We’ve noticed a lot of investors getting positive on housing recently. In fact, housing is cited as the driver for the UBS economic team’s rosy 2012 forecast. While we don’t dispute that recent economic data has been better than feared, we take significant exception to the idea that housing is poised for smooth sailing. Here we present two risk factors looming large in our outlook but virtually unnoticed among investors: the 2012 election and the prospect for significant disruption to the current housing finance system.
The amount of political risk in the housing market is currently large and underappreciated. The FHA’s share of mortgage purchase volume is just under 40%, while Fannie and Freddie combined have an almost 60% market share, leaving a sliver (less than 5%) for the private lenders.
Government support for the housing market is currently at or extremely near its high-water mark, and there’s very limited potential for upside from here. If government support gets curbed, private lenders won’t step up unless rates rise significantly and credit risk decreases (i.e. higher down payments and tighter standards). These factors will decrease demand and make home prices fall. Falling prices will in turn increase lenders’ caution towards the asset class, creating a downward spiral.
2012 Presidential Election
The two current front-runners in the Republican primary, Newt Gingrich and Mitt Romney, hold very similar views about the housing market. Both believe that the market should be allowed to clear — a euphemism for accelerating the realization of the downside. That means, at minimum, that no new initiatives will be forthcoming, and pressure will be applied to existing initiatives. Don’t come crying to Mitt Romney when your home price falls.
Here’s what the candidates have had to say:
“As to what to do for the housing industry specifically, and are there things you can do to encourage housing? One is, don’t try and stop the foreclosure process. Let it run its course and hit the bottom. Allow investors to buy homes, put renters in them, fix the homes up, and let it turn around and come back up. The Obama administration has slow walked the foreclosure processes that have long existed, and as a result we still have a foreclosure overhang. Number two, the credit (that) was given to first time homebuyers was insufficient and inadequate to turn around the housing market. I think it was an ineffective idea. It was a little bit like the cash-for-clunkers program, throwing government money at something which was not market oriented, did not staunch the decline in home values anymore than it encouraged the auto industry to take off. I think the idea of helping people refinance homes to stay in them is one that’s worth further consideration. But I’m not signing on until I find out who’s going to pay and who’s going to get bailed out, and that’s not something which we know all the answers to.”- Mitt Romney speaking to the Las Vegas Review-Journal’s editorial board.
“Remove obstacles to job creation imposed by destructive and ineffective regulations, programs and bureaucracies. Steps include: Repealing the Sarbanes-Oxley Act, which did nothing to prevent the financial crisis and is holding companies back from making new investments in the U.S; Repealing the Community Reinvestment Act, the abuse of which helped cause the financial crisis; Repealing the Dodd-Frank Law which is killing small independent banks, crippling loans to small businesses and crippling home sales; Breaking up Fannie Mae and Freddie Mac, moving their smaller successors off government guarantees and into the free market; Replacing the Environmental Protection Agency with an Environmental Solutions Agency that works collaboratively with local government and industry to achieve better results; and Modernizing the Food and Drug Administration to get lifesaving medicines and technologies to patients faster.” – Newt Gringrich campaign website.
Right now, Intrade has Obama winning re-election at 50.3% – clearly too close to call. As far as the Republican nomination goes, Intrade currently has Romney at 46% and Gingrich at 33%. The following charts demonstrate.
President Obama and the current legislators haven’t expressed much interest in further housing initiatives, either. HARP 2.0, the slightly-expanded refinance program, fell well short of what its advocates had been hoping for, and the long-rumored GSE bulk REO program hasn’t gone anywhere in months.
Finally, the recent failure of the combined lobbying might of the NAR, NAHB, and MBA to get higher GSE loan limits extended underscores the total lack of government appetite for housing programs.
So the possible outcomes for the 2012 election are either no change (Obama re-election) or a decrease in support (Republicans win the presidency).
Two catalysts for government support to fall
There are at least two important catalysts in 2012 that will force the government to reconsider current support levels – the GSEs’ Treasury Support Agreement and an FHA bailout.
The first, as we’ve noted in the past, is the expiration of the GSEs’ Treasury Support Agreement at year-end 2012. While the agreement to continue funding the GSEs will probably get renewed, there’s a small risk that it won’t – and either way, the approaching deadline could drive plenty of noise and spook the markets. (The debt-ceiling debate might be a good analogy here.)
The second catalyst is the FHA, which looks increasingly like it will need a bailout. In its annual report to Congress, released a few weeks ago, the FHA reported estimated economic net worth of $2.6 billion backing $1.078 trillion insurance in force, for a capital ratio of just 0.24% (or 417x leverage). One year ago, the capital ratio was 0.50%, and in 2007 it was 6.4%. The FHA’s annual report claims it’s adequately capitalized, but this conclusion relies on home prices not falling at all from here. Specifically, its says:
“With economic net worth being very close to zero under the base-case forecast, the chance that future net losses on the current, outstanding portfolio could exceed current capital resources is close to 50 percent. Negative house price growth in FY 2012, rather than stable or growing prices, would cause such a situation to develop.”
Needless to say, our view on home prices is different from the FHA’s median assumption of growth in 2012.
The government will have to pony up to recapitalize the FHA. FHA mortgages are fed into Ginnie Mae MBS, and Ginnie Mae MBS are explicitly backed by the full faith and credit of the United States government. So if the FHA runs out of funds, the government will have little choice but to step up. To do otherwise would be a default – not out of the question these days, but not very likely either.
How to play it
The clear way to play FHA turmoil is with the private mortgage insurers. These companies compete with (and are constantly undercut by) the FHA. An FHA pullback could be read as a big positive for Radian Group (RDN), Genworth Financial (GNW), Old Republic International (ORI), and MGIC (MTG) (and PMI Group, should it emerge from bankruptcy). However, we think enthusiasm would be short-lived. A dramatic decline in the 40% of the market that the FHA is now supporting would be a big negative for demand, and home price declines would follow. Since the MIs are so exposed to home prices, this would be a net negative for the industry. Accordingly, we would use any strength on FHA rumors as an opportunity to put these battered stocks back out on the short side.