California Housing Market – Three Years to Recover?

I’m glad that a Federal Reserve Bank study published last year (May 2005) presents solid evidence that the employment rate and loan-to-value are two of the most important predictors of defaults and foreclosures, otherwise yesterday’s news about dropping housing prices would cause me more concern than is warranted.

Given that my company’s business is investing in residential mortgages, primarily in California, I have a vested interest in seeing a stable housing market. So when luminaries like Berkeley economist Ken Rosen says, as reported in the S.F.Chronicle, that the California housing market my take three years to recover and is expected to decline by 4.8% next year and 2.9% the year after, I take note, and then I do some quick math.

If you’re an investor in a mortgage pool, what you want is for the borrowers to keep paying their loans. If the job market is weak, or the borrowers in the “pool” have, on average, too little equity in their properties (or inversely, the loan-to-value is too high), then if falling property values evaporate the equity, there is a substantially greater likelihood that borrowers may default, leading to foreclosures. To the extent that loans aren’t paying interest and principal, investors in the pool aren’t obtaining their yield objective, or potentially, face a risk of capital loss.

For some, the devaluation Dr. Rosen predicts hurts, but the fund my company manages, and those with similar loan underwriting policies, the average equity held by borrowers in the portfolio is large enough to withstand the single digit declines described; in fact, our fund’s average loan-to-value is 63% (or 37% equity). The Fed study predicts that at this level, we face a foreclosure rate of about 1%.

Nonetheless, as I said, stability is a good thing, so I was pleased read that various indicators are keeping housing devaluations in check, such as the Index of Leading Economic Indicators which rose 0.2% in October. Economists Ken Goldstein of the Conference Board (an industry-backed research group in New York who produces this Index) said “the economy is unlikely either to reheat or get significantly cooler. Instead, the kind of slow growth now being experienced could continue right through the winter and into the spring.”

Good if it happens, but it’s great to be protected nonetheless.

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