What the Worst-Case Scenario for Housing Looks Like

Hank Paulson is Treasury Secretary of the United States. He used to be the leader of Goldman Sachs. He has immense political power. He understands finance. Wall Street respects him.

On Tuesday, Hank Paulson appeared on CNBC. He said the problems in the housing markets "have further to run."

Fannie Mae is the largest buyer of mortgages in the United States. It has lent $750 billion to American homeowners. On Tuesday, Fannie Mae CEO Daniel Mudd predicted the housing downturn would last until 2010.

Right now, people are worried about housing. Two years ago, people thought housing could never go down. Now they think housing will not stop falling. Every time I open a newspaper, I see stories about the collapsing real estate markets, broke homeowners, and huge inventories of unsold houses.

When powerful men like Paulson and Mudd start chiming in, you know the contagion has spread.

Here's the thing: To beat the stock market, you need to worry about things that no one else is worrying about.

Right now, everyone worries about housing. Sure, home prices could keep falling, and the pain could last for another few years. But you won't make any money betting on that scenario, even if it does happen. Why? Because everyone's already worried about it. And their fears are already priced into the market.

To give you an example, yesterday I read a research report from a Wall Street investment bank. The analysts performed a worst-case analysis on eight major U.S. homebuilder stocks.

These analysts assumed that the value of homebuilders' raw undeveloped land had fallen 75%. Then they cropped new home sales prices by 40% and assumed inventory would sell at 75% slower rate than it's selling for right now.

In other words, with the stroke of a keypad, they sent the homebuilding business back to the Middle Ages.

Here's the interesting thing: Having made these awful assumptions, they calculated book value for the eight major homebuilding stocks. Book value is the capital invested in the business that belongs to shareholders. It's what you have left when you add up all the assets and subtract all the liabilities.

The research found that, right now, these homebuilding stocks were trading around par with their worst-case scenario book values. Homebuilder stocks usually trade at a premium to book value. In other words, current homebuilder share prices are trading at a discount to the worst-case scenario.

In summary, I don't think the stocks of homebuilders have much further to fall. Everyone's worried about them... including the most powerful people in Washington. This tells me the market has already priced in everyone's fears.

There's another reason not to worry about any further downside in housing and stocks. When too many people worry about something, politicians get involved and try to fix the problems. This generates votes for their campaigns. (And they usually succeed – even if they create bigger problems somewhere else.)

Hank Paulson was on CNBC to discuss his plans for a federal bailout of bankrupt homeowners and more tax cuts. Mudd was speaking at an event hosted by the U.S. Chamber of Commerce. He was there to urge lawmakers to fix the situation with legislation.

That's why I think there's little downside here. Prices are low, everyone's worried, and we have the politicians on our side. It's time to find something else to worry about...

Good investing,

Tom