This Old House is a Money Pit

By Tobin Smith

By now, you've either made a small fortune shorting financial and homebuilding stocks, or you feel like you missed out on some easy money. But it's not too late to make a killing shorting these beaten-down stocks.

The Commerce Department released data on Aug. 19 that showed construction starts of new homes fell to an annual rate of less than 1 million units in July -- a 17-year low.

These numbers show that we are finally working off some of the excess inventory that was built up during 2002-2007. However, we are nowhere near the end of the correction in the homebuilding sector, or the financials for that matter.

Overdevelopment Meets Underdemand

Let's do some math so that you're clear on where we really stand in the cleansing process of the housing bubble aftermath.

In an article called "The Elusive Bottom," Merrill Lynch (MER) economist David A. Rosenberg tells us that housing development started to peak and began to roll over at 2.3 million units in 2006.

Based on pure demographics (i.e., population growth and new household formations), he states that the "natural level" of annual housing demand in the United States is around 1.45 million units. And, from 2003 to 2007, builders added, on average, nearly 2 million residential units per year.

Well, here's a news flash: That's about 35% more than the natural demand could absorb.

Rosenberg points out that we were building homes and condos as if we had the same demographics as we did in the 1970s. For those of you who don't remember, that's when 78 million boomers were buying their first pad.

So, with five years of 35% annual overbuilding of homes and condos, we're left with about 2.5 million extra units in the United States.

And logic tells us that we need to under-develop by 2.5 million units just to get back to natural demand equilibrium. After all, we are not demolishing these excess units -- yet.

But wait, there's more.

You can't forget about the homes bought with subprime, Alt-A and NINJA ("no income, no job and no assets") loans.

Consider this: Forty-five percent of the 20,000 homes sold in California last month had been foreclosed on, and many of these were existing homes bought during the housing bubble mania.

And, since a majority of the homes being bought existed before the 2002-2007 boom, their sale does not reduce the number of excess new homes -- it simply takes them out of the resale pool.