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Recovery, What Recovery?

This report was originally prepared and posted for subscribers to the Wall Street Examiner Professional Edition in printable pdf format on 2/4/07. We invite you to try the service risk free for 30 days.

Recovery? What recovery? Behind all the Wall Street hoopla about a US housing market recovery, and behind skyrocketing homebuilder stock prices, the truth is that when you look at the recent data graphically, there’s no “there” there.

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This big “recovery” touted in the mainstream financial rags and infomercial media is like a dead cat bounce, or even a dead rat bounce. Mortgage application activity remains barely above the lows set in 2006. Any uptick in rates will send new applications plummeting. In the week ended January 26, mortgage applications were in the same range they have been in since early November, virtually unchanged compared with the same period last year, and down 66% since the May 2003 peak. The recent “recovery” barely registers on the chart.

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Both purchases and refis broke their downtrends as rates collapsed in the second half of 2006. But rates are rising again. If the rise in mortgage rates continues, the “recovery” in housing will reverse into an unmistakable death spiral, exposing the fact that on this issue, as with so many others, the emperor (Wall Street) has no clothes.

In the week ended 1/26, purchase mortgage activity was down 6% versus one year ago, and down 22% from the July 2005 peak. Excluding the two spikes in the Christmas and New Years holiday weeks, which were due to bogus seasonal adjustment factors, the purchase index is in exactly the same range it has been in for the last year—down 20-22% from the peak levels of 2005. In short, there is no recovery. Month to month there was virtually no change.

Refi activity was up 11% from a year ago, as those facing rate resets were churned into new mortgages with lower teaser rates, but refis were down 80% from the May 2003 peak. As loan standards tighten, and with no increases in equity, we can expect to see the refi numbers beginning to contract in short order.

Mortgage purchase applications appeared to rise sharply in late December and early January. I wrote at the time that the data was bogus. The Mortgage Bankers Association uses both seasonal adjustments and adjustments for the holiday shortened weeks. The two weeks in which the huge spikes occurred are the weakest of the year. There’s almost no business being transacted in the real estate industry during that time. The resulting seasonally adjusted readings are extrapolated from numbers that are so small they cannot be used reliably as the basis for anything. I suggested that the numbers would not hold up, and they didn’t.

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For sure the market did get some help from falling rates in the fourth quarter 2006. But that can only take things so far because the market has a fundamental supply and demand problem largely independent of interest rates. The problem will be exacerbated if rates rise. Any increase in mortgage rates now is likely to lead to the total collapse of the housing market, while lower rates won’t help much. After a two month move up, as of early February bond yields may be ready to pull back a bit. It will be interesting to see how mortgage applications respond. Of course, if there’s no pullback in yields and the trend resumes to the upside, then game over.

The problem is fundamentally weak demand amidst a backdrop of burgeoning supply. In the last stages of the bubble, when it had run out of qualified borrowers, the mortgage industry found ways to foist claims on those who will never be able to pay. By turning unqualified borrowers into buyers, the mortgage bankers and brokers enabled the creation of an overhang of supply that will take years to work off. Even with a seasonal reduction of listings on the market in December, there is still a massive supply overhang, with more supply coming this spring when recently discouraged sellers who pulled their houses off the market put them back on. Data from this week suggests that that process is already under way. In 29 major metros, the inventory of listings increased in 24 over the month ended February 1. The unweighted average increase was 3.2%.

Most would-be sellers won’t sell at current price levels. They are kidding themselves into thinking that their houses are worth more than the market will bear. Many will have no choice but to face the music come spring.

In September 2006, after the bull was long out of the barn, the federal government finally promulgated new rules which will severely limit the use of exotic “liar loans” that magically turned unqualified borrowers into buyers. Recent well publicized failures of a number of subprime mortgage lenders are also forcing a tightening of lending standards. There are no longer enough qualified borrowers at the bottom of the pyramid to eat into that tidal wave of foreclosures that will be bearing down on the market, and to keep the pyramid from toppling over.

Housing inventories have been rising and demand tailing off. This historical chart was compiled by the US Senate Joint Economic Committee in May of 2006, covering data through February 2006, one year ago. It shows the rise in sales during the bubble years, and the beginning of the decline in mid-2005. The Senate chart shows a seasonally adjusted annual rate. It is not directly comparable to the NAR chart below which shows unadjusted monthly totals.


The chart from the National Association of Realtors below, shows that the Spring 2006 recovery peaked in May. From June to November, sales dropped roughly 33%. Inventories remained sky high. This was after rising by approximately a million units between fall 2005 and summer 2006, stabilizing at approximately 7.3 times monthly sales. The listing inventory then dropped from 3.85 million units in October, to 3.5 million in December, a drop of 10% as discouraged sellers pulled their properties off the market. At the same time, while contract closings leveled off for two months, new contracts continued to plummet in December, breaking the November 2005 low. Based on the number of contracts, sales are at a new low. Some recovery.

Chart includes an estimate of listing inventory for January based on the data from

The NAR reports the inventory to sales ratio as the number of months in inventory at a seasonally adjusted sales rate. I have devised an unadjusted inventory/contract ratio. While the NAR does not report actual contract numbers, they do report an index of pending homes sales showing month to month changes based on the base year of 2001. It is easy enough to calculate from that an estimate of the total number of contracts in a given month. Using that estimate the following chart shows the progression of the inventory to contracts ratio. Some recovery!


Keep in mind that these charts represent national data. The housing and real estate lending markets are no longer local. Problems will not be contained within local markets. They will immediately metastasize through the entire system. The collapse of the mortgage and home building industries will be triggered by the worst markets.

Nationally the inventory to contract ratio is nearly 10, in other words, the supply of listings has risen from a 5 month supply in March of 2006 to a 10 month supply in December. The increase has actually accelerated in the past two months while the market has supposedly been recovering, but in the worst markets the imbalances are even worse. In the worst of the worst, South Florida, where I live, the number of closed sales in December 2006 dropped 16% from December 2005 to 3,553 units (after already having dropped sharply in 2005). Meanwhile housing inventory had more than doubled to 101,667 units, for an inventory to sales ratio of 28.61.

By comparison, in the Phoenix, Arizona area, which is another really hot market (but it’s a dry heat), the inventory to sales ratios are much healthier, but they too have nearly tripled in the past year from a very tight 2.27 to a more problematic 6.51. No doubt about it, the perfect storm is brewing in Florida., which tracks real time MLS inventories in major metros, reported a rise in inventory in the majority of major metros ranging from 0.1% to 17% over the past month. The average was 3.2% (table next page). The inventory overhang is finally beginning to accelerate the decline in asking prices, as measured by comparing the one year change with the change over the last nine months. The average metro area decline of 4% over the past nine months would be around 4.9% excluding Atlanta, Seattle and Dallas. The overall 9 month price change has gone from -3.4% to -4% in the past month.

Some recovery.


Additional evidence on the “recovery” comes from the Census Bureau (not that their data is especially reliable). Their quarterly housing survey includes a line item of the total vacant housing units for sale. This would include builder units. In the fourth quarter of 2006 the number of vacant units for sale had increased to 2.1 million, from just over 1.4 million in the third quarter of 20-05. The annual rate of increase is also skyrocketing, reaching 33% in Q4 06. The chart below speaks for itself.


The National Association of Homebuilders conducts a member survey of the traffic of prospective buyers. Maybe this is the “recovery” they’re talking about. They report the data as a diffusion index on a scale of zero to 100. A reading of 50 means that an equal number of respondents are reporting good or very good traffic versus poor or very poor. The index is seasonally adjusted in order to remove seasonal influences from month to month comparison. This index has declined from a high of 55 in June and July 2005 to a reading of 21.6 in August 2006, the lowest reading since January of 1991. In January 2007 the index reached 26, equaling its “recovery” high in November 2006. In spite of lower interest rates, and lower prices in the market including massive sales incentives offered by the builders, the index has risen all of 4.5 points after dropping 33.5 points. The present sales index has risen from 32 to 36, after dropping from 72 in June of 2005. This “recovery” has barely registered on the chart, remaining near the lowest levels recorded since the end of 1991. Housing was then in the pits of the worst recession since 1933. Of course recoveries have to begin somewhere, so we’ll see how far this one progresses.


What are the odds that this is a bottom? After several strong years culminating in regionalized bubbles in the mid to late 1980s, the index dropped relentlessly for 43 months, finally reaching readings in the teens in November 1990 through January 1991 before beginning a slow recovery. By that time, numerous builders had gone bankrupt, new construction had ground to a halt, and numerous banks had been taken over by the FDIC and Resolution Trust Corporation. The current decline is only in its 17th month, builders are still building, inventories are still building, and only the first handful of mortgage banker failures has hit the wires. Not only has the recovery not begun, but the contraction would appear to be only in its very earliest stages.

Not only is supply mushrooming, but demand is shriveling. Affordability is clearly the issue. With unqualified borrowers now removed from the potential demand pool, the problem will only get worse. The least affordable (i.e. most expensive) markets in the country had the highest percentage of ARM borrowers. The Federal Housing Finance board reported that in the third quarter of 2006 in the San Francisco MSA, 51% of borrowers used ARMs, down from 65% in the second quarter as rate differentials between ARMs and fixed rate mortgages narrowed. In the San Diego market 53%% of borrowers used ARMs, versus 62% in the second quarter. Los Angeles went from 57% to 48% using ARMs. Contrast that with low priced markets like Cleveland, OH and Pittsburgh, PA where only 2% and 3% of buyers used ARMs in the third quarter. Where affordability is not an issue, buyers make rational choices. Where they can’t, they don’t.

Here’s another little tidbit that’s going to present a problem as housing values “moderate”. From December 2005 to December 2006 the average loan to price ratio rose from 75% to 78%. Borrowers are starting out with even less equity than they did a year ago. The percentage of borrowers with less than 10% equity also rose, from 15% to 22%. Lenders are increasing their risk exposure in spite of ample evidence that the trend of collateral value is down. At the current rate of housing value decline, the 15% of borrowers who borrowed more than 90% of the purchase price in December 2005 will be under water within a few months. Many of them already are. Those with ARMs facing rate resets from low teaser rates will not be able to refinance because they have no equity.

As the spread between fixed and adjustable rate mortgages narrows, the percentage of ARMs has finally begun to shrink after holding near 30% in spite of the rise in ARM rates. ARMs were 21.4% of total applications in the week ended January 26. The record high was 36.6% of total applications in the week ended March 25, 2005. The use of ARMS remained stubbornly high until the Q4 2006 when spreads with the fixed rates narrowed dramatically. All of these borrowers will have difficulty refinancing due to inadequate equity.

To some extent the persistence of the use of ARMs was because many of these loans were “option” ARMS based on “stated income”, the so called liar loans. Now that borrowers are actually going to have to qualify for these loans at realistic maximum, rather than minimum payments, the use of these loans has dropped dramatically. That should reduce overall mortgage volume, which should lead to shrinkage in liquidity creation out of this sector. As Fannie and Freddie’s portfolios shrink, it should put pressure on systemic liquidity. Other players have to step in and pick up the slack in order to avoid a meltdown. So far, foreign central banks have done that in spades, keeping the liquidity spigots wide open to ensure that US mortgage markets continue to function.

Those borrowers who took one year ARMs over the last 3 years are facing maximum rate resets. Those with 3/1 ARMs initiated in 2004, where the initial rate was fixed for three years at rock bottom rates, are now facing huge payment increases. Likewise, those who began with 5/1 ARMs in 2001 at rates lower than today’s, will begin to face increases this year. The resets on these products is forcing foreclosures to increase, and will continue to do so for several years. Rising numbers of ARM borrowers are going to be crushed by rising mortgage payments, insurance, taxes, and utilities.

This is one of the primary reasons housing inventory for sale ballooned at unprecedented rates over the past year. Owners who could no longer afford the carrying costs put their homes up for sale. That was a voluntary act. With the low sales to inventory ratios and declining prices, more of that inventory will become forced and involuntary. As lenders dump waves of REO properties on the market, prices will break sharply.

Another problem forecast here well before it was recognized by the crowd is the well documented disappearance of speculators from the purchase market. In most cases those speculators, aka flippers, now have a different nomenclature: Bagholders. In some markets they reportedly accounted for 25% of new home sales in 2005. With prices plunging, speculative buyers are out of the market and are only adding to the inventory overhang.

As a case in point, here’s an illustration of the problem in microcosm. I have mentioned previously that I have relatives living in a small Toll Brothers subdivision in St. Augustine, Florida, a small town about 45 minutes from Jacksonville. Toll is developing the remainder of an old PUD that failed in the 80s. They finished the 57 unit subdivision where my cousins live in early 2006. They are now building out a larger subdivision of similar homes with more luxury features. As of last June, nine of the homes in the earlier group were vacant and for sale. In early January when I visited there, those same nine homes were still for sale, most with sale signs that had the words PRICE REDUCED, or GREAT NEW PRICE!

This is just one small subdivision, not in a bubble market overpopulated with speculators in comparison with Florida’s big markets. If 15% of the units are vacant and in the hands of bagholders here, what must the numbers be in the bigger, once hotter metropolitan markets. Well here’s a clue. In South Florida, housing inventory for sale has risen by 102% over the past twelve months. Much of that is bagholder inventory, and most of that will eventually end up in the hands of lenders, to be put on the market at fire sale prices. Drastic price reductions are coming to a market near you soon.

Sellers are always the last to get the news when the real estate market turns down. Prices may appear to stay stubbornly high, but the truth is that fewer and fewer sellers can get their price. Reported sales prices are not equilibrium market prices. By the time the point of recognition arrives, it is too late, and prices will adjust to an equilibrium level in a violent and sudden downward adjustment.

Sellers are only now beginning to adjust to reality, as shown by the table derived from data on on listing prices. As long as inventories remain bloated, and continue to grow versus the rate of sales, the market will not be in equilibrium, and prices will continue to fall. Where and when the bottom will be can only be forecast when the rate of sales increases enough to begin shrinking the inventory. Since that process hasn’t started yet, those forecasting a bottom are whistling in the dark. In fact, as we watch the 10 year Treasury yield tick higher, the thought occurs that the sales rate may drop as inventory growth begins to accelerate in the months ahead.

Falling prices will also put an end to the refi cash out game that has been propping up the US economy. This will pressure systemic liquidity, possibly forcing interest rates to rise further, unless the Fed and FCBs act to offset that. So far, the FCBs have been more than willing to pump massive waves of dollars into Fannie Mae and Freddie Mac securities. That has subsidized the market, keeping mortgage rates abnormally low. It has kept things from being worse than they are. But in the end, it can only delay the inevitable adjustment. It cannot deny it. The Law of Supply and Demand has not been repealed.

Data from the Federal Housing Finance Board (FHFB) based on a survey of approximately 28,000 conventional mortgage sales transactions, showed that average sale prices for all homes has essentially plateaued since June 2005. The NAR’s data is consistent with that. The anecdotal reports from around the country suggests that the data isn’t telling the whole story, perhaps because it reflects less than an equilibrium level of sales. With the vast majority of sellers refusing to budge, they can’t sell their properties at all. The prices thereby reflected in the data are meaningless. The 4% average decline in asking prices over the past 9 months doesn’t begin to tell the whole story either. We won’t know the extent of the damage until the log jam begins to break, in other words, until sellers begin to hit the bid.

The National Association of Realtors estimated sale closings at 470,000 units in December 2006, versus 527,000 in November 2005, an 8% decline year to year. Listing inventory fell by 312,000 units month to month, thanks to discouraged sellers and seasonal factors, but was up 662,000 units year to year (26%). We know from the data that inventories began growing again in January, and I now estimated them at 3,631,000 units. The inventory to monthly sales ratio rose from 5.5 to 7.5 over the past 12 months. The inventory to contract ratio has risen from 7.41 to 9.88 over the same period. We know from the mortgage data that there was no increase in contracts from December to January. Based on the January inventory estimate, the current inventory to contracts ratio is now over 10. The market is not recovering. It is deteriorating.

Volume data on pending sales (contracts not yet closed) from the NAR shows that sales activity has weakened on a year to year basis as prices apparently plateaued. The index is based on a value of 100 for the year ended 2001. It dropped from a record level of 150 in June 2005 to a reading of 76 in December 2005. That broke the December 2004 low of 82. Then, for the first time since the data was collected, the index dropped in April. Normally the index peaks in June. Another new low was set in December. The index was down 7.6% year to year. Normally January is turnaround month with one of the biggest jumps of the year. Based on current mortgage applications data, there will be no recovery this January.

Closed sales volume was virtually unchanged in December versus November. Sales reflect contract activity from one to two months ago on average. Contracts reflect the current market. The index also does not include the impact of cancellations. The contracts data suggests that closed sales will decline sharply over the next two months. Fannie and Freddie won’t be funding as many new mortgages.

As bad as things are, it could have been much worse. With Fannie Mae under government mandate to reduce its size, the market’s ability to meet liquidity demands could have been crimped. That would have resulted in rising longer-term interest rates. It hasn’t happened because foreign central banks (FCBs) stepped in to absorb all the paper being liquidated by the GSEs, and then some, so the GSEs have not faced any liquidity issues, and they have continued to fund the markets. Data from the commercial banking sector and the Fed’s primary dealers indicate that these key players were also adding Fannie and Freddie paper in 2006, allowing the market to continue functioning smoothly even as rate pressures continued to build. But the FCBs are the lenders of both last and first resort for the secondary mortgage market.

The forces now at work in the US real estate market are likely to throw the mortgage market into crisis at some point, a crisis that could start a chain reaction throughout the financial sphere. It’s going to take more than just a few sub prime lender blowups here and there such as those we have seen over the past month. ( The system can still paper those over. But as the expected wave of foreclosures and defaults grows, eventually the problems will reach critical mass and will begin to impact Fannie and Freddie themselves. And what will the FCBs do about the $600 billion in partially worthless paper they are holding? The timing is uncertain, but the pressure is building.

As the mammoth unsold housing inventory continues to put pressure on prices, and as adjustable rate mortgages and other costs continue to pressure more borrowers into foreclosure, we should see more lenders have problems in the months immediately ahead. Real cracks in the system should begin to show up within the next twelve months. Systemic problems which have been papered over by massive FCB buying of GSE paper will become more obvious if the FCB subsidy is reduced. But as long as the FCBs have dollars to recycle and they choose to recycle them by buying mortgage backed paper at inflated prices (thereby suppressing yields) things will look better on the surface than they actually are. A weakening US economy would slow the rate of dollar recycling, and hurt the mortgage and fixed income markets.

These forces could come together in the perfect financial storm, but it could be a story that takes a long time to unfold. History tells us that once the price tide has clearly turned, it usually takes two to three years or more for prices to hit bottom, and many more years for the market to recover.

As for the “housing recovery” being touted by Wall Street analcysts, it’s fiction. The recovery in the housing stocks is one of those trends that George Soros talked about— based on a false premise. When the crowd finally recognizes the truth, payback is going to be a doozy.

Lee Adler
The Wall Street Examiner
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Lee Adler

I’ve been publishing The Wall Street Examiner and its predecessor since October 2000. I also publish, and was lead analyst for Sure Money Investor, of blessed memory. I developed David Stockman's Contra Corner for Mr. Stockman. I’ve had a wide variety of finance related jobs since 1972, including a stint on Wall Street in both sales, analytical, and trading capacities. Prior to starting the Wall Street Examiner I was a commercial real estate appraiser in Florida for 15 years. I was considered an expert in the analysis of failed properties that ended up in the hands of bank REO divisions, the FDIC, and the RTC. Remember those guys? I also worked in the residential mortgage and real estate businesses in parts of the 1970s and 80s. I have been charting stocks and markets and doing analytical work since I was a teenager. I'm not some Ivory Tower academic, Wall Street guy. My perspective comes from having my boots on the ground and in the trenches, as a real estate broker, mortgage broker, trader, account rep, and analyst. I've watched most of the games these Wall Street wiseguys play from right up close. I know the drill from my 55 years of paying attention. And I'm happy to share that experience with you, right here. 

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