Housing slump may last for years

by Levi Folk | September 11, 2007

As the U.S. housing situation continues to deteriorate, the effects are being felt much further afield, and have unleashed an unwinding in leverage and a contraction in credit that has repercussions for the broader markets. It is fair to say that the risk of a full-blown recession in the United States has risen in recent weeks, given the dislocations in credit markets—and that lowers the outlook for stock markets.

Judging by the resilience of the broader indexes, stock investors are shrugging off the notion that mortgage defaults in the United States have implications for the broader economy, and this would seem overly optimistic.

The U.S. housing recession is still deepening, and house prices are likely to fall further in order to alleviate the number of unsold homes on the market—the supply of which rose to a 16-year high in July. The most recent statistic on pending home sales is dire, plummeting to a six-year low in July. Tighter lending standards in the wake of the recent credit mark squeeze are clearly exacerbating the problem.

It is highly conceivable that the housing market could stay depressed for years, much as it did in the early 1990s. The S&P Case-Shiller home price index spent roughly eight years in the doldrums after it collapsed in 1989. It wasn't until 1997 that the excesses were worked out from the system and housing prices rose with any force.

In the wake of the credit crunch that we witnessed in August, banks are still hoarding cash to cover potential liabilities in opaque markets for Special Interest Vehicles (SIVs). It has recently come to light that banks have lending commitments to these SIVs, off-balance sheet entities, which have some liabilities tied to the mortgage-backed securities market. As a result of these concerns interbank lending has collapsed and money-market interest rates have risen.

Spreads on high-yield bonds have widened by almost 1% since bottoming in June at a 240-basis-point spread over U.S. treasuries. The higher spreads increase the cost of borrowing for sub-investment grade companies and should coincide with lower equity valuations and fewer private equity transactions.

The global mergers and acquisitions (M&A) boom that started in 2003 is "winding down" according to the Wall Street Journal, and the level of deals completed in 2006 may not be reached again for years. Credit easy money and high investment banking fees for unleashing the buyout frenzy. Many of the private-equity deals were highly ambitious in terms of leverage assumed and will not get funded in the recently sobered lending environment.

Investment banks have been downgraded by Wall Street analysts only very recently as they are coming to terms with the fact that the highly lucrative investment banking and loan securitization businesses will see weaker earnings in the first case and outright collapse in the second case.

There is also the question of who will buy the US$300-billion in loan commitments to finance pending private-equity transactions that the banks are on the hook for—and which they will surely take a hit on. Finally, off-balance sheet loan obligations to SIVs are another potential liability for banks to be digested by investors.

Higher oil prices, currently at US$76 per barrel, are a drag on consumer spending and prospects for even higher prices remain. Energy prices are spiking higher as OPEC refuses to increase output into a very tight oil market. OPEC will likely be forced to ease quotas in the fourth quarter of 2007 to meet a 2.5 million barrel per day (mbd) supply deficit according to the International Energy Agency (IEA). More importantly, the IEA estimates effective OPEC spare capacity at only 2.89 mbd, so oil prices could potentially make near-term records.

Consumer spending has remained resilient throughout the year yet it remains the wildcard that could make or break the U.S. economy and stock prices over the next year. Weakness in housing prices, high oil prices and the potential for slower job growth could ultimately sink the consumer.

As credit troubles were brewing in mid-July, I recommended a short position in U.S. housing through put options in the PHLX housing sector index. The index is off almost 25% since then.

Option puts still represent a good hedge for investors who own energy stocks, where fortunes are undoubtedly tied to the global economy. Given recent developments in housing and credit markets, downside surprises are possible and investors would be wise to take some money off the table.