EFFECTS OF THE HOUSING MARKET ON THE STOCK MARKET
Buying a house is the most important investment we make in our lifetime. What we often forget is that one housing transaction leads to a whole series of transactions, which generate income and jobs for the economy and boost Stock Market earnings. Furthermore, the Wealth Effect of owning a home affects consumer spending behavior, which is critical as consumption represents over half of US National Income.
WHO DOES HOUSING BENEFIT DIRECTLY?
If you look at the S&P500, you will see that the weight of all Home Builders together makes up a very small proportion of the index. However, both Home Builders and Home Buyers need to buy good and services from other parties.
Home Builders need building materials, e.g. Timber, Steel, Cement, Bricks, Tiles, Insulation, Cabling and Glass. They buy or lease their equipment,e.g. diggers, trucks, cranes, loaders, saws and drills. They need the services of planners, architects, garden designers, accountants, lobbyists, brokers and bankers, as well as their own office and on-site staff.
The house buyer will get a loan from his banker and will need house- and life- insurance. He will probably use the services of a mortgage broker or real estate agent and engage an architect. When the family move in they will need house alarms, furniture, carpets, wallpaper and they will maybe have a new kitchen or bathroom put in. They will purchase new fridges and freezers, cable TV, phones, computer and internet services and visit the garden centre.
If a new housing estate is being built then we are talking about new infrastructure, i.e. roads, water, sewage systems and connections to the power-grid and to the phone lines. Shopping malls, supermarkets, hairdressers and various amenities will open. Then new councils will be established to raise taxes and administer the community.
THE NEW FINANCIAL INDUSTRY - PROFITING FROM THE HOUSING MARKET
A year ago Pimco's Bill Gross warned us that Financial Institutions held $300 billion of worthless sub-prime securities, which they are now admitting and against which they making provisions in their balance sheets. But what has this to do with the housing market and the stock market? Well everything!
There is a whole financial industry out there based on the housing market. After making loans to customers to finance their homes, many banks securitize or sell their mortgage book to other institutions. These mortgage securities are basically bonds, which are backed by home mortgages and which use the interest received from the mortgage holders to pay the interest on the bond. The concept is old enough and can be traced back to the Pfandbriefe issued in Germany in the 18th Century.
Then in recent years the financial industry expanded this basic concept and terms like ABS (Asset Backed Securities) and CDOs (Collateralized Debt Obligations) became the buzz words. The industry leveraged the traditional mortgage based products, created derivatives and started packaging loans to sub-prime customers, which were given a higher rating by the Rating Agencies, because it was claimed that the risk was diversified away. The demand for these products and a booming housing market fueled a fire, whereby the banks started lending to people with no previous credit rating, packed them into these products and sold them on and these products were in turn packaged into other products and sold on.
This bubble reached a peak in 2006 and it is this "2006 Sub-Prime Vintage" Lending exposure which is causing worldwide panic, with banks as far apart as Northern Rock in England and the Saxony Landesbank in Germany, effectively going bust because of their investment in US Housing securities. In March 2008 the Investment Banking name of Bear Stearns disappeared as the FED had to find a buyer in the shape of JP Morgan to take over this bankrupt institution. The FED had no choice, but to step in as Bear Stearns was a major player in the credit default swaps market ("CDS"), another brainchild of the Finance Industry.
These CDS instruments are meant to insure banks against their loan exposure against defaults. However, today they are held by hedge funds, fund managers and insurance companies, all helping form a new bubble. The notional amount of the CDS contracts outstanding is about $45 trillion, which is 5 times US household wealth. The market is totally unregulated and nobody knows who the ultimate lender is in this chain of CDS holders. George Soros says that when defaults occur, the prospect of a financial institution not being able to fulfill his obligation "hangs over the financial markets like a sword of Damocles."
After very low default ratios for years, we see that these numbers are beginning to rise. The spreads on the CDS market have narrowed in recent months, coming from a point where we seemed to be on the brink of a real catastrophe. That the credit cycle had to turn was inevitable and it was overdue. The unfortunate thing is that the credit defaults are rising at a time when the banks are having other problems with collapsing sub-prime and housing markets, as well as rising prices and a weakening economy.
HOUSING WEALTH AND CONSUMPTION
As house prices were rising in the USA we saw that Americans were consuming more than they were earning. This is what economists call the Negative Savings Ratio and arose from the Feel Good Factor which bolstered the economy. Many Home Owners topped up their mortgage loans from the banks, effectively taking equity out of the increased property value and buying goods, particularly imported goods which led to record US trade deficits. Some of this money may even have found its way into the stock market. In Europe (particularly the UK, Spain, Ireland and Finland), many people took out mortgages to buy second homes for own-use or buy-to-let.
So the Housing Wealth Effect clearly led to an explosion of US Consumer Spending, which extended even beyond the US. The problem now is that the Housing Market is in decline and Consumer Spending is following suit. This will have an enormous impact on the US Economy as Consumer Spending represents over 50% of National Income, or GDP. Furthermore, the whole world will also experience this downturn, as the Americans were major importers of world goods and services, during the boom period.
THE LENDERS: A VICIOUS SPIRAL
Stock markets remain under pressure, particularly in the banking sector. Here the banks have to have massive rights issues to patch up their damaged Core Tier One ratios after writing off their sub-prime exposure. Unfortunately LIBOR rates, or the rate at which banks lend to each other overnight, remains stubbornly high and it is clear that banks are currently unwilling to lend to each other. This is also reflected in the securitization markets, a very important source of income for banks in recent years, which have simply dried up as banks are unwilling to take on new mortgage exposure. The consequences of this unwillingness to lend to anybody, particularly house buyers, will be a catastrophe.
If banks do not lend to customers, then we have a failure of the transmission mechanism, leading to a decline in the velocity of money in the economy. Ultimately this ends up in a situation similar to the depression which Japan went through after its collapsed property bubble.
Recent anecdotal evidence does seem to indicate that bank managers are under instruction to say no to loan applicants, no matter what track record they have. Furthermore, Bankers are all too eager to repossess homes on defaulting homeowners as is evidenced by multi-year high foreclosure numbers coming from the US and the UK.
Stability will need to be seen in the housing markets. Some 40% of US subprime loans will default over the next two years. There will be such an overhang of property on the market that many people will enter the negative equity trap and will consider giving their keys back to the bank. Assuming 6m subprime loans defaulting over the next two years, this would mean foreclosures will be double the amount of home sales, being 600,000 units per year. These numbers indicate a 1930s type scenario and on that basis the investor would be best advised not to invest in any mortgage related financial stocks.
CONCLUSION
Housing generates business and jobs for the whole economy, which in turn boosts corporate earnings and the stock market. A new finance industry has sprung up, with a whole range of products to sell, based on securitized mortgages and loan default insurance. Unfortunately this financial industry was highly leveraged and we find ourselves now in a negative spiral, with house prices falling, foreclosures rising, mortgage lending drying up and the consumer no longer buying, which has hit the economy and is why the stock market is falling.