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Investors have much to learn from the U.S. housing mess

by Wayne Cheveldayoff, 2006-06-29

After reviewing the numbers behind the deteriorating U.S. housing market, a top investment analyst in California recently sold the family home and moved with his wife into a rental apartment.

His knowledge and experience led him to the conclusion that things will get a lot worse in the housing market as it works off a speculative bubble and this will have negative implications for credit markets overall and the U.S. economy.

The analyst, Mark Kiesel, who works for one of the largest U.S. fund managers, the Pacific Investment Management Company (PIMCO) in Newport Beach, California, recorded his thoughts on the housing market in a special June 2006 report called “For Sale” (see www.pimco.com).

Here is his reasoning: “Recent house price gains have likely come primarily from rising speculation and ‘creative financing’ because affordability is declining and inventories are rising. When asset prices diverge from fundamentals, I favour taking the other side of the trade – even if it involves moving. Amy wasn’t thrilled about moving, but my sense is she will look back on our sale and view it as a good one. In the end, the fundamentals should win out.”

One of the fundamentals he talks about relates to how housing price increases roughly match income gains over the long run. “With current 13-per-cent annual housing price gains exceeding the 4-per-cent growth in personal disposable income by a record margin, today’s environment appears unsustainable,” he says.

“The current 9-per-cent gap is unprecedented in looking back over the past 30 years. This trend should reverse course. While Fed tightening has so far done little to change lending standards, delinquency rates are picking up and foreclosure rates are rising. In addition, banking regulators are beginning to crack down on risky loans and lending practices. These are clear signals that lending standards are set to tighten….Speculators are shifting from buyers to sellers. Mortgage application growth is slowing. Finally, and most importantly, the supply and demand imbalance in the housing market is turning sharply for the worse as inventories soar.”

He also concludes that ‘creative financing’ caused many to buy homes when they shouldn’t have done so. For example, interest-only and negative-amortization mortgages (where borrowers are allowed to increase the mortgage balance by missing monthly payments) represented 1 per cent of total mortgage originations five years ago but had climbed to 22 per cent in 2005. The existence of ‘creative financing’ allowed the housing market to continue to climb even as the Fed raised interest rates during the past two years.

However, the higher mortgage rates are starting to have an impact, as popular one-year adjustable rate mortgages are being reset.

The analyst notes that the mortgage rate on a one-year interest-only, adjustable rate mortgage two years ago was 3.36 per cent, which on a $200,000 mortgage would have meant a mortgage payment of $560 per month. Now, the rate on the same type of mortgage is 5.62 per cent, which on the same $200,000 mortgage requires a mortgage payment of $937 per month, or 67 per cent higher. People who locked in for 30 years are not as bad off, but the overall effect of rising interest rates is that people can afford less house now than they could before.

Here are some lessons from all this for Canadian investors. First, just because interest rates are low for a long time, don’t expect them to always be low.

Second, don’t think of your house as an investment, as what goes up can also come down. Keep in mind that anyone who bought in Central Canada during the peak of speculative fever in 1987 experienced a severe decline in house price in the order to 30 per cent before the market bottomed in 1994.

Third, don’t put all of your money into housing. Some of your savings need to be in liquid assets for emergencies (such as to pay your mortgage if you lose your job) and invested for your retirement.

Fourth, don’t expect the good times to continue forever in Canada. The Canadian economy is in great shape overall right now but if the burst of the U.S. housing bubble leads to a U.S. recession, the energy and metals sectors could cool and manufacturing, which greatly depends on selling to the U.S., could deteriorate further – with implications for the Canadian housing market.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2006 Wayne Cheveldayoff