Stormy Times For Homebuilders

Homebuilding cycles are lengthy and today’s is firmly headed downward. Here’s why…

Homebuilding cycles are created by multiple economic and financial factors. Importantly, when the factors’ positive trends link up, they produce a powerful, key driver: Homebuyer desire. Once ignited, new home sales rise. As the desire spreads, demand grows, and new home prices rise. Those developments serve to “prove” new home buying is the way to go. So, up goes the desire further – and so on.

Rising mortgage rates? No problem. The potential gains far outweigh the monthly payment increases. Plus, mortgage interest is tax deductible. Plus, banks, brokers and homebuilders roll out other mortgage options that start with lower payments. Plus, homebuyers know they can always refinance and pull out some gains.

Those rising prices also raise lender enthusiasm. Credit rating requirements ease as do down payments – after all, the collateral is sound, desirable and appreciating in value. Wall Street helps by collecting all those new mortgages into new, attractive-yielding, securitized bonds and selling them to enthusiastic investors.

However, no homebuilding uptrend lasts forever. When a boom finally goes blah, all those linked factors and enthusiasts begin to wilt. Realistic thinking returns, and all the action retrenches, with new home sales falling even as the homebuilders continue building. The increased for-sale inventory then produces cutbacks and special “sale” pricing. At that point, a new homebuilding down leg becomes evident.

History shows the homebuilding cycles in action

The cycles are clear by looking at two homebuilder trends in the graph below: The number of new, single-family homes sold, and the number of homes for sale (think inventory). Note especially what happens at the end of an uptrend – sales slow and turn down, while homebuilding continues, pushing up the number of unsold homes. Finally, the homebuilders throw in the towel, drop prices and cut production. Then, the downtrend continues until the next point at which the factors positively align again.

Today’s homebuilding market has unusual factors that could worsen the downtrend

Naturally, the Fed’s first steps of interest rate raising affected mortgage rates significantly. This year, as the Fed raised the Federal Funds rate (upper limit) from 0.25% to 4%, the 30-year mortgage rate more than doubled from about 3.1% to 6.6%. The sharply higher rate hit the enthusiasm of not only potential homebuyers, but also mortgage lenders and investors.

As an example, the Vanguard Mortgage-Backed Securities Index Fund is down over 12% this year (distribution income included)

But that wasn’t all. The Federal Reserve and U.S. commercial banks have stopped buying mortgage-backed bonds. As the graph below shows, they used to have an understandable relationship. When the Fed was buying (and pushing prices up, yields down), the commercial banks were absent. Then, when the Fed stepped away or did some selling, the banks bought. But then Covid struck…

Clearly, the Fed and commercial banks had a huge, joint effect from 2020 through first quarter 2022. Then they simultaneously stepped away. That sudden void in buying, atop the Federal Reserve’s rising rates, drove mortgage rates up higher and faster than Wall Street expected. The situation is explained well in The Wall Street Journal Article (Nov. 16), “Banks Curtail Purchases of Mortgage Bonds“… (Underlining is mine)

“Bank of AmericaBAC
Corp. gobbled up hundreds of billions of dollars of mortgage bonds during the height of the pandemic. But with rates rising, its buying spree has ended.

“Banks have stepped back from buying mortgage bonds. So has the Federal Reserve, the largest investor in that market. Foreign buyers and money managers are curtailing purchases too, analysts say.

“The lack of buyers has helped push mortgage rates to their highest level in 20 years. The average 30-year fixed mortgage rate topped 7% recently, further cooling a housing market that was red hot just a few months ago.”

The bottom line – Don’t fight a homebuilding downtrend

From The Wall Street Journal (Nov. 17), the appearance of good news: “Home-Builder Stocks Stage A Big Comeback.” (Underlining is mine)

“Shares of home builders, building-products and appliance companies are rebounding, outperforming the broader stock market, after mortgage rates eased off their recent highs.

“The SPDR S&P Homebuilders exchange-traded fund rose 9.3% in the past week, recently posting its strongest run since April 2020.”

“Behind the jumps are signs that some of the pressures on the housing market are beginning to ease.“

Some pressures easing is inadequate rationale for reversing a homebuilding downtrend. In fact, the article’s “some” turns out to be only the mortgage rate mini-drop from the fleeting peak of 7% to today’s 6.6%. Furthermore, the rest of the article is devoted to everything that is going wrong with homebuilding, including negative comments from homebuilders.

Then, there are the unmentioned Fed plans – to keep interest rates headed up. Moreover, the next bout of increases will put the economy and financial system in a period of “active” tightening by the Fed. See my previous (Nov. 19) article for a full explanation:

MORE FROM FORBESInvestors: Federal Reserve’s Inflation Fight Moves From ‘Passive’ To ‘Active’ Tightening – Powell’s Promised PainBy John S. Tobey