Global Market Commentary

April 23, 2014

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Standards Ease for Home Loans
Still Tough For Homebuilders, But Looking Better for Suppliers

Even though it was exotic financial instruments and an over-leveraged system that brought on the financial crisis in 2007 and 2008, the first shot fired was the collapse of the sub-prime lending market. Readers will remember the slack lending standards that resulted in so-called “ninja” loans (no income, no job, no assets). Those loans were then packaged into collateralized debt obligations (CDOs). As the underlying assets — dodgy loans — went south, the resulting contagion nearly brought down the global financial system.

As a result, one of the notable characteristics of the recovery has been the tightening of banks’ standards for lending to homeowners. Predictably, in the time since the crisis, banks have swung in the opposite direction, requiring borrowers to have better credit and more money to put down. And since the Great Recession has hurt wages and damaged the credit of many consumers, the result has been a headwind for household formation — one of the basic drivers of a healthy housing market.
credit 1

Lenders Look For More Business

Now, though, lenders are beginning to change their tune — somewhat. Their confidence in the ongoing recovery
of the housing market is one factor, but another is that the pool of borrowers seeking to refinance their mortgage
is shrinking.

This means more competition for a shrinking pool of mortgage originations, unless lenders loosen the very tight standards they adopted in the wake of the financial crisis.  Originations are expected to decline by 36 percent this year otherwise, as refinancing is exhausted.



Lower Down-Payments

Community banks are credit unions are the forefront of the shift, but larger banks are beginning to follow suit. TD Bank recently lowered its minimum down-payment to 3 percent, expanding a program which had approved 5 percent down-payments last year. Wells Fargo, the nation’s largest originator, is also getting less picky, permitting more of a borrower’s down-payment to come from family gifts rather than his or her own savings.

At the peak of the housing bubble, loans with less than a 10 percent down-payment comprised about 44 percent of originations. That evaporated during the recession — but in the past year the figure has come back up to about 17 percent.

Credit Standards Ease — Modestly

Lenders are also showing more flexibility in accepting lower credit ratings from borrowers. Lending Tree’s
average credit rating for home purchase loans dropped to 679 in March from 719 at the same time last year.

Credit Requirements Getting Less Stringent… But Still Tight
credit 3It’s important to note that in spite of the modest loosening of lending standards, the present developments seem really to be a return of moderation after a period of extremely conservative practices brought on by banks’ pain during the recession. And they’re still tight, even by pre-housing bubble standards. Readers probably have
heard anecdotes about worthy borrowers experiencing tough times securing a loan — and though that situation may be easing, it is not returning to the irresponsible heyday of the bubble by an stretch.

A Recovery — But Probably Not a Boom

What this implies to us is that the housing market is strengthening — modestly. Consumer finances are strengthening — modestly. And household formation is strengthening — modestly. Consumers are eager to take advantage of this modest easing, because they believe that rates can’t do anything but rise longer-term (an accurate perception, in our view).

They also believe that housing prices will continue to rise, and are eager to buy as soon as possible. We think
this perception is also accurate. Under normal conditions, first-time buyers comprise about 40 percent of home
sales. In February, that figure was just 28 percent. Prices have been driven up by cash buyers — investors and speculators seeking to capitalize on rock-bottom prices, either to resell properties or to rent them.

We Favor Suppliers and Retailers Over Homebuilders

Given the real but modest pace of the recovery, then, we think that investors may see better results by looking at manufacturers and retailers of home-related goods rather than at the homebuilders themselves, for several reasons.

First, the homebuilders will likely be more volatile. They will be more likely to whipsaw with each hint, announcement, or policy move by the Federal Reserve. Although the broad market has reached an uneasy peace with the reality of the tapering of QE, the homebuilders’ stocks may whipsaw with each perceived clue about the Fed’s forward guidance on rates. And we have seen that the Fed’s communication can be frustratingly unclear for investors, despite its best intentions.

Second, although the recovery is real, it is not extremely robust. It is true that there is still significant pent-up demand that would require more housing starts. But still, while demographers estimate that 1.5 million new homes a year will be required to keep pace with population growth, housing starts this year are expected to rebound only modestly — to 1.1 million from last year’s 925,000. It’s on the way, and a cause for medium-term optimism, but it is hardly a blistering recovery.

Third, retailers (such as Home Depot and Lowe’s, which together account for more than 90 percent of the U.S. home-improvement market) and manufacturers (such as flooring maker Mohawk and cabinet and fixture maker Masco) stand to benefit not just from the new residential construction that’s occurring, but also from renovation and remodeling. Consumers’ improving financial positions will increase new home sales slowly — but even more, those who aren’t buying new homes will finally be able to make improvements they’ve been putting off for years.

Fourth, retailers and building supply manufacturers will benefit from an upswing in non-residential construction and remodeling — another phenomenon that we think is likely to show an uptick at this stage in the economic cycle, as businesses accelerate capital expenditure to support expansion.

And fifth, many retailers and suppliers have rationalized their operations and become leaner, more efficient, and more focused during the recession. As the housing market gradually returns to normal, we may see that those efforts will reap outsized gains for investors.

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