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13 August 2012
Economist Insights Out of the shadows
With the Eurozone in ongoing crisis, everyone has forgotten about US housing where the financial crisis began. It is now five years since house prices started to fall in the US and after a period of stabilisation we are seeing a gradual upturn. The overhang of unsold homes is declining but there is still a ‘shadow inventory’ of homes in foreclosure that will prevent an acceleration. Falling house prices and mortgage rates have done a lot to improve affordability, but banks are still cautious to lend. US housing will still take many years to really get back to health. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management firstname.lastname@example.org
Gianluca Moretti Fixed Income Economist UBS Global Asset Management email@example.com
With the Eurozone in an ongoing existential crisis, it is easy to forget about the sector that triggered the financial crisis: the US housing market. Housing is important not just because of construction spending (which reached about 6% of US GDP at the peak), but also because it is the single most important asset for most households. The home acts as collateral against lending and determines how affordable it is for people to move to areas where job opportunities arise. During the US housing boom, too many houses were built, the prices paid were too high and too many people bought homes they could not really afford. Lenders loaned too much money without enough checks on who they were lending to. When the party stopped, the US was left with a big overhang of housing inventory that everybody wanted to sell but nobody wanted to buy. House prices fell by about 20% from their peak, leaving many households with homes worth less than their mortgages. Unemployment was rising and confidence was down. It was clear that it would be years before the housing market could recover. Well, it has been years. In fact, it is now just over five years since US house prices began their precipitous fall in the second quarter of 2007 and three years since house prices began to stabilise. Over those three years there have been some ups and downs, with some big swings caused by temporary policy incentives. In recent months the trend has been steadier and upwards. The improvement so far is hardly the start of a new boom, but the turn upwards has to start somewhere. The headwinds remain significant; there is still a massive inventory of
homes for sale that will need to be worked off (see chart 1). Compared to the mid-1990s, the number of homes for sale (existing and new) relative to the number of households almost doubled at the peak. It has taken a long time, but that ratio is now back down to the previous levels.
Chart 1: Receding shadows New and existing homes for sale plus stock of homes in foreclosure, as percentage of number of US households (four quarter moving average) 5 4 3 2 1 0
84 86 88 90 92 94 For sale In foreclosure
Source: Bureau of the Census, National Association of Realtors, Mortgage Bankers Association, UBS Global AM
A shadow hanging over this improvement is the stock of homes in foreclosure proceedings. This shadow inventory, as it is often called, represents homes that banks and other lenders are repossessing and will one day want to sell so as to recoup some of their loan. Since everyone knows that these houses will be sold at some point, house prices are
restrained. Part of the housing market improvement has been the gradual reduction in the shadow inventory – in part this has come from foreclosed homes being processed and sold, but in part it comes from fewer homes entering foreclosure in the first place. The rate of decline of the shadow inventory is unlikely to accelerate. Housing is nothing if not local, and problems were often focused in a city or even a neighbourhood. Banks who hold a lot of repossessed properties in one area do not want to put them all up for sale at the same time – to do so would send prices plummeting and ensure that they make a loss. Instead, every time they sense some strength in the market they drip-feed a few more properties onto the market in the hopes of preventing the price from falling. House prices in these areas therefore may be unlikely to fall, but they are unlikely to rise. Banks will also be holding on to the foreclosed properties for a long time. Since unemployment is still high and households are still pessimistic, what has driven the improvement in housing data? The answer is simply the price of housing. If a market cannot clear by changing quantities (e.g. generating more demand) it will need to clear by changing prices (downward). The price of housing has fallen so much that it is now more affordable. By 2005, the ratio of house prices to median incomes had risen by more than 60% over the average from the 1990s (see chart 2). About half of that move has now been reversed. There are also other sources of improvement, not least the cost of financing. When you take out a mortgage the most important calculation is not so much the price of the house (although that affects the initial deposit) but rather the cost of servicing the mortgage. If the mortgage rate falls, you can buy a more expensive house with the same monthly outlay. If the term of the mortgage is extended, the principal that is paid each month will be less. Housing affordability according to one index is now at the best that it has been since the index began in 1986. This index compares the cost of servicing a mortgage against the median household income. Hence it takes into account mortgage rates and the term of the mortgage.
Chart 2: Affordable steps Ratio of house prices to median income and housing affordability index, rebased to average of 1991–1999 = 100
180 160 140 120 100 80 60 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Price to income ratio Housing aﬀordability index
Source: Bureau of Economic Analysis, Federal Housing Finance Agency, National Association of Realtors, UBS Global AM
Despite the big improvement in the affordability index, this probably overstates the likelihood that more houses will be sold. Required deposits have increased relative to the price of houses, and many households will not be able to find that deposit. Bank lending standards have also tightened so much that some households are not even considered for mortgages. Nonetheless, for those that remain, a combination of low interest rates and low prices have brought real benefits. US housing is taking the first tentative steps out of the shadow of the crisis, but it will likely be several years before it is in the clear.
The views expressed are as of August 2012 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fundspecific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for any errors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered “forwardlooking statements”. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Management’s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. © UBS 2012. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 22377
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