The US housing market remains resilient, defying our expectations of seasonal weakness in the winter months. We expect moderate increases in prices on an aggregate level to continue, but with ongoing divergences among regions. In this paper, we examine these regional differences, based mainly on state-determined foreclosure processes. We also examine the implications for consumers’ balance sheets in relation to increased equity in residential real estate.

1. Investment Research
Update on the Improving Foundations of
US House Prices (March 2013)
Ronald Temple, CFA, Managing Director, Portfolio Manager/Analyst
The US housing market remains resilient, defying our expectations of seasonal weakness in the winter months. We
expect moderate increases in prices on an aggregate level to continue, but with ongoing divergences among regions. In
this paper, we examine these regional differences, based mainly on state-determined foreclosure processes. We also
examine the implications for consumers’ balance sheets in relation to increased equity in residential real estate.

2. 2
We continue to be encouraged by the resilience of home prices in the
United States. We had been concerned that seasonal weakness during
the winter would erode some of the price gains homeowners enjoyed in
the first half of 2012, but that has not occurred. Instead, home prices
have been stable through the most recent report from S&P/CaseShiller which included transactions from November to January. We
could still see some slippage in prices in the next two or three reports,
but our confidence is increasing that we are likely entering the spring
and summer season in a strong position for further price increases—
particularly in regions where home prices overshot on the downside.
The states that were most prominently oversold were those that had
non-judicial foreclosure processes, which allowed lenders to seize
homes and sell them without a court hearing. The ease of foreclosing in
these states led to a more rapid resolution of bad loans but also meant
that distressed supply overwhelmed demand, pushing prices well below
fair value. These states are now well into the rebound that we believe
will continue.
Looking ahead, we expect moderate increases in prices at an aggregated
national level with uneven performance by region. In this update, we
provide more background on the basis for our expectations by examining the ongoing divergence across different markets as it relates to the
number of homes either seriously delinquent (over 90 days past due)
or in foreclosure. The widening gap between the judicial and nonjudicial states (states are shown in Exhibit 1) should drive very different
expectations in 2013 and beyond. The variance between states is likely
to be reinforced by a virtuous cycle in non-judicial states where higher
home prices are leading to a lower number of foreclosures and underwater loans nationally, as shown in Exhibits 2 and 3. Last, we show the
wealth implications of home price increases for the US consumer as
supported by the latest US Federal Reserve (the Fed) data on owners’
equity in residential real estate.
Exhibit 1
Non-Judicial and Judicial States
NH
VT
MT
MN
NY
WI
SD
MI
WY
PA
IA
NE
IL
NV
CA
UT
CO
KS
IN
MO
OH
WV
VA
KY
NC
TN
AZ
ME
ND
ID
OK
NM
SC
AR
MS
TX
Non-Judicial
Loans in Foreclosure (%)
8
Judicial 5.69
6
National 3.41
4
Non-Judicial 1.79
2
0
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
As of January 2013
Source: Lender Processing Services, “Mortgage Monitor,” January 2013
Exhibit 3
Borrowers in Negative Equity
Number of loans in Negative Equity (millions)
20
17.0
15
9.8
10
5
Jan-10
Jun-10
Dec-10
Jun-11
Dec-11
Jun-12 Oct-12
As of October 2012
Source: Lender Processing Services, “Mortgage Monitor,” December 2012
The Judicial Divide
WA
OR
Exhibit 2
Foreclosure Inventory
AL
GA
LA
FL
Judicial
As of January 2013
Alaska is non-judicial and Hawaii is judicial.
Source: Lender Processing Services, “Mortgage Monitor,” January 2013
MA
RI
CT
NJ
DE
MD
Foreclosure rules are generally driven at the state level. Out of all states,
24 require a judicial proceeding to foreclose on a home. The other 26
(and Washington, DC) are non-judicial, as illustrated in Exhibit 1.
The value of the US housing stock is roughly evenly divided between
non-judicial and judicial states. In Exhibit 4, we have included a table of
the eleven states with the highest value of housing stock. In these eleven
states, 57% of the value of housing is in non-judicial states and 43% is
in judicial states. Importantly, the number shown is only for the homes
with an outstanding mortgage. Given that about one-third of American
homes are owned with no mortgage debt, one could add 50% to each
of the values shown in the exhibit to approximate the total in each state
(assuming that homeowners across the nation behave similarly).
The $8.3 trillion of housing value in the states shown in Exhibit 4,
as of September 2012, represents about 66.7% of the national value
of homes with mortgage debt outstanding ($12.5 trillion). The total
value of the US housing stock, including homes with no mortgage
debt, stood at $17.2 trillion at that time, per data from the Fed and
Haver Analytics.

3. 3
Exhibit 4
Home Values by State for Homes with Mortgages
State
$ billions
California
State
$ billions
2,725
Illinois*
491
New York*
816
Virginia
442
Florida*
790
Washington
421
Texas
649
Maryland*
421
New Jersey*
633
Pennsylvania*
404
Massachusetts
531
Total
8,323
As of September 2012
* Indicates a judicial state
Source: CoreLogic
Exhibit 5 shows the significant difference in serious delinquency and
foreclosure rates for judicial and non-judicial states. California (which
represents over 20% of the value of the US housing stock) is the starkest example of the rebound from oversold conditions. Having seen
the overhang of serious delinquencies decline from 12.5% of all loans
in the fourth quarter of 2009 to 5.0% of loans at the end of 2012,
home prices in California have rebounded sharply. Based on the S&P/
Case Shiller 20-City Home Price Index (the 20-City Home Price
Index) shown in the Appendix, prices have increased by 25.3% in San
Francisco, 13.2% in Los Angeles, and 13.1% in San Diego from their
respective lows in 2009. These increases compare with a national price
increase of 9.0% for the 20-City Home Price Index from the low of
March 2012, and 4.9% from April 2009.
In fact, when we survey the results of all cities in the 20-City Home
Price Index, the ten cities that have rebounded the most from the lows
are all in non-judicial states while six of the remaining ten cities are in
judicial states. For example, New York City home prices have seen the
smallest rebound from the lows in the index, rising only 2.7% from
the March 2012 low.
Exhibit 5
Loans in Foreclosure or 90 Days Past Due
It is important to recognize that we are not advocating the idea of a
state being non-judicial. In fact, we would argue that the economic
and social disruption of the housing crisis was much more severe in
non-judicial states than in their judicial peers because it was simpler
to foreclose on homes. The resulting flood of supply likely sent home
prices lower at a swift pace, forcing millions of borrowers into negative equity positions. This might not have occurred if the supply of
distressed sales had flowed more slowly into the market. The result of
this downward spiral of excess distressed supply was that more people
made the economic decision to strategically default (i.e., stop paying
their mortgage even when they could have sustained their obligations),
under the impression that hope of a price rebound was lost. Turning
the previously described example of New York City on its head, home
prices in the New York City area are down “only” 25.1% from their
peak in June of 2006 versus the 20-City Home Price Index which
is down 29.2% since its peak in July 2006. Perhaps more tellingly,
prices in cities that have rebounded the most from this cycle’s lows,
San Francisco, Phoenix, and Detroit (among others) are still down
substantially more than in New York City.
As we look forward, we can see how the unwinding of the oversold
condition in judicial states might play out. Lender Processing Services
reports that the number of borrowers who are in negative equity positions has declined from a peak of 17 million in February of 2011 to
just under 10 million borrowers as of October 2012 (see Exhibit 3).
We can reasonably assume that the bulk of the decrease in underwater
borrowers has occurred in the states with the largest price rebounds.
Assuming that is the case, there are interesting dynamics on both
the supply and demand fronts. As it relates to supply, higher prices
can lead to more supply from homeowners who had previously
been unable to sell their homes due to their inability to pay off the
remaining mortgage balance even after receiving the proceeds of the
sale. Now that these owners can sell their home and move to take
advantage of other employment opportunities or to change their
financial position, there could be increased supply of homes for sale in
a non-distressed position. Likewise, banks might be tempted to unload
their foreclosed homes more rapidly to the extent they did not do so
at lower prices. By contrast, the key driver that could reduce supply
is that homeowners who had contemplated a strategic default are less
likely to do so when prices are increasing.
Non-Judicial States
Judicial States
(%)
25
(%)
25
20
15
California
Texas
Virginia
Massachusetts
Washington
20
15
10
Pennsylvania
Illinois
Maryland
10
5
New York
Florida
New Jersey
5
0
1990
1995
2000
2005
As of December 2012
Source: Mortgage Bankers Association, Haver Analytics
2010
2012
0
1990
1995
2000
2005
2010
2012

4. 4
On the demand side we hold a positive view, as buyers who had been
waiting for even cheaper prices might realize they missed the lows and
should rush to take advantage of still very attractive valuations. As
prices continue to increase, we would expect to see increased availability of credit for home purchases and even (at some point) home equity
loans as borrowers move further into positive equity positions.
These factors are, overall, very positive for consumers as we expect
their balance sheet improvement will lead to higher confidence
levels for homeowners, even when they might not be enjoying price
increases themselves.
Wealth Effects
While house prices are interesting in and of themselves, what really
matters, in our opinion, is the wealth effect of house price appreciation.
As we indicated in our Investment Research paper1, The Improving
Foundations of US House Prices, the most important aspect of the home
price recovery is that the middle class is disproportionately exposed to
housing with over 60% of the typical family’s assets being the primary
residence. Data from the Fed indicate that the value of residential real
estate owned by individuals has increased from $16.2 trillion as of the
end of 2011 to $17.7 trillion at the end of 2012. This increase of 8.7%
is substantial on its own, but the effects of leverage augment the appreciation. Owners’ equity in residential real estate has increased by 25%
from $6.6 trillion to $8.2 trillion in the same period of time, as shown
in Exhibit 6. The difference in the dollar value of the increase in equity
versus the value of the home is due to mortgage debt reductions.
Exhibit 6
Household Equity in Real Estate
($ trillions)
15
10
5
0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
As of December 2012
Source: Federal Reserve Board, Haver Analytics
Conclusion
While the signs to date are almost universally positive, we would be
remiss if we did not note the negatives. To date, credit availability
remains tight. Home equity originations in 2012 were $4 billion for the
entire year according to Inside Mortgage Finance. This figure compares
to $430 billion in 2006. We recognize this was during the period leading up to the housing bubble and do not expect to return to these levels.
However, we do believe it is realistic to expect home equity originations
to return to levels of $100 billion per year or more over the years ahead,
allowing consumers to tap their growing wealth again. Moreover, at
$503 billion, purchase mortgage originations in 2012 were the lowest
since 1995 per data from the Mortgage Bankers Association and Haver
Analytics. To emphasize the context of the recent low mortgage originations, in 1995, the United States had 97 million households and home
prices were lower, versus today’s 114 million households at higher
prices.
Overall, the environment for US housing remains favorable. We believe
the middle class is finally getting a reprieve after a brutal loss of wealth
in the great financial crisis. The good news is that there is still a substantial amount of upside, in our view. A shortcoming of the potential
upside is that it depends on where the homeowner lives. We will monitor the results carefully as the implications for investors vary by region.
The most important conclusion from our analysis is that consumers’
balance sheets are improving and this should lead to a more resilient
economic recovery in the years ahead.

5. 5
Appendix
S&P/Case Shiller 20-City Home Price Index (January 2000 = 100)
City
Low Since
December 2008
Date of Low
High Since Inception
(January 1987)
Date of High
Current
Change from Low
(%)
Change from High
(%)
Phoenix
100.22
Sep-11
227.42
Jun-06
126.69
26.4
-44.3
San Francisco
117.71
Mar-09
218.37
May-06
147.45
25.3
-32.5
64.47
Apr-11
127.05
Dec-05
80.01
24.1
-37.0
Detroit
105.77
Mar-11
171.12
Sep-06
124.95
18.1
-27.0
Atlanta
Minneapolis
82.54
Mar-12
136.47
Jul-07
96.90
17.4
-29.0
Las Vegas
89.87
Mar-12
234.78
Aug-06
104.04
15.8
-55.7
159.18
May-09
273.94
Sep-06
180.23
13.2
-34.2
Los Angeles
San Diego
144.43
Apr-09
250.34
Nov-05
163.28
13.1
-34.8
Washington
165.94
Mar-09
251.07
May-06
187.42
12.9
-25.4
Miami
136.99
Apr-11
280.87
Dec-06
153.51
12.1
-45.3
Denver
120.21
Feb-09
140.28
Aug-06
134.17
11.6
-4.4
Seattle
128.99
Feb-12
192.30
Jul-07
141.30
9.5
-26.5
Tampa
123.91
Feb-12
238.09
Jul-06
135.20
9.1
-43.2
Portland
129.01
Mar-12
186.51
Jul-07
140.74
9.1
-24.5
Chicago
102.76
Mar-12
168.60
Sep-06
111.62
8.6
-33.8
Dallas
112.26
Feb-09
126.47
Jun-07
120.51
7.3
-4.7
Charlotte
108.23
Feb-12
135.88
Aug-07
115.15
6.4
-15.3
Cleveland
Boston
94.22
Feb-12
123.49
Jul-06
100.07
6.2
-19.0
145.83
Mar-09
182.45
Sep-05
153.80
5.5
-15.7
New York
157.43
Mar-12
215.83
Jun-06
161.64
2.7
-25.1
Composite-20
134.07
Mar-12
206.52
Jul-06
146.14
9.0
-29.2
As of 26 March 2013
Data include transactions from November 2012 to January 2013.
Source: Standard & Poor’s
Notes
1 Paper available at: http://lazardnet.com/lam/global/investment_research.html
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Published on 28 March 2013.
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