The approaching “fiscal cliff” is a foreboding reminder for many that the U.S. is not out of the woods when it comes to the housing recovery. Experts agree that failing to reach a long-term deal on the U.S. deficit could trigger another recession, and that’s not the only threat. Investors who are now fueling the recovery could stop spending money before individual homeowners jump into the market, which could halt the recovery, as could an increase in supply from more foreclosures coming onto the market. Overall, analysts warn that a long-term housing recovery is not guaranteed and buyers should be mindful of the risks. For more on this continue reading the following article from TheStreet.
Housing turned the corner in 2012, but what if around the corner there is a giant cliff?
The consensus view is that the market has bottomed and that home prices will continue to rise in 2013. But most positive forecasts rest on assumptions that could easily be upset.
Everyone agrees that all bets are off if Washington fails to reach a deal over a long-term fix to the federal deficit, triggering an automatic expiration of tax breaks and mandatory spending cuts in 2013- a concern commonly referred to as the "fiscal cliff."
Economists fear that if politicians "go over the cliff", the economy will fall back into a recession. It would be the "opposite of the stimulus", says Jed Kolko, chief economist at Trulia.
"The stimulus in 2009 pumped $800 billion into the economy over a few years. The fiscal cliff could take $600 billion out of the economy in one year," said Kolko. "If nothing in the fiscal cliff is resolved, if we do have big tax hikes and spending cuts persisting through next year that will hurt the economy and the housing market."
Kolko expects the fiscal cliff will be resolved, but other external shocks also remain.
A disorderly break-up of the Eurozone for instance could trigger a credit crunch once again that could see interest rates and unemployment rise.
According to Paul Diggle at Capital Economics, every 0.25% rise in interest rates reduces home price inflation by 1% to 2%. Meanwhile, "as unemployment rises, the mortgage delinquency rate would also increase and banks would be forced to dispose of a growing shadow inventory at a quicker pace. The inventory of homes for sale would increase sharply," says Diggle. "In these circumstances, the housing recovery would falter. Our model suggests that house prices could easily fall by 5% per annum over the next few years."
This is of course a bear-case scenario. Diggle’s actual forecast is for a 5% rise in 2013 and a 4% rise in 2014. But the bear-case is not improbable.
Even if we set aside broad, macro concerns, there are still some reasons to be cautious about the housing recovery.
Housing demand in 2012 has been mostly from institutional investors who have seized the opportunity to buy distressed homes at deep discounts and convert them into rentals. While plenty of money is still sitting on the sidelines,that money can disappear if investors determine that the opportunity is no longer attractive.
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Hedge Fund Och Ziff Capital (OZM) recently pulled out of the REO (bank-owned foreclosed homes) to rental business .
Institutional investors "may help drive home price appreciation in the short run, but are not likely to do so in the long run," Quinn Eddins, head of research at Radar Logic, a real estate analytics firm, wrote in a recent note."As prices for REO increase, the expected future appreciation must also increase in order for investors to achieve the same return on investment. If prices rise to a point where investors’ expectations of future home price appreciation do not support their desired returns, then demand for REO will decline and prices could fall again."
Perhaps the rise in prices we are seeing now will lure enough traditional home buyers into the market to offset the decline in institutional interest. But in an interview with TheStreet, Eddins said he believes that scenario is unlikely.
First-time buyers still have difficulty getting credit. Even those with excellent credit scores might not be able to save enough for a downpayment amid an uncertain unemployment outlook.
Banks may be encouraged to loosen their credit standards amid rising prices, but that too remains uncertain without clarity on new mortgage rules. The Consumer Financial Protection Bureau is expected to release its rules on what constitutes a "qualified mortgage" in early 2013.
The rules will define what counts as a safe mortgage, one that a borrower has the ability to repay. Banks will have greater legal protection if they make qualified mortgages.
While clarity on the rules will help unlock some constrained lending, the agency needs to ensure that borrowers are protected but at the same time not define a safe mortgage so narrowly that it limits lending.
"We don’t want to end up with any unintended consequences that prevent private capital from returning or further restrict sound lending and ultimately go counter to the reset we’re trying to achieve," Bank of America (BAC) CEO Brian Moynihan said of the mortgage rules in a speech at the Brookings Institution Friday.
Meanwhile, on the supply side, the tight inventory situation that has helped drive prices higher might not last.
In some states such as Florida, New York, New Jersey and Illinois, where a judicial foreclosure process requires banks to prove in court that the borrower is in default in order to foreclose, there is a large and growing backlog of foreclosed properties that are yet to come on to the market.
The share of mortgages in foreclosure in judicial states averages 6.6% compared to 2.4% in non-judicial states, according to the Mortgage Bankers Association.
According to former Morgan Stanley analyst Oliver Chang, who now runs Sylvan Road Capital , the "years supply" of foreclosed homes in New York is 40 years!
Shadow inventory, which refers to the amount of troubled loans still in the foreclosure pipeline that are yet to hit the market, has become less of a concern in the past year.
One major reason has been that the big banks- Bankof America (BAC), JPMorgan Chase (JPM), Citigroup (C) and Wells Fargo (WFC) have increasingly opted for short sales and other forms of mortgage relief such as loan modifications instead of foreclosures.
The shift has been good news for the housing market. One, short sales sell at a lower discount to the market than foreclosures, thus easing the pressure on home prices. Secondly, pursuing foreclosure alternatives first ensures that distressed inventory hits the market in a more measured pace rather than all at once.
Yet, no one can be sure that this shift away from foreclosures is permanent. Much of this change of heart has taken place in the wake of the foreclosure robo-signing scandal. First, there was a moratorium on all foreclosures. Now banks are rushing to comply with the terms of the $26 billion mortgage settlement signed earlier this year, which requires them to actively consider foreclosure alternatives.
Once they meet their quota, it is unclear how they will deal with delinquent loans on their books. "The disposition strategy of banks is material to the market," said Eddins. Even if the shift to short sales is permanent, home prices will "go up a step", but not as much as they would do in a healthy market, he says.
"Short sales is a preferred strategy for banks and borrowers," says Eddins. "But you are always going to have REO and a lot of it."
Home prices in cities such as Phoenix have risen more than 20% in the past year, largely on the back of a decline in distressed sales and heavy investor demand.
But Eddins is not convinced that markets in Phoenix and California are out of the woods. According to the analyst, these markets have not risen on the strength of demand from households. They had a good year but it could easily erode.
"I don’t think housing will fall off a cliff but it can hit a new low," says Eddins. Radar Logic does not forecast prices but in Eddins estimate, he won’t be surprised if home prices fall 5% to 10% in 2013 and that is not including a shock from the fiscal cliff.
Even the optimists out there are quick to note that housing still has a long way to climb. "The sheer extent to which housing is now undervalued argues strongly that the next big move in prices is more likely to be upwards than downwards," says Capital Economics’ Diggle. "But even in a scenario that saw prices rise by an average of 8% a year, while earnings growth averaged 4%, it would take until 2019 before housing returned to fair value."
This article was republished with permission from TheStreet.