Written by Marc Courtenay

Saturday, 07 October 2006

Federal Reserve Chairman Ben S. Bernanke warned earlier this week that housing is likely to undergo a "substantial correction".  Is he just "jaw-boning" (trying to talk prices down) or does he know something we don't know? Mr. Bernanke knows that home prices have doubled and tripled in many areas over the past 5 years and that the Fed had lowered interest rates to near record levels--making home loans easier to qualify for and monthly payments more affordable. It encouraged one of the biggest refinancing booms in the history of the mortgage industry and propelled a huge number of people to become realtors (California has over 500,000 licensed realtors alone).  It was a great time for lenders like Countrywide Financial Corp. (symbol CFC) which is currently selling for 7.5 times next years projected earnings.

But homeowners who have borrowed heavily against their homes now worry that, as housing sales and starts fall, prices might also see a tumble. A large number of borrowers will see their mortgage interest rates increase as their adjustable rate mortgages get an adjustment higher--moving their monthly cost higher as well. There is no doubt that in large parts of the country--California, Florida, The Pacific Northwest and parts of the East Coast--housing has increased for years, but now homeowners are seeing a turnaround.  In our neighborhood on the coast of southern California, homes are taking a lot longer to sell, and the inventory is quite a bit higher than last year.

So the Fed Chairman's warning last week takes on great significance for many people, including those who own or are contemplating the ownership of housing stocks such as Toll Brothers (symbol TOL), D.R. Horton (symbol DHI), Hovnanian Enterprises (symbol Hov) and Levitt Corp. (symbol LEV). Many analysts right now think it is too soon to begin buying this beaten down sector. The most encouraging bit of news that could positively affect these stocks is that, since mortgage interest rates are tied to the 10 year treasury bond, they should actually subside to a more favorable level over the short-term.

This, added to the sinking of oil prices, the lowering of gasoline costs, and the overall expectation that the Fed will keep interest rates where they are for now when they next meet on Oct.24th, has at least half of the prognosticators believing that the American economy is worthy of optimism. But if the housing market is due for a "substantial correction" as the Fed chairman says, then where is the extra cash going to come from that will keep our consumer economy expanding?  In the longer-term, whether the Fed will choose to fight inflation or prevent a recession might be the bigger issue.