The bear market in U.S. residential real estate began in July 2006. Over the last twelve months, new and existing home sales have plunged in the double-digits – the worst decline for housing since the late 1980s. Although the decline for this sector has indeed been steep and in some cases, spectacular, history suggests that this unwinding process has further to run as more lenders are squeezed in 2007.
First -- the good news.
Although financial risk has increased for lenders since last year and has exposed the consumer to declining household wealth, the current strains in the sub-prime mortgage market probably won’t tip the United States into recession in 2007. The banking system is heavily exposed to real estate but unlike previous real estate “bubbles” and subsequent bear markets, balance sheets are strong and asset quality is generally high. The most leveraged mortgage lenders have already been heavily punished by the stock market since February, paving the way for private equity and venture capital firms to scoop-up any residual distressed assets. Plus, the Federal Reserve will remain on the sidelines and in fact, probably cut lending rates over the next several months to breathe life into the real estate market.
On the other side of the coin, the housing market has now lost the sub-prime borrower, estimated at 15-20% of the entire mortgage-lending market. It will become much more difficult for high-risk borrowers to secure mortgages as lenders continue to tighten their standards. This assumes that the bear market will therefore take longer to adjust, thereby prolonging the slowdown not only in housing but also the broader U.S. economy. At just 1.3%, first quarter gross domestic product (GDP) is the slowest expansion since 2003 when the economy was just emerging from recession.
According to the Federal Deposit Insurance Corporation (FDIC), U.S. banks with the greatest residential real estate exposure at the end of 2006 include Wachovia at 33.4% of total real estate assets followed by Wells Fargo at 31.5%, and Bank of America at 23%. Again, the good news for the economy and the banking sector overall is that loan delinquency rates are still low by historical standards while the number of bank failures in this economic cycle remains very low or benign. For example, at the height of the last real estate crisis in October 1990, Citibank was having difficulty rolling over its commercial paper, a sign of major liquidity problems. The delinquency rate on commercial real estate loans exceeded 12% in 1991 while loan delinquency rates soared. Of course, the Savings & Loans crisis of 1990-1991 resulted in massive losses for residential mortgage-backed loans; the Resolution Trust Corporation (RTC) was thereafter created to clean-up the mess and stabilize the weakest segment of the banking system. Today’s sub-prime mortgage woes, though serious, do not compare to the devastation that afflicted the banking system 17 year ago.
The rest of the real estate industry in the United States is largely strong and performing well in 2007, which explains why most REITs, or real estate investment trusts, have not crashed. Some parts of the market are soft, including California, Arizona and Southern Florida, regions that appreciated by staggering amounts over the last seven years. But even in the most speculative markets, delinquency rates are still low.
Commercial mortgage-backed defaults sport even lower delinquency rates than residential property loans. Although banks have certainly boosted their exposure to all segments of the real estate industry since 2000, overall loan quality remains good and booming earnings until recently have created a cash reserve for most lenders.
The U.S. sub-prime loan crisis has further to unravel before bottoming. But again, most banks have sufficient capital reserves from years of strong earnings to cover their losses.
The major risks to the U.S. and global financial system in 2007 lie with Federal Reserve monetary policy, employment growth trends, consumer and corporate spending and systemic risk posed by hedge funds and other institutions laced with carry-trade loans and other synthetic derivatives. The housing bear market is not a major risk to the U.S. economic cycle; the markets have largely discounted this event by hitting new all-time highs almost daily since mid-April. However, investors should expect a major stock market correction this spring or summer as consumer spending, tied to a great extent to housing values, eventually start to spend less amid declining household wealth and possibly, rising unemployment.
