In the second quarter of 2012, the largest jump in home prices in seven years made the major news sources stand up and take notice, reviving predictions of the bottom in the housing market.

Research firm CoreLogic stated that, year-over-year, home prices in the U.S. housing market rose 2.5% in June 2012 from June 2011. Mortgage lender Freddie Mac, which uses different methods to obtain its numbers, claims that home prices rose an even better 4.8% in the U.S. housing market.

While investors were focused on these numbers, they paid less attention to another critical aspect of the housing market. The Federal Housing Finance Agency (FHFA) didn’t allow Fannie Mae and Freddie Mac to reduce the principal on mortgages where the properties are worth less than what the owners paid for on their mortgages (source: Wall Street Journal, August 6, 2012).

The FHFA claims that the benefits of a principal write-down in the U.S. housing market are unclear. In addition, if such a practice were allowed, it says that homeowners in the housing market who are current on their mortgages may default in order to claim the principal reduction.

While these may seem like legitimate arguments, the reality is that 11 million mortgages in the housing market (24% of total home mortgages outstanding) are underwater—the mortgage is higher than the value of the home in today’s prices. (Source: CoreLogic)

If we look at the number of homeowners who have equity of 20% or less in their homes (value of home in excess of mortgage), we capture another 25% of all mortgages outstanding. These homeowners don’t qualify for the 20% or more equity required as a down payment to trade up homes.

In addition, those homeowners who are at least 30 days late on their mortgage payments have increased to 6.5 million, according to RealtyTrac. Furthermore, there are millions of homes that have still not been foreclosed on that will add to the supply of homes over the next few years.

Basically, close to half of all mortgages in the U.S. housing market are held by homeowners who are basically stuck.

Until this housing inventory is cleared out and until the U.S. homeowner feels comfortable to buy and sell again as in the past, there is no way there can be a sustained housing market recovery.

As soon as home prices rebound and as soon as there is actual demand in the housing market, what do you think these homeowners will do, dear reader? They will sell, which will continue to put pressure on home prices and the housing market in general.

Certainly, between now and then, there will be periods where the housing market will show signs of life and there will always be pockets of strength within the housing market. In general though, until this situation with half of the mortgages out there basically stuck is resolved, there will be no housing market recovery.

Michael’s Personal Notes:

Synonymous with the average American’s love for consumer spending is the average American’s love of their credit card, at least until recently.

Consumers used less credit in June than forecast. (Source: Reuters, August 7, 2012.) The numbers for May were also revised downward. What this signifies is that there is little consumer confidence, without which consumer spending has nowhere to go, as people have been keeping their credit cards in their wallets.

Credit card (consumer) spending experienced a $3.7-billion contraction; its largest decline since April 2011! (Source: Bloomberg, August 7, 2012.)

The amount of credit fell to its weakest level in eight months, which highlights the deterioration in consumer confidence that spilled over to consumer spending.

It is no coincidence that credit contraction confirms weak retail sales and weak jobs growth, which means little in the way of consumer spending growth; and, since 70% of gross domestic product (GDP) is consumer spending, GDP growth is in trouble!

Much to the relief of the stock market, credit has been growing steadily since 2010, which supported consumer spending and so GDP growth. Now, since credit is contracting to levels not seen since 2011, speculation is that, if it contracts further, we could return to 2010 levels, which would put the U.S. economy into a recession.

This is quite a conundrum, dear reader, as this weak consumer spending report made economists nervous about consumer confidence and consumer spending. The contraction, however, is completely natural.

The consumer still has high levels of debt, so the responsible thing to do is spend less and pay down the debt. The problem is that some market analysts don’t like to see consumers being frugal, because it means less consumer spending, which in turn means no GDP growth and a possible recession.

However, it is only when debt levels return to more manageable historic norms—where the consumer has roughly $0.50 of debt for every $1.00 of income—that consumer confidence can truly take hold, which will in turn feed into consumer spending.

The problem is that, to get to that historic level, the average American would have to cut back on consumer spending to a great degree, which would drag the U.S. economy into a recession.

Whether the Federal Reserve likes it or not, or whether certain market analysts like it or not, this is what the American consumer may do. Reducing interest rates and making loans available doesn’t mean consumer spending can just keep rising.

High debt levels force the average household in America to eventually do the responsible thing, which is pay down debt and put a halt to consumer spending. While that is the right thing to do, consumers paying down debt (instead of spending) is exactly how recessions are started.

Where the Market Stands; Where it’s Headed:

This morning we get word that economic data from China showed that exports rose just one percent from the year-ago period, and imports rose 4.7%. This was against analyst expectations for respective gains of eight percent and seven percent. The downdraft in China’s economy is something we have been predicting in Profit Confidential since early 2012. (In fact, my co-editor George Leong even made a video on it: “A Problem 23 Times Bigger than Greece.”)

We near the end of bear market rally in stocks that started in March of 2009.

What He Said:

“You’ve been reading my articles over the past few months and have seen how negative I’ve become on the U.S. economy. Particularly, I believe it’s the ramifications of the faltering housing sector that are being underestimated by economists. A recession doesn’t take much to happen. It’s disappointing more hasn’t been written on the popular financial sites and in the newspapers about the real threat of a recession happening in 2007. I want my readers to be fully aware of my economic opinion: I wouldn’t be surprised to see the U.S. economy in a recession sometime in 2007. In fact, I expect it.” Michael Lombardi in Profit Confidential, November 13, 2006. Michael was one of the first to predict a U.S. recession, long before Wall Street analysts and economists even thought it a possibility.