major problem in today’s housing market is not only sales to new home owners. The “move up” market, or existing owners who want to sell their current house to buy another house, is basically frozen. Outside of speculators exiting the market, this is a major reason why cancellation rates have risen. It isn’t only the speculators and investors backing away. Potential new homebuyers can’t sell their existing home to another buyer. As a result, they cannot move up. Changing buyer sentiment, more restrictive credit and less aggressive appraisals are all helping to restrict marginal buyers.

Where’s The ATM ?

Over the past several years, consumers leveraged rising housing prices and easy credit availability using their home as an ATM. Mortgage equity withdrawal (MEW) soared, allowing consumer spending to grow faster than income growth over the past several years. This process was facilitated by rising home prices and loose lending standards. As long as housing prices were rising, lenders were willing to lend, and consumers were willing to spend, as rising housing prices gave them the confidence to draw down on savings.

Today, mortgage equity withdrawal appears tapped. Consumers have been accessing their homes as bank accounts, but housing prices are now falling in many areas, and credit is becoming more difficult to obtain. The slowdown in MEW has been remarkably swift. Over the past year, consumers tapped over $400 billion less equity out of their homes than the previous year. And, in looking at the four-quarter moving average of MEW divided by nominal GDP, the change in MEW as a percent of nominal GDP is now –1.8% (Chart 7). Slower housing price appreciation is causing mortgage equity withdrawal to fall sharply, and is set to detract from U.S. economic growth.

 

[Kimosabi]

Part 3

To understand why corporate profits may be at risk as a result of the slowdown in MEW, let’s turn our attention to consumer spending. Companies make money when consumers spend. And, consumers have been spending in part due to rising housing prices, which have allowed consumers to grow debt faster than nominal GDP. Why are corporate profits as a percent of nominal GDP at new highs? Some would argue the reasons are: (a) healthy productivity gains, (b) cost cutting, (c) strong global growth, and (d) low long-term interest rates due to robust global savings. Instead, I suggest turning the focus back to the consumer and housing. Thanks to rising housing prices, consumers have been able to grow spending significantly faster than income growth, through unprecedented increases in mortgage equity withdrawal. In fact, the growth in mortgage debt parallels the growth in corporate profits (Chart 8). As a result, corporate profits, and thus economic growth, are highly dependent on housing prices. As housing prices turn negative, corporate profit growth will eventually follow.

Housing Is Today’s Leading Indictor

Housing is today’s leading economic indicator. To quote our forecast from one year ago in For Sale, “with a softening housing market, we should expect tighter lending standards, a moderation in the willingness to take risk, a slowdown in the pace of asset price appreciation, less liquid markets, and rising volatility in financial markets.” On the economic front, I believe declining housing prices and tighter credit are set to unleash a sharp downturn in housing turnover and job creation. As housing prices fall, corporate profits are expected to be at risk as consumers pull back their spending.

Housing is a momentum market. Turnover rises when real housing prices, as defined as housing price appreciation (HPA) minus mortgage rates, are rising. Turnover slows when real housing prices are falling (Chart 9). Today, the growth in real housing prices is falling. We believe real housing prices will turn further negative in 2007, causing new and existing home sales to decline towards 5 million units per year, down from a peak of over 7.5 million units per year in 2005.

Housing starts and permits tend to be a good leading indicator of job growth. Through February 2007, housing starts are down –28% year-over-year. This type of decline in housing starts typically leads to a sharp slowdown in job growth, within roughly one year (Chart 10). As a result, I believe that job creation is set to slow, possibly materially. The U.S. economy created approximately 200,000 new construction jobs last year. It would not surprise me if we lost 400,000 construction jobs this year, as homebuilders complete their existing projects and then lay off workers. As corporate profit growth deteriorates with a slowdown in housing, business investment and consumer spending, layoff announcements across all sectors of the labor market will likely pick-up.

Investment Strategy

At PIMCO, we have anticipated the warning signs in housing and positioned our portfolios accordingly. Our duration is above index with an emphasis on the front-end of the U.S. yield curve given our view that short-term interest rates should trend lower. Our overall credit exposure is under-weight with a cautious stance on cyclical industries such as home builders, paper, building products, home appliances and retailers. Industries we favor include energy, refining, pipelines, utilities, rails, cable, metals and mining, healthcare and telecom. Given today’s environment of tight credit spreads, poor covenant protection and heightened event risk and economic uncertainty, we believe our conservative investment strategy makes sense, especially given our more negative views on housing.

Housing is today’s leading indicator of economic growth and risk appetite. An extended downturn in housing will likely lead to slower job creation, softer corporate profit growth, tighter lending standards and weaker consumer and business confidence. The Fed should lower the Fed Funds rate as soon as we have confirmation that the employment situation is deteriorating. By that time, credit spreads will have already anticipated the fact that risk appetite is set to turn for the worse.

For renters and potential homebuyers, my advice is to still rent. The housing market has turned for the worse but the unwinding of this bubble will take more time. Unfortunately, this is not good news for the U.S. economy, job creation or corporate profits. Nevertheless, investors who are patient and adopt a conservative investment strategy should prosper over the next few years.

Mark Kiesel
April 12, 2007
http://www.pimco.com/LeftNav/Global...ves/2007/U.S.+Credit+Perspectives-+5-2007.htm