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Friday, April 10, 2009

Why Wall Street is Missing the U.S. Housing Recovery

By William Patalon III


Wall Street created the U.S. housing bubble and now it’s missing the real estate rebound.

And Andrew Waite understands why.

Waite is the publisher of the Personal Real Estate Investor, a glossy magazine that focuses on investors who buy houses or condos to manage for income or to fix up and sell for a profit. But he’s not some industry cheerleader whose statements are nothing but spin.

He’s a true expert on the U.S. housing sector who goes out of his way to "educate" journalists about the true state of the American housing market, and who criticizes most of the "indicators" in use as useless and irrelevant. Plus, as a onetime Wall Street venture-capitalist who subsequently joined Silicon Valley’s Sand Hill Road private equity crowd, Waite really understands how the Wall Street investment game is played - and, in the case of the U.S. housing market, the missteps Wall Street made and why.

"Wall Street analysts and economists do not understand the housing industry," Waite told Money Morning in a recent interview. "While stocks and bonds are relatively simple to analyze, housing is anything but. Unlike stocks, housing is a non-tradable asset."

But through the creation of mortgage-backed securities, Wall Street tried to transform housing into a tradable asset. That lack of understanding set the stage for the housing bubble. And it’s the same miscalculation that is keeping the big-money crowd from understanding that the housing market may have already bottomed - and may well be on its way back up.

Let’s look at both miscues.

Building a Bubble

Stocks and bonds are "tradable assets." They trade on central exchanges - in a very efficient manner - and play well into the kind of mathematical averaging that paves the way for all sorts of indices (the Standard & Poor’s 500 Index), and sub-indices (the Dow Jones Transportation Index).

That’s not the case with housing, which is very granular in nature - meaning how housing does in one neighborhood differs greatly from how it does in another. Housing is a "non-traded" asset because it is hard to trade - and when it does trade does so in a highly inefficient market.

As Waite says, housing is referred to as "real" property for a reason: Unlike stocks or bonds, which are paper representations of the underlying asset, housing is the asset itself. People live in houses, and most don’t buy them as investments - they buy them to live in. The typical house is owned for five to seven years, and only about 5% of the U.S. housing stock turns over in a single year. In a "normal" period - by that, I mean a stretch that’s not artificially souped up by the unrealistically loose credit that led up to the subprime-mortgage debacle - prices escalate perhaps 3% to 4% annually. And there aren’t the whipsaw pricing patterns that we see with stocks.

Even so, as part of its mission to transform housing into a tradable asset, Wall Street designed a reporting system that, true to form, was badly flawed, Waite says. The measures applied to the market - sample size, methodology, and statistical presentation - work well for assets that are dynamically traded, as stocks are. But they don’t work for housing:

* Stocks are analyzed by looking at the underlying company’s fundamentals, meaning the conclusions reached are very much tied to the specific earnings power of that firm.
* Housing, by comparison, is analyzed make "illogical" generalizations about the market that fail to reflect reality.
* Stocks are analyzed in a forward-looking fashion, being all about earnings projections and expectations.
* Housing analysis ends up being backward looking (45 days to 180 days), meaning the conclusions that are reached are likely outdated by the time we see them.
* Housing ends up being treated like a commodity, with "five-star" neighborhoods (where sales are brisk and the asking price is now being exceeded as prospective purchasers bid the values up in hopes of landing the house) being "averaged in" with "disastrous" one-star neighborhoods.

Says Waite: "Housing indexes and statistics emanating from Wall Street take a cynical view of housing … and they misrepresent the actual value of housing by ignoring the critically obvious point - most housing purchases are ‘buy, occupy and hold’," and aren’t a speculative play aimed at short-term profits.

By misfiring so badly, Wall Street established an environment in which housing prices were expected to escalate at better-than-their-historical norms, fanning the speculative flames. The easy credit made available by the mortgage-backed debt market only made matters worse. Banks made loans, and Wall Street bundled those loans into an asset-backed security - giving the banks back the cash that they could then use to make their next round of loans. Because the loans were "averaged" out, the resultant securities were given the highest credit ratings by the ratings agencies - which was more than the securities deserved.

It was a recipe for disaster - or, at least, for a bubble.

Wall Street never saw it coming.
Anatomy of a Rebound

Wall Street has also failed to understand the dynamics of a housing market recovery - which is already in the works, Waite says.

And he should know. The portion of the real estate market that Waite’s magazine caters to - the real estate investor - is significant. In fact, a groundbreaking study commissioned by the magazine, and conducted by real-estate researcher REALTrends Inc., in concert with Harris Interactive, found that real estate investors account for 22% to 28% of all home sales (existing and new) each year - a total of 1.5 million to 1.64 million houses each year. That’s a big piece of a $300 billion industry, so it provides a very solid sample.

According to Waite, the housing market bottomed last year. But that bottoming takes place in stages. Housing values continue to decline. But values can’t bottom, solidify, and then head north until sales volumes increase, Waite says.

"First you get volume, and then you get valuations," Waite says.

And it doesn’t get better across the board all at once: Sales will improve in a "predictable sequence" that start with the very best neighborhoods, work their way down to the really good neighborhoods, and finally reach the plain old good developments.

As noted, Waite says the very best neighborhoods are already seeing strongly improved sales, with actual bidding battles taking place as prospective buyers willingly pay more than the asking price in order to land the choicest properties.

As those markets sell out, and the credit spigots open, demand will move from the very best neighborhoods down to the "pretty good" residential properties, Waite says.

Three reports released over the course of three straight days the last week of March seem to support Waite’s view.

Sales of new homes rose 4.7% in February - the first increase in seven months, the U.S. Commerce Department reported March 26. The day before that report came out a government gauge of home prices posted its first gain in almost a year. And the third of that "hat trick" of upbeat reports issued that same week said that sales of previously owned homes - the biggest share of the market - also increased in February.

The plunge in housing prices is also starting to have an effect. In a second report issued March 26, the California Association of Realtors said that existing-home sales in the state were up 83% in February from the previous year. The reason: The median home price was down roughly 40%, which is helping shrink inventories to about a six months’ supply from 15 months in 2008.

If Waite’s theory is correct, as sales of new and existing homes pick up on a month-to-month basis, prices will follow.

But true to form, Wall Street is demanding proof.

The data "have allayed some fears that the housing market would continue to freefall," Omair Sharif, an economist with RBS Greenwich Capital, told The Wall Street Journal. "But it’s way too early to say if we’ve hit bottom."

But Waite fervently believes that bottom has already been hit and that it’s all uphill - over the long haul - from here.

"Wall Street would have you believe that putting money into a house is as sophisticated as putting money in a mattress," he said. "But as it continues to prove, nothing could be further from the truth."

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