Friday, June 17, 2005

Trillion Dollar Kablooie

Volume of ARMs Adjusting by Year:

2005: $80 billion
2006: $300 billion
2007: $1 trillion

The 2007 figure according to the NY Times represents 12% of outstanding mortgages.

12% of mortgages adjusting in one year is going to be painful. Even if long term rates remain low, ARMs are predominantly written off short term rates, which have risen dramatically in the past 2 years.

Wednesday, June 15, 2005

Durable Good to Asset Class

I believe that the concept of home ownership has fundamentally changed in the United States in the past 3 years. Homes have been transformed from a durable good into an asset class. Historically, a home has been a long lasting durable good. It functioned as a place of shelter, security, and comfort. Homes were purchased for the tangible benefits they provided the owner. Today homes are an asset class. People buy homes because they believe they will receive a return from owning one. Even when someone buy a home for the tangible benefits it provides they still fundamentally believe they can and will make money from owning it. This shift helps to explain why 40% of the homes purchased in 2004 were for second-home or investment purposes. It also explains why transaction volume has doubled in the last few years. You live in a home, but you trade an asset.

Homes are a perverted asset class. Unlike stocks, bonds, or even commercial real estate an occupied home produces no income. And in the hottest markets the income from renting a home does not cover the mortgage payment. Homes are not easily traded and have high transactions costs for doing so. But if enough people see their homes as investments, than homes become an asset class.

If homes are an asset they can lose money, a lot of money and many people can get hurt. If homes are an asset people are going to sell them just like they sell stocks or bonds when they depreciate. This is in sharp contrast to the past when people thought of their homes principally as a place to live and thus a downturn gave them no reason to exit, because a fall in financial value changed nothing about the tangible benefits a home provides (shelter, security, etc.). However, a fall in value changes a lot about the benefits an asset provides (returns). It will be very easy for the investors who bought 40% of homes last year to walk if home values fall, because they don't live in their assets.


I saw Bruce Karatz, CEO of KB Homes, speak today at a real estate conference. He explicitly said that there was no bubble and that housing prices have appreciated because of fundamental demographic changes. He completely avoided talking about the impact of interest rates and went as far as saying that sales volume may remain at record levels for the next 20 years. While I think his opinions are preposterous, I understand that as the CEO of a publicly traded home builder there is no way he can say there is a bubble.

He made no mention of any fundamental economic drivers of home price appreciation other than job growth, which he claimed was less than stellar. Bruce also claimed that homes will not drop in value because there has been little over building compared to previous cycles. While most public homebuilders learned their lesson about spec building in the last cycle and have vastly reduced their WIP. The potential for oversupply still exists, if according to the NAR 40% of the new homes in 2004 were sold for investment or second home purchases, these can come back on the market quickly. People do not move out of the homes they occupy if they go down on value, but if their investment properties go down, why would they not get out?