While everyone expected Existing Home Sales to drop in July, the drop was far more than expected. In July, used homes sold at an annual rate of just 3.83 million, the lowest level since 1996. That is a plunge of 27.2% from the June pace of 5.26 million, and is 25.5% lower than the year-ago pace of 5.14 million.
The month-to-month decline is actually worse than it appears since the June numbers were revised down from a 5.37 million pace. So relative to where we though used home sales were running, the decline is actually 28.7%. It was also FAR below the consensus expectation for a 4.72 million pace.
Single-family home sales were down 27.1% on the month and down 25.6% year over year. Condo sales were down 28.1% for the month and 24.0% lower than last year. The plunge in sales comes even as the average mortgage rate fell to 4.56% from 4.74% in June and 5.22% last year. The first graph below (from http://www.calculatedriskblog.com/) shows the history of existing home sales.
Tax Credit Expired
Existing home sales had been propped up by the home buyer tax credit. To qualify, people had to reach an agreement by the end of April, but they had until the end of June to close on the sale, and existing home sales are recorded at closing. Thus there was a huge ($8,000) incentive to rush and close before the deadline. The tax credit was supposed to end last fall, but a last minute middle of the night extension (and actual expansion of the program) was added in Congress. That is why there is the earlier spike in the graph.
It is abundantly clear to me from the graph that the tax credit did almost no net good at all in stimulating home sales. All it did was shift the timing of the sales that would have otherwise occurred. Most of the activity actually happened in the first wave, and the extension and expansion did very little good. Expanding the program so that existing homeowners could participate was particularly stupid, since that does not even reduce the inventory on balance. Help for first-time buyers at least accomplished that, albeit by increasing the rental vacancy rate.
The worst month-to-month decline was in the Midwest where sales fell 35.0%, followed by the Northeast, down 29.5%. Sales in the South were down 22.6% and in the West they were down 25.0%. The pattern was similar for the year-over-year comps. The Midwest was down 33.3%, followed by a 30.3% decline in the Northeast, a 23.0% fall in the West and a 19.8% decline in Dixie.
The Party Is Over
So we threw a very expensive party, and now we are suffering from the hangover. The most important thing about existing home sales is not the direct impact that sales have on the economy. That impact is actually very minimal. Nothing is produced when an existing asset changes hands. Most of the economic activity associated with an existing home sale comes from people redecorating after they move into a “new for them” home. That helps stimulate sales for paint makers like PPG (PPG) and carpet companies like Mohawk (MHK).
Relative to the size of the transaction, the effect on the overall economy is minimal. That is not the case with new home sales, each of which generates an enormous amount of economic activity and are traditionally the key to pulling the economy out of recessions.
The key reason why anyone should pay attention to used home sales is what they say about the direction of home prices. Housing is the principal store of wealth (or at least it used to be before prices collapsed) for the vast majority of American families. Housing wealth is far more evenly spread across the county than is stock market wealth. While many people might have a little bit of exposure to the stock market in their 401-k program, most equity wealth is held by the richest few percent of the people in the country.
While in the “new gilded age” of the past decade, the rich have built houses in the Hamptons that exceed the excesses of the Newport cottages of the last gilded age, none have $100 million homes, but $100 million stock fortunes are far from unheard of.
The key to the future direction of home prices is in the level of sales relative to the number of houses available in inventory.
Inventories of existing homes rose by 2.5% to 3.98 million. While that is still well below the record set in July of 2008 of 4.58 million homes, it is still a very high level. Just as with any store, the level of inventory has to be compared to the level of sales to be meaningful. The plunge in the level of sales, combined with the rise in the absolute level of inventories caused the months of supply to surge to 12.5 months from 8.9 months in June.
A healthy market has about six months of supply on hand, less than half the current level, and during the bubble, months of supply were routinely around 4 months. The current level is 1.4 months higher (12.6%) than the previous record of 11.1 months set in July 2008.
Well, what happens when a store has too much inventory, and customers are not coming through the door? The merchant starts to mark things down and has a sale. It is no coincidence at all that the previous bulge in the months of supply coincided with the most rapid period of falling home prices. While next month might see a slight rebound in sales from the July level, there is virtually no chance that it will recover to the April or May levels. Thus, it is likely that the months of supply are going to stay elevated, most likely still in the double digits for several months to come.
Expect Falling Prices
Existing home prices are going to fall. If they didn’t, it would mean that the most fundamental of all economic laws, that of supply and demand, has been repealed. And I think the legislation to do that is stalled in committee in the Senate (just kidding). Fortunately, relative to rents and incomes, the price of houses are now roughly in line with historical norms, not wildly inflated the way they were a few years ago.
That, of course, does not mean that housing prices cannot over shoot to the downside, but it does mean that we will probably not see another 30% decline like we have seen since the top of the bubble. However, I would not rule out a decline on the order of 10 to 15% over the next few years.
The consequences of such a decline would be extremely serious. Housing is a very leveraged asset. In the stock market, using all of the 50% margin you normally have available to you is considered being extremely aggressive. In housing, putting 20% down is considered being very conservative. During the bubble, it was common for people to put down less than 5% when buying a home.
As housing prices decline, more and more people will be pushed underwater on their mortgages. While there is no margin clerk with housing, forcing you to put up cash as soon as the home slips below the waves, it does have very serious consequences.
If the value of a house is more than the amount of the mortgage or mortgages, the rate of foreclosures should be zero. Regardless of how cash-flow constrained the homeowner is, he is always going to be better off simply selling the home rather than letting the bank take it. If the value of the house is less than the mortgage, it is often in his best economic interest to simply stop paying his mortgage and let the bank take it, even if he has plenty of cash available to him.
How much that is in the homeowners advantage depends on how far below the waves the house is. There are plenty of non-economic considerations that go into that decision. For most people, after all, a house is a home, not simply an investment. People do care about what their neighbors say. They care about pulling their kids out of the schools they are attending to move to a new school district. Ruthlessly defaulting on your mortgage will hurt your credit score, as well, so there is an economic consideration.
Thus, most people who do have the cash flow available, will try to stay current on their mortgage. If they can’t do that they are likely to take the intermediate step of working with their bank to arrange a short sale, where the house gets sold, but the bank agrees to get less than the full amount of the mortgage, so people don’t have to bring a big check to closing.
For the most ruthless, though, the best bet is often to just stop paying the mortgage and live rent- and mortgage-free until the sheriff shows up at the door. Given the overhang of foreclosures (and the extremely sloppy record keeping at the mortgage firms as the mortgage has been passed from one investor to another and sliced and diced to make exotic securities), it is not uncommon for people to be able to “squat in their own house” for well over a year.
The “depth of the water” matters a great deal. Few people that have the cash flow available will decide to stop paying on their mortgage if they are only down by $1,000. But if the house is worth $50,000 or $100,000 less than the mortgage, then those non-economic factors are more likely to be overwhelmed. If the cash flow is not available, say because one or both of the breadwinners in the family has been laid off and can’t find work after months and months of looking, then the decision to stop paying the mortgage becomes much easier.
Prices Have Not Started Sliding Yet
So far, we have not seen prices start to slide again. The median price of an existing home sold in July was actually 0.7% higher than it was a year ago (single family up 0.9%, condos down 1.7%). The tax credit did have the effect of propping up the prices of existing homes. After all, if a transaction is subsidized by a third party, both the buyer and the seller will split the benefit. In this case the buyer gets his benefit when he files his 1040, the seller gets hers through a higher sales price. That effect is likely to fade quickly in coming months, but did not seem to show up in the July numbers.
While the direct impact of existing home sales is not that serious, the implications of this report for future home prices are very dire. Falling home prices will mean more foreclosures, and that means more bad loans for the banks. People will also feel less wealthy, and they will respond by saving more and spending less, and that tends to slow the economy down.
If people planned to finance their retirement by selling off their home bought long ago at lower prices, they are not going to be able to have the sort of retirement they thought they would without additional money in the bank. If downsizing the home once the nest was empty was a big part of the college tuition plan, well, maybe the kids will just have to go to community college instead.
Thus the impact of home prices is vital to the overall health of the economy, and existing home sales are significant in so far as they provide insight into them, not from the direct economic impact.
Looking Ahead to New Home Sales
The impact of new home sales, which will be released tomorrow, is much larger in terms of the growth of the economy. Since they are recorded when the contract is signed, they have already been suffering from the post-tax credit hangover. Thus the drop in July is not going to be anywhere near the size of the drop in existing home sales.
Actually a slight increase to an annual rate of 334,000 is expected from the June rate of 330,000. That is still one of the lowest sales rates on record, and those records go all the way back to the early 1960’s.
If I had to pick a single reason why this recovery has been so anemic, it would be because to the exceptionally low rate of new home sales. Used homes are extremely good substitutes for new homes, and with the supply of used homes at record highs relative to sales, that is not exactly going to stimulate a lot of new home sales.
Thus, the real problem is not just the hangover from the tax credit party, but the cirrhosis of the liver caused by the constant housing binge from 1997 to 2007. That damage is going to take more than just a few aspirin to cure.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
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