The Credit Crunch on Housing

As a boy in Florida, I lived not far from a house with a yard that included a huge truck-mounted cannon and a big net, the tools of a Ringling Brothers performer who was shot from the cannon during each circus show.

It strikes me that his act is now being duplicated by hundreds of thousands of homeowners as they are catapulted from the mortgage-lending process, most without the benefit of that big net. As most Fools know by now, a perfect storm of inappropriate subprime mortgage loans granted to the least creditworthy among us, combined with declining housing prices, is causing home foreclosures to rise like breakfast biscuits across the nation.

Indeed, with those foreclosures expected to exceed 750,000 this year -- and, potentially, to climb to nearly 1 million in 2008 -- the effects on both housing's recovery and the general economy could linger well into the future. After all, every one of those foreclosures represents another unit added to our already high inventory of houses on the market. Add in the effects of substantially tightened lending standards on the future ability of numerous Americans to get any sort of mortgage financing, and it seems to this cowboy that housing's recovery will almost certainly be slow and arduous.

Blasting the builders
The most immediate effects for you Fools with investing on your minds -- in addition to the crushing of the share prices of such lenders as Countrywide (NYSE: CFC  ) and Washington Mutual (NYSE: WM  ) -- would be the necessity of a double dose of caution when you're thinking about putting your money into homebuilders such as Beazer (NYSE: BZH  ) , D.R. Horton (NYSE: DHI  ) , Lennar (NYSE: LEN  ) , or Ryland (NYSE: RYL  ) . It strikes me that it's easy now to be too smart by trying to find the builders' precise bottoms and not recognizing the myriad of factors that are likely to keep the brakes on a housing recovery well into the future.

But to some extent, these are all extractions. The Wall Street Journal, however, did a fine job last week of describing the plight of one California family facing the specter of possible foreclosure on a home they purchased less than two years ago. On the $90,000 combined annual income of the two parents -- there also are two teenage daughters, one of whom is in college -- the family purchased a $567,000 home in Orange County's city of Fullerton.

Because they had little money for a down payment, and "so-so credit," the family gravitated to a 2/28 loan, which meant that they'd receive an attractive interest rate for the first two years, and then their subprime loan would "reset" to a predetermined level above the interest-rate margin for the remaining 28 years. Now, the family, which pays $38,400 per year for their home before interest and taxes, faces a December reset that they informed the Journal could push their payments to $50,000 a year.

This exorbitant slice of their income isn't their only problem, however. They'd love to refinance to a more manageable rate, but their house likely has declined in value since they bought it, and since their original down payment was accounted for by a second -- or piggyback -- loan, they have no equity in the house. In fact, they're effectively "upside down" on their original pair of loans. To further complicate matters, the higher lending standards that have recently emerged in the mortgage industry are likely to prevent them from getting any sort of new loan.

More tough sledding
Certainly, the Journal's rendition of their story is a poignant one. But I'm not certain who deserves the more vigorous dressing-down: the family that bought far more house than their income and credit status justified, or the mortgage broker and lender who combined to make such obvious craziness possible. I think the key, however, is that this story likely represents a fairly commonplace tale among the million or so homeowners who will reluctantly turn over their house keys to their lenders next year. But beyond that, its lessons about the health of housing for the foreseeable future are vitally important:

  • Most of the sour (and sound) loans that were made in recent years found their way into asset-backed securities, many of which accordingly have begun to stink, causing problems for both their U.S. and international holders.
  • As a result, and given the increasing number of foreclosures emanating from the subprime sector, there has recently been a major shift in lending standards. Most mortgage originators have moved from lending to anyone who could fog a mirror to only writing more conservative mortgages they know can be sold.
  • A number of lenders have gone toes-up during 2007, with New Century Financial being the most notable example. The increasingly precarious state of some others is only adding to the heightened restrictiveness of those still making new loans.
  • There is a steadily increasing possibility of a new wave of government intervention and standard-setting in mortgage lending. Democratic presidential candidate Hillary Clinton has, for instance, called for a bailout program for those faced with foreclosure. For anyone who believes that such a program would be initiated without a spate of new regulations, I have a wonderful bridge for sale at a closeout price.
  • As mentioned, the inventory of houses for sale is being fed by the growing number of foreclosures, as well as by those desiring to unload their homes before resets -- along with a host of investors who've decided that real estate isn't the sure road to riches they'd once believed. That fattened inventory is hardly beneficial to the builders.
  • Many builders tailor a large percentage of their products to first-time buyers, lots of whom haven't had an opportunity to amass the savings necessary for meaningful down payments. Those builders -- who include some of the names mentioned above -- will be hindered by new lending standards and by the reduced availability of piggyback loans to cover that first 20% of a home's purchase price.

Patience pays
In all, since few homes are bought for cash, and since mortgage lending is so crucial to builders' efforts to market their homes successfully, I'm betting that the abovementioned factors will retard housing's recovery more than generally expected. With that in mind, I urge my Foolish friends to wait until the homebuilders' business strengthens obviously and meaningfully before accumulating positions in the group. You may miss a few points off the bottom, but you'll likely do wonders for the preservation of your capital.

Related Foolishness to build on:

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Fool contributor David Lee Smith doesn't own a share in any of the companies mentioned, and obviously doesn't want his Foolish friends to, either. He welcomes your emails. The Motley Fool has a disclosure policy.


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