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Our Outlook on the Housing Slump--Page 3

Notwithstanding recent turmoil, evidence may indicate the worst is over.

There's also been some recent work done around the foreclosure subject by Drs. Charlie Calomiris, Stan Longhofer, and William Miles. They argue in a recent paper that while rising foreclosures are correlated with price declines, there's no evidence to suggest that price declines caused by increasing foreclosures are of significant magnitude. As a result, they argue that the current foreclosure tsunami will have less of an impact on prices than most analysts think. Although we've done no independent work to verify their model, they may be on to something. This is important, as a smaller, but still disruptive, batch of prime and Alt-A variable-rate loans are going to reset in the 2009-10 timeframe.

Government Intervention Helpful over Short to Medium Term
The recent seizure of the government sponsored entities (GSEs)  Fannie Mae (FNM) and  Freddie Mac (FRE) by the Treasury Department should provide an important shot in the arm for the housing market, as it's become increasingly obvious that neither entity was properly capitalized to carry out its mandate of providing affordable financing to qualified U.S. homebuyers. As the chart below shows, before the intervention the spread between conventional mortgages and 10-year Treasuries had risen to historically high levels as investors repriced the perceived risk of holding GSE debt.

After residing at well more than 200 basis points for several weeks before the recent takeover, we expect the spread to approach its long-run average in the mid-150 to 180 range in the not-so-distant future. And with 10-year Treasury rates now hovering in the 3.5% range, it's not unreasonable to expect conventional conforming 30-year mortgages to be offered in the 5%-5.5% range in the not-so-distant future.

The recent tightening of the GSE spread, as well as the intention to modestly grow both entities' portfolios over the next several months, has the potential to provide a material boost for the entire housing market. Encouragingly, the spread did not widen on the  Lehman  bankruptcy announcement on Sept. 15, indicating that investors remain reasonably confident in the now-explicit government guarantee. Yet with capital so constrained throughout the credit markets, there's no guarantee mortgage credit is going to be any more available than today's anemic levels. That said, the government's intervention is a good step, and indicates, among other things, that authorities are focused on stemming the slide in home prices.   

We view the government's actions to put Fannie and Freddie into conservatorship as the largest positive of all the government actions taken throughout the past six months within the mortgage markets. With both entities now better able to fill the void left by the exit of almost all other financing sources, we think there's reason to believe the mortgage market may slowly approach something resembling normal operation over the next several quarters. Before this latest action, any reprieve from what has become a very dysfunctional mortgage financing market was very much in doubt.

The risks to the thesis are several, and all are to the downside. As we write, the global investment banking world is being turned on its head, and nobody knows for sure what will be left of the world's capital market's ability to absorb risk in the future. Mortgage lenders are reeling from catastrophic losses. Those that survive are now left with crippled balance sheets and are not in the position to expand lending operations anytime soon. Job growth is now solidly negative, a phenomenon that reduces household formation as low-income families shack up with others, 20-somethings stay in their parents' homes while they ride out the storm, and immigrants defer home purchases until sunnier days. Downpayment assistance is set to expire in October, eliminating a large source of capital for first-time buyers. Homebuilding executives have been net sellers of their company's shares even when valuations were significantly lower, an indication they see a long hard slog ahead with little potential for share-price appreciation. The new home market appears to have taken another leg down in recent months. The foreclosure crisis is far from over, as a large cohort of Alt-A and prime option ARMs are going to reset starting in 2009. And credit quality of higher-quality mortgages continues to deteriorate.

To be clear, we still expect price declines throughout the country for at least the next few months, and for production to slow as well. Furthermore, even once we're on the other side of this crisis, homebuyers shouldn't expect heady appreciation anytime soon. Those days are long gone.

Yet markets tend to bottom when the fundamentals look the worst. Is the U.S. housing market currently at that point? We don't know, but there's reason to believe the U.S. housing market may be starting to slowly repair itself. And while recent dislocations in the capital markets will likely extend the downturn, we maintain there's a decent chance the worst of the current housing slump is behind us.

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