TWO MORE POSITIVES ON HOUSING, PLUS THREE REASONS TO BE CAUTIOUS

Two weeks ago we highlighted three incremental positive datapoints for the housing market: (1) California's $10k homebuyer tax credit, (2) Bank of America's plan to roll out principal forgiveness on a limited basis, and (3) the White House's renewed plan to combat foreclosures under new HAMP initiatives. Today, we are highlighting a few additional positive datapoints, combined with a word of caution in looking ahead.

First, yesterday's February pending home sales report was decidedly positive. Remember, pending home sales are a better leading indicator than existing home sales. While both measures are released with roughly a one month lag, existing home sales reflect contract closings, which reflect activity from 1-2 months prior. In other words, February existing home sales reflect buying activity from December/January. In contrast, February pending home sales, which was released yesterday, reflect contracts being signed, which will close in one to two months. In this respect, pending home sales lead existing home sales by approximately 1.5 months, which is why this is where the focus should be. The February pending home sales index rose to 97.6 from 90.2 in January, a month-over-month increase of 8.2% and an increase of 17.3% from the prior year. The following chart demonstrates.

TWO MORE POSITIVES ON HOUSING, PLUS THREE REASONS TO BE CAUTIOUS - pending

Some context is necessary here. When the original homebuyer tax credit was set to expire on November 30, 2009 it pulled forward significant pending home sales volume into September and October. As the following chart shows, September volume rose 18.6% yoy while October was up 29.8% yoy. November then dropped to a yoy rate of 16.7% (down 13.7% mom) and went on to drop further in the months of December and January. Remember, all this data is seasonally adjusted, so winter vs summer should be irrelevant. From a timing standpoint, we think February corresponds with September (i.e. both 2 months prior to the tax credit expiration, and March will correspond with October (one month prior). We expect to see a significant uptick in March sales once the data comes out a month from now. Between now and then we wouldn't be surprised, and in fact would expect,  to see the broad-based housing-related credit tailwinds persist.

TWO MORE POSITIVES ON HOUSING, PLUS THREE REASONS TO BE CAUTIOUS - pending yoy

Second, HUD announced that it is changing its definition of foreclosure to now include loans that are 60 days delinquent. This will enable HUD to more aggressively deploy funds under its Neighborhood Stabilization Program, which require that homebuyers seeking grants use that grant money only for "foreclosed" homes. The program has disbursed some ~$6 billion to date, and it is expected that this number could increase materially with the new definitional change that will allow buyers to step in earlier than they otherwise would be able to. The White House has been using the housing-related government agencies (HUD, FHA, Ginnie Mae) and quasi-government agencies (Fannie Mae, Freddie Mac) to shoulder much of the heavy lifting in repairing the housing market, separately, and in addition to, Congressionally legislated initiatives such as HAMP and HAFA. We think the move by HUD represents yet another step in this direction.

While these datapoints are undeniably positive for the housing market, we remain skeptical of investors' exuberance around the recovery in the housing market for three reasons.

First, after the March pull-forward of activity ahead of the tax credit expiration on April 30, 2010 has passed, we expect to see a significant fall-off in buying activity just as we saw in the late Fall following the November 30 expiration.

Second, mortgage rates are rising. 30-year conventional rates are up 25 bps in the last few weeks. This is principally due to the 40 bps backup in 10-year treasury rate, and we expect the 10-year to continue to rise over the next year, and mortgage rates to rise with it. We expect additional pressure on mortgage rates to come from the Fed's exit from the Agency MBS purchase program last week. While it's unclear whether this will pressure mortgage rates directly through reduced Agency MBS purchasing, or indirectly through reduced Treasury purchasing (which drives Treasury rates higher in turn pushing mortgage rates higher), we think its clear that the end of the Fed's program will adversely effect mortgage rates. Further, once Fannie and Freddie complete their $200 billion repurchase program in a few months, we think that could add further pressure to the market, pushing rates higher. We've published in the past the significant sensitivities of buyer's purchasing power to even small changes in mortgage rates. We think this will be an overhang as we move further into 2010.

The third risk we're highlighting this morning is the official rollout of the HAFA program yesterday. The HAFA program is the Home Affordable Foreclosure Alternative program. For those borrowers who don't qualify for a HAMP loan modification, they may qualify for assistance under the HAFA program, which provides incentives to servicers to allow short sales and deeds-in-lieu (DIL) of foreclosure. While this may ultimately be preferential to the alternative of foreclosure for both the lender (or asset-backed investor), the reality is that foreclosure volume has been held back from hitting the market for some time now through a combination of HAMP, lender modification programs, state moratoriums around foreclosure and various other incentives lenders have to kick the foreclosure can down the road. HAFA may provide a significant boost to an already bloated unsold inventory of housing stock. Remember, HAFA has been in place for several months, but hadn't yet gone effective until yesterday meaning that servicers have already built up pipelines of eligible HAFA borrowers - many of whom are in the system already, paperwork complete, because they applied, but didn't qualify for HAMP. This inventory should hit the market in the next few months as HAFA ramps up, right at the time when we envision both natural demand diminishing because of the pull-forward and mortgage rates rising.

The key to this call is understanding the duration differences. To reiterate, we expect that in the near-to-intermediate term (1-3 months) the data will get better before it then gets worse over the intermediate-to-long term. Along these lines, we would expect the trends and the rally to continue as long as housing is improving. However, once we move beyond the near-to-intermediate term, we see the headwinds starting to pile up.

We have been working for the last several weeks on a robust housing industry model to try and make more quantifiable sense of these moving pieces, and until the model is complete we consider our conclusions preliminary. That said, we do see a number of potential cross currents, if not outright headwinds, converging around housing in the not too distant future. The question is whether they will be more or less powerful than the onslaught of new government and private sector initiatives to combat the housing crisis.

Joshua Steiner, CFA