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Why falling mortgage rates are boosting homebuilder stocks

Brent Nyitray, CFA, MBA

REITs are getting bullish as bonds rally on tensions: Should you? (Part 4 of 7)

(Continued from Part 3)

Mortgage rates had decreased as the the big banks competed for business

Mortgage rates are the lifeblood of the housing market, which is why Bernanke and the Fed began conducting quantitative easing (or QE) in the first place. Lower rates allow homeowners to refinance, which increases their disposable income and helps stimulate economic growth. Lower rates enable first-time homebuyers to move out of an apartment and into a house, which means higher consumption (and good things for home improvement retailers like Home Depot and Lowe’s). Consumption accounts for some 70% of the U.S. economy, and consumption has been depressed since the housing bubble burst. The Federal Reserve would prefer to keep rates as low as possible for as long as possible.

Mortgage rates fall as the ten-year bond rallies

The average 30-year fixed-rate mortgage fell 4 basis points as the ten-year yield fell 9 basis points, and TBAs rallied. With the refinance boom over, originators are overstaffed and cutting prices to drive business. We’ve seen a number of small originators go out of business, as they found themselves unable to compete in a purchase-driven mortgage market. The purchase market is fundamentally different from the refinance market in that it’s driven by relationships and not price. Last week, we heard from the biggest banks in the mortgage business, and every one reported drops in origination activity of 30% to 40%. Margins are getting squeezed as bankers compete for business.

The confirmation of Mel Watt as FHFA Chairman might give originators a break, as he’s expected to endorse further government homeowner assistance, which could mean an extension of HARP (Home Affordable Refinance Program) eligibility dates. This could trigger a new refinance boom.

Recently, the FHFA issued new loan level pricing adjustments for conforming loans. Loans with FICO scores above 680 and loan-to-value ratios above 80% will see higher rates. Not only that, but the FHFA also increased the guarantee fee for conforming loans by 10 basis points. Mel Watt put these increases on hold.

Effect on homebuilders

Homebuilder stocks, like Lennar (LEN), Toll Brothers (TOL), PulteGroup (PHM), and D.R. Horton (DHI), have been reporting decent fourth quarter earnings, but it appears that traffic is increasing in the previously dormant East Coast and Midwestern markets, as the West Coast probably moved too far too fast. An alternate way to invest in the sector is through the S&P SPDR Homebuilder ETF (XHB).

Given that the economy could have depressed household formation numbers, there’s real pent-up demand for housing. Housing starts have been below historical averages for the past ten years. With low mortgage rates and increasing demand—and a strengthening economy—homebuilders now have the wind at their backs. The builders that have exposure to the red-hot West Coast market did very well. For homebuilders, the top-down macro picture looks good.

Continue to Part 5

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