Profit From the Housing Bust

The housing market terrifies me. It was recently announced that median new home prices fell 9.7% year over year, the largest such drop in 35 years.

And I think that it could get worse. Consumers are over-leveraged, they're used to low interest rates, and they've purchased expensive real estate using unconventional mortgages. This combination could lead to disaster.

Big bad debt
Consumer debt has grown significantly during this housing boom. In 1985, the ratio of household debt to disposable income was about 73%. Today, this ratio is well above 125%. I see several reasons for this huge amount of debt.

First, instead of paying off their mortgages, consumers are borrowing money against the equity in their homes. In the third quarter of 2005, homeowners borrowed $235.9 billion against their equity -- a huge number equal to 10.4% of their after-tax income. The amounts declined in 2006 to $152 billion in the second quarter and $113.5 billion in the third quarter, but still represent about 5% of after-tax income.

Second, housing prices have gone up, forcing consumers to shell out more money for housing. Yale professor Robert Shiller examined housing prices from 1890 to the present. According to his calculations, if you exclude inflation, a house that sold for $100,000 in 1890 was selling for about $110,000 in 1997. During that 107-year-span, even at the peaks of the market, that house never sold for more than $125,000. Yet in 2006, that home was selling for almost $200,000. So we're way higher than we've ever been before.

A third reason for consumers' increasing debt is that unconventional adjustable-rate mortgages like hybrid ARMs and option ARMs are enabling homebuyers to increase their debt by reducing their initial payments.

Hybrid ARMs typically have a low fixed "teaser" interest rate for several years, after which the interest rate resets to the market rate. Option ARMs allow borrowers to pay only the interest on the loan, or sometimes even less. After years of payments, the buyer can owe more than they did initially.

The initially low rates of unconventional mortgages can be deceptive. If homebuyers believe that their short-term mortgage payments are representative of their long-term cost, they may purchase more expensive houses than they can actually afford.

These loans have become common -- in the first quarter of 2006, 26% of new loans were interest-only or negative amortization. And option-ARM borrowers aren't paying them off. According to UBS, about 70% of option-ARM holders make the minimum payment.

A catalyst for a crash
The combination of these effects is startling. In 1985, the equity-to-value ratio for homeowners was 69% -- homeowners owned 69% of their homes. Today, we're at an all-time low below 54%.

My concern is that the huge consumer debt load combined with unconventional mortgages could cause a housing crash. When the market's going up, option ARMs are manageable, since growth in the house's value accrues to the homeowner, increasing equity. When the market's going down, the option ARM borrowers' equity can vanish quickly, leaving them with more debt than the house is worth.

Combine this observation with Schiller's observations that housing prices are way higher than they've ever been before, and it seems like there's room to fall.

If you're searching for a catalyst, you don't need to look any farther than the hybrid ARMs. According to Fannie Mae (NYSE: FNM  ) , in 2006, the teaser rates disappeared on about $300 billion worth of mortgages. But in each of 2007 and 2008, $1 trillion in mortgages will reset -- roughly 12% of all mortgages each year. Furthermore, borrowers have to adjust to more than just the loss of the teaser rates. Market rates are higher as well. Some borrowers could see interest rate increases of 4%-5%, causing a huge spike in their monthly mortgage payments.

The results could be catastrophic. The virtuous cycle that pushed up housing prices and allowed consumers to increase leverage and spending on the way up could turn into a vicious cycle on the way down. A housing crash could hurt the entire economy, and not just through job losses. If 5%-10% of consumer spending is a direct result of people borrowing equity in their homes, that money could quickly dry up.

Investment opportunities
However, uncertainty also can also bring the opportunity for profit.

If you are prepared to consider a very risky short strategy, then homebuilders and lenders might seem like obvious targets. I'd start by looking for the most leveraged companies. And when it comes to lenders, I'd look at mortgage lenders like Countrywide Financial (NYSE: CFC  ) and consumer finance operations like Capital One Financial (NYSE: COF  ) , since most lenders are likely to be hurt.

One "problem" with these companies is that they're relatively cheap on a P/E basis. If a crash doesn't materialize, then they may actually increase in value. So, another way to play the short side is to target the entire market. If a housing meltdown causes consumers to reduce spending, most companies would be hurt. I've bought a few SPDRs (AMEX: SPY  ) puts to guard against such a scenario.

If you'd rather focus on the long side, it can be challenging finding investments that will benefit from a housing bust, since most companies suffer during a recession. However, collection agencies like Portfolio Recovery Associates (Nasdaq: PRAA  ) could potentially gain business.

The best strategy might be to wait for the depths of the bust, then buy the companies with the strongest balance sheets and biggest competitive advantages. I'm thinking about companies like Lowe's (NYSE: LOW  ) in home improvement and LandAmerica Financial (NYSE: LFG  ) in title insurance. At that point, these businesses will likely have unusually low profits and be trading at low multiples.

The Foolish bottom line
I think this is where investors will reap maximum profits -- by buying great companies at the point of maximum pessimism. Just look at how well the survivors of the savings and loan crisis of the early 1990s have done. Some of those companies went on to become 50-baggers. In 15 years, we may see the same from the survivors of the housing crash.

To view some great companies in a variety of different sectors trading at low valuations, why not try a 30-day trial of Motley Fool Inside Value? Click here to learn more.

Fool contributor Richard Gibbons only becomes this pessimistic on Mondays. He owns SPDR puts, but does not own any other securities discussed in this article. Portfolio Recovery Associates is a Motley Fool Hidden Gems recommendation. Fannie Mae is an Inside Value recommendation. The Fool has a disclosure policy.


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