WEEKLY ECONOMIC ANALYSIS: July 2nd, 2009

Provided by TEAM Financial Services

"The preservation of the sacred fire of liberty and the destiny of the republican model of government are justly considered... deeply, ...finally, staked on the experiment entrusted to the hands of the American people."
- George Washington

Items for Discussion

The housing bubble and subsequent collapse has been at the epicenter of the global credit bubble, the financial/banking crisis and the largest recession since the 1930’s. This is a topic we haven’t touched upon in a while, but we thought it was a good time to revisit given the number of prominent people calling for a housing bottom to emerge currently. The first chart this week is an update of a chart we’ve shown from the New York Times in the past. It shows a home price index compiled by Professor Robert Shiller of Yale University. The chart does a fabulous job of showing how insane the bubble was earlier this decade, as well as the fact that we are still significantly above the median long term range – let alone going to distressed levels as they did in the 1930’s-1940’s.


Part of the optimism we are seeing is based on initial signs of stabilization in some of the home price indexes. However, stabilization does not necessarily mean that a recovery is imminent. As the next chart shows, home prices took about 6 years to recover in real terms following the bottom of the early 1990’s housing price decline in the Case Shiller 10 index.



TEAM actually views the potential for stabilization in home prices as a very negative sign. This is very counterintuitive on the surface, so we’ll explain. A tremendous amount of recent home sales has occurred at the lower and mid levels of the housing stock. Subprime was the initial wave of mortgages that drove foreclosures and that market segment were disproportionately at the lower end of home prices. This major liquidation of homes is well into the process and we wouldn’t be surprised if prices in that market segment do stabilize or even head modestly higher (assuming interest rates don’t spike which is a whole other story).

The pending mortgage storm to hit is dominated by prime borrowers and in the higher price segment of the housing market, which until this year had held up reasonably well. The schedule for mortgage rate resets in Alt-A and Option ARM mortgages explode starting this summer and into mid 2011. TEAM expects there to be a long cycle of mortgage defaults in foreclosures in this market segment, which is likely to lower prices in the segment dramatically – just as it has in the lower price segment following the subprime implosion.

If prices in the higher price segment are going to go down, then how can we expect overall price indexes to go higher? This is a paradox that is easily explained with an example. Let’s assume that the sales mix for 10 buyers of cars is 9 Toyota Corolla’s and one Corvette. The Corolla’s were priced at $20,000 two years ago, but due to incentives and price cuts, the buyers can by their Corollas for $15,000, or a 25% decline. Over the past two years, the price of the Corvette remains stable at $50,000. The overall index for the 10 cars would drop by about 20% = (9 x $5,000)/9($20,000) + $50,000. The average price for a car sold is $18,500, down from $23,000 two years prior.

Now let’s use some more hypothetical assumptions. Let’s assume the Corollas recover in price by 10% back to $16,500, but that the price of the Corvette falls 20% to $40,000. This mix results in the average price of the cars to $18,850 – a 2% increase. This is obviously an example only to show how the math works. The housing stock in the US is dominated by lower and mid priced homes. What is the big deal if the “rich” or “mass affluent” see their home values decline significantly?

First, due to the crazy underwriting standards that developed during the bubble, many middle class households bought way too much house that they could not and cannot afford. Many were driving Corvettes when they should have been in a Corolla. The combination of job losses and mortgage resets can be toxic. Refinancing mortgages has been difficult due to prices coming down and mortgages becoming “under water”, where the mortgage balance is higher than the current value of the home. The modification program put in place at the federal level has largely been a failure, with recent reports showing that over 50% of modified loans have ended up in default and foreclosure anyway.

Second, the “rich” and “mass affluent” own a disproportionate percentage of the productive assets in this country. Most have already suffered massive declines in the value of their investment portfolios. Many businesses are in distress due to tight credit conditions and weak demand. If a significantly declining home value is thrown into the mix, this is just one more development that is likely to impact the aggregate risk preferences of our nation’s owners of capital. An increase in risk aversion could drive more and more of this capital into lower risk vehicles, like municipal bonds, CD’s, etc. A decline in available risk capital could serve as a major headwind to innovation and future job creation.

While we remain skeptical that a durable home price recovery is on the near term horizon, the best case scenario we can imagine one in which the lower and mid price market segment recovers modestly, while the higher end segment endures a significant decline. A second wave of mortgage defaults and foreclosures likely to hit that market segment would be yet another strain on our financial system. We certainly hope that the outlook is far better than we expect, but as we always say, we don’t forecast or invest based on hope.

Market/Economic Climate

TEAM believes that the broad stock market averages and economically sensitive segments of the commodity markets are in the early stages of what could end up being a significant correction. We’ve chronicled over the past two months how the market internals have been getting progressively weaker. This kind of analysis does not pinpoint precise market bottoms or tops, but it does provide a valuable context as to the potential vulnerability of a market if selling intensity picks up for whatever reason. It just so happens that investors appear to be having second thoughts as to the robustness of a potential economic recovery.

Thursday’s employment report certainly contributed to this anxiety, as job losses remained significant in the month of June. We still believe that a relatively uneven economic recovery will emerge during the 2nd half of this year and into 2010. However, we believe many markets had begun to price in a robust recovery and may adjust lower if perceptions shift more towards expecting a modest or disappointing recovery. Client portfolios remain defensive and significantly hedged.

Humor for the Weekend

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.