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Eight Market Spins About Housing by
Perma-Bull Spin-Doctors...And the
Reality of the Coming Ugliest Housing
Bust Ever….
Nouriel Roubini | Aug 26, 2006
My recent detailed analysis of the high risks of a housing-led recession in 2007 has
stirred some serious discussions and debates in the blogosphere and the press. Now that
the onslaught of bad news about housing (see the table below) has taken the force of a
tsunami that will soon trigger an ugly recession, Goldilocks spin-masters and perma-bulls
are on the defensive. Since the housing slump is now undeniable – and rather than a
slump it looks like a really ugly bust - the new line of defense of perma-bulls is to argue
that the problems of the housing market are only a healthy correction from bubbly
excesses, that housing is only in a modest slump that will soon bottom out and recover,
and that housing problems will not lead to wider macroeconomic troubles such a broad
recession. What a set of Delightfully Delusional Dreams that smash against the ugly
reality of recent free falling housing data shown in the table below.
The difference a year makes
Recent data quantify housing cooldown (year-over-year changes).
Builders’ sentiment -52.2%
New-home sales -21.6%
Purchase-mortgage applications -20.9%
Building permits -20.8%
Housing starts -13.3%
Existing-home sales -11.2%
Existing-home inventories +39.9%
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New-home inventories +22.4%
Source: MarketWatch
This free falling bust in the housing sector – that I warned about in my last paper - was
indeed colorfully depicted today by David Rosenberg and by Steve Roach, as cited in the
FT: "New home sales are now down 22 per cent year-on-year, which is a swing of
gargantuan proportion from the plus 26 per cent trend exactly a year ago - this is the
weakest trend in a decade," said David Rosenberg, North American economist at Merrill
Lynch. "The only thing 'orderly' out there right now is the guy carrying the stretcher."
Stephen Roach, chief economist at Morgan Stanley, added: "America's housing bubble
finally appears to be bursting." He said a post-housing bubble shakeout could take at
least two percentage points off the overall US gross domestic product growth rate.
Indeed, in a matter of months, the gravity-defying housing boom and bubble turned into
an alleged “orderly slowdown”; then, the orderly slowdown turned into a euphemistic
“soft landing”; and next, the soft landing slipped into a “slump”; most recently, the slump
worsened into a hard landing; while the latest data suggest that the hard landing recently
turned into a bust. And soon enough this housing bust will turn into a rout and an
unprecedented meltdown. To paraphrase the witty Rosenberg, soon enough the only thing
“soft” and “orderly” about the collapse of a comatose housing market will be the
undertaker carrying the coffin.
As the onslaught of data about the disorderly housing meltdown is piling up, even
evergreen perma-bulls such as the WSJ op-ed page are now in defensive and semi-panic
mode and are attacking “not-so-cool economists” (what does that is supposed to mean?
that you need to be “cool” or hip to be right? what a stupid remark from a WSJ op-ed
page that is starting to nervously sweat about the coming recession and is losing its own
well-groomed “cool”) that worry about a housing-related bust; but then, the same WSJ
op-ed page goes on to warn about the housing slump and blaming only the Fed's past
loose monetary policies for the ugly hangover from the housing bubble (more on this
below).
I have analyzed in detail in my last blog why we will soon have a housing related
recession; these views have been widely picked in the press, most prominently by Paul
Krugman in his Friday column in the NYT. While, as Krugman correctly points out, I
may be the only “well-known” economist who is arguing that we will have a housing-led
recession, many other very prominent economists – including Krugman himself as well
as Ed Leamer (who calls a soft landing scenario a “fantasy”), Jim Hamilton (see also
here) and Bob Shiller (who predicted the tech bust stock of 2000 and is now predicting a
housing bust) – are now of the view that there are serious risk of a housing market bust
that could then have macro consequences.
Then, whether this housing bust will lead to a recession or not is the only remaining
uncertainty: Krugman himself does not yet share my “certainty” - as he puts it – about a
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recession but, short of that certainty, he is fully of the view that the housing bust will be
“ugly” and has some risks of triggering a broader economy-wide recession. So, the
“Shrill Order of the Reality-Based Reputable Eeyores” is growing by the day and I am
proud to be in company of such distinguished academic and non-academic colleagues.
For now, since a lot of spin is being furiously spinned around – often from folks close to
real estate interests - to minimize the importance of this housing bust, it is worth to point
out a number of flawed arguments and misperception that are being peddled around. You
will hear many of these arguments over and over again in the financial pages of the
media, in sell-side research reports and in innumerous TV programs. So, be prepared to
understand this misinformation, myths and spins.
In the rest of this blog below I will thus deconstruct and unspin eight commonly heard
spin arguments on why we should not worry about the coming housing bust.
Continue reading this blog right below...
Spin
#1: Housing prices are not falling, have never fallen and will not fall
Some folks are still deluding themselves that home prices have not fallen yet and that
they will not fall in the future. Indeed, since the Great Depression of the 1930 we have
not had a year-on-year fall in median home prices, as opposed to some quarters in which
home prices were falling. But now median existing home prices are only 0.9% up
relative to a year ago and new home prices are only up 0.3% relative to a year ago.
Worse, actual median home prices are falling – on a y-o-y basis - in every US region with
the exception of the South. They are even falling in the Mid-West where, allegedly, there
was not housing bubble to begin with.
Worse, as the NYT was reporting today, home sellers are now providing a variety of
financial benefits (seller paid closing costs, buyer-side realtor bonuses, and seller
subsidized mortgages, even $30K swimming pools free) that effectively reduce the price
of a sold home, even if the headline price is officially not reduced: “The typical incentive
package from a home builder consists of upgrades to the house — granite countertops
instead of humdrum tiles, stainless-steel refrigerators and stoves instead of plain white
models and wood blinds instead of plastic. At the extremes, some have thrown in $30,000
swimming pools.” Estimates of this effective price cut – via side benefits to buyers – are
in the 3% to 8% range. So, while officially median home prices are “only flat” relative to
a year ago, the effective median price has already sharply fallen. And if you were to
control for CPI price inflation – now running above 4% - home prices are even lower in
real terms relative to their nominal value. More ominously, futures contracts for home
prices predict a 5% fall in home prices in 2007, and even a larger percentage fall in a
number of key cities. It is now clear that, for the first time since the Great Depression,
even official - i.e. not fudged by side incentives and subsidies - median home prices will
be falling on a year on year basis; the typical lag in the adjustment in home prices to a
gap between supply and demand and an increase in inventories of unsold homes will be
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trigger for this home price bust. On a year on year basis, real home price may fall as
much as 10% or even more.
Why would prices fall so much if we have never had – since the 1930s – a year on year
fall in median home prices? The reason is clear: part of the increase in prices in the last
few years was not due to fundamentals but, rather, to a pure speculative bubble. Thus,
once this bubble bursts the reduction in speculative demand that had lead to a sharp
increase in the supply of new homes well above any fundamental demand, must need to
an actual sharp fall in the prices of the previously bubbly asset. If there had not been any
new supply response above fundamental demand, the bursting of the bubble would have
led to a smaller price response. But since the initial bubble led to a glut of new housing
whose support was only the speculative demand, the final bust requires a sharp fall in
price and this fall in price is greater than otherwise: once fundamental demand falls, the
real price of homes must be lower than before the bubble started as the increase in supply
during the bubble was much greater than the increase in fundamental demand. So, over
time the cumulative fall in home prices over the next two years may actually be very
large. And, indeed, in the most bubbly regions of the US, home prices are already starting
to fall – in real terms – at double digit levels.
Spin
#2: We have never had in US history a recession that was initially triggered by
a housing bust. So, it cannot happen this time around
This spin goes in a number of varieties. One version of the argument is that housing busts
are usually the consequence of a recession triggered by other factors; i.e. it is claimed that
an exogenous shock in housing has never been the initial cause of a recession. Others
argue that the housing slump can lead to a recession only if there are other major shocks
in the economy, such as a war or oil supply shock like in 1974 or 1990. But my argument
about a housing-led recession has always been based on the fact that multiple bearish
shocks – high oil prices, the delayed effects of the increase in short and long term interest
rates, in addition to housing – have been buffeting a US consumer with falling real
wages, negative savings, falling confidence and rising debt and debt servicing ratios. So,
while the housing bust is necessary to tip over the US consumer, it is not the only factor
that will trigger the coming recession. Also, while it is true that housing may not have
been the initial trigger of a downturn in past recessions, it is also true that past recessions
– namely the one in 2001 – have been triggered by an asset bubble that went bust.
In the 1990s, the tech stock bubble – in part fed by a Greenspan complaining about
“irrational exuberance” but then wimping out and doing anything about such a bubble –
led to a massive over-investment of new capital spending in tech goods (computers, IT
networks, pet.com style internet companies, internet-related capital goods, etc.). This
super-glut of capital goods first led to the tech stock bust in the Nasdaq in 2000 when it
became obvious that these investments had low returns; then it lead to a bust of real
investment in software, equipment and machinery as the massive glut of capital goods
and excess capacity led to sharply falling investment rates for four years (from 2000 until
2004) to run down such excess capacity in the economy.
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In the last six years a similar bubble – an even more massive one – has taken place in the
housing market and has led to a boom and bust cycle that is qualitative identical to the
tech boom and bust of the 1990s. Initially, higher and higher home prices – fed by easy
Fed policy, speculative demand and a most favorable tax treatment of housing – first led
to a price bubble, then to a sharp increase in the supply of new housing, and finally to a
glut of new homes. At the beginning of this cycle, expectations of rising prices made
speculative demand for homes even higher, in a typical bubble fashion. But eventually
you had a fall in housing demand as speculative high prices and rising interest rates (that
came too slow and too late) made the purchases of housing less affordable to many.
More recently, the growing gap between rising supply and falling demand led to an
inventory adjustment – an increase in unsold homes. Next, you had a sharp fall in the
stock prices of homebuilders – by almost 50% by now - as the demand for their new
homes started to fall and their profits started to shrink. Then, most recently the reduction
in the production of new homes – as signaled by sharply lower housing starts and
building permits – ensued as homebuilders with falling revenues and profits and lower
expected demand finally reacted to the growing glut of unsold inventories. Finally, we
are observing now the unavoidable price adjustment with an actual fall in actual housing
prices as the glut of unsold homes is now putting sharp downward pressure on actual
prices.
So, and this is a crucial point, most US recessions have been triggered by a turnaround in
real investment. In most cases this fall in investment started in non-housing sectors – and
was triggered by a variety of economic shocks - but then spread to the housing market
once the economic slowdown got underway. But in the 2000-2001 episode, the actual
initial trigger for the slowdown was not a severe monetary tightening (even if the Fed did
hike interest rates by 175bps between 1999 and 2000) or a severe oil shock (even if oil
prices rose from low teens to high teens in 2000): it was rather the bursting of the bubble
and the bust of the tech sector – first the stocks, then the real investment – that led to the
recession. So, bubble cycles can and do lead to booms and busts that then cause
recessions – in the US and abroad. The reaction of the Fed to the tech bust of 2000-2001
then generated the housing bubble of the last five years in a new cycle of boom and bust.
So, the crucial point is not whether exogenous shocks to housing have ever led to a
recession: the crucial point is that recessions triggered by bursting assets bubbles have
occurred – most recently in 2000-2001 and will occur again this year as the housing
bubble is imploding.
In a previous longish paper (“Why Central Banks Should Burst Bubbles”) and other
writings, I have analyzed and criticized in detail the asymmetric Fed approach to asset
bubbles that is the source of these booms and busts. In the view of Greenspan, Bernanke
and Kohn the Fed should never target asset prices and should not try to prick an asset
bubble for two reasons: you are not sure there is a bubble in the first place; and trying to
prick an asset bubble is like attempting to perform “neurosurgery with a sledgehammer”,
i.e. the treatment will always be too harsh and kill the patient, i.e. economy. Thus, the
Greenspan-Bernanke view is that you do nothing when bubbles fester on the way up and
then you aggressively ease monetary policy when bubbles burst, since such falling
bubbles risk to cause severe real, not just financial, damage to the economy. This
asymmetry is the source of the Greenspan-Bernanke “put” and the moral hazard that this
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asymmetric insurance has created in financial markets: let bubbles fester on the way up,
do nothing about them and then pick up the debris and shelter investors from the free fall
when the bubbles burst. Speak about moral hazard. This is what happened in the tech
cycle of the 1990s and the same bubble cycle was created in the last few years in the
housing market. We will now see whether Bernanke will try to rescue the housing market
with aggressive Fed easing. Certainly, the next Fed move will be a cut when – in the fall
or winter - the signals of a US recession become even stronger than they are now.
Unfortunately, the Fed is running out of bubbles to be created and allowed to fester.
Thus, the “not-so-cool” but “perma-bull” WSJ op-ed page has it partly right and mostly
wrong: right in pointing out that the housing bubble was in part triggered by the Fed
easing too much and for too long and starting to tighten too little and too late. Mostly
wrong because: a) it supports the now flawed view that the Fed should not target asset
prices while sounding the usual and tired gold-bug style alarms about the risks of
inflation that are allegedly priced into the high asset prices of a barbaric relic such as
gold; b) it has been pushing the Fed to keep on tightening monetary policy now when the
coming recession will already reduce inflation; c) deluding itself in believing that a
recession is now avoidable, even more so if the Fed were to follow the senseless advice
of the WSJ and keep on raising the Fed Funds rate when the economy is spinning into a
recession. <>So, in summary, it is a spin to argue that housing alone cannot trigger a
recession. The tech bubble and bust did trigger a recession in 2001; and the housing
bubble and bust will trigger a deeper and nastier recession next year than the one in 2001:
as I have analyzed in detail in previous writings the effects of the housing bust will be
more severe and intense than those of the tech bust because the aggregate demand, wealth
and employment effects of housing are much larger than those of the tech sector. So, this
will indeed be the first housing-led recession and the second-in-a-row bubble-led
recession in six years. Also, as in all the US recessions since 1973, this investment bust –
in most cases first in non-residential investment and consumer durables – in this case first
in residential investment and consumer durables – will be the combination of three
similar factors: 1. shocks that hit investment, be it bubbles or other factors; 2. a monetary
tightening; 3. an oil shock. This has been the pattern in every recession since the 1970s
and it will be the same pattern in the recession of 2007.
Spin
#3: In spite of the housing slump, the levels of activity in the housing market
are still very high relative to a few years ago. So, there is no housing bust, only a
healthy correction.
Whenever I present on TV my views on a housing-led recession there is a pundit or
anchorman or guest expert that shows a few colorful charts of the housing markets and
spins: “Yes the housing market is correcting and housing starts and sales and all other
indicators are now falling BUT they are falling from very high levels; for example,
housing starts are still in the millions! LOOK: all these indicators were sharply rising
year after year and now they are only softening downwards; their absolute level is still
high relative to three or four years ago! SO, this is only a healthy adjustment from some
modest excesses!”
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These arguments are total nonsense for various reasons: 1. if an indicator that is at a high
level is falling at an annualized rate of 10, 20 or 30% - as many housing indicators are
now - there is still a housing bust regardless of the previous level: when first and second
derivatives show an accelerating fall, this is a bust and levels may, in due time, go back to
the previous lower level of a few years ago. 2. in a rising economy where economic
growth is positive, every real economic indicators heads up over time given the trend
growth of the economy: GDP, employment, consumption, real estate data, etc., they all
do. So, every economic time series looks like a rising chart given the underlying trend in
the economy: if you chart GDP over the last 60 years you see a straight line up where you
can barely notice – only by using a magnifying lens – the dozen or so recessions that did
occur during that period. Indeed, in a long term chart of the level of GDP these recessions
look like barely noticeable ripples in a increasing line. Still, when you get a recession
GDP falls and that fall – however short – is ugly and painful for jobs, incomes and the
economy. <>So, saying that housing indicators – while now sharply falling - are still
high or higher than previous levels is spin: of course they are still higher as long run
economic growth, demographic change with population growth and migration and a big
huge bubble for the last decade made them go higher and higher for years for
fundamental and non-fundamental reasons. Leaving aside periods of housing busts (and
we have had many of these busts in the last 60 years), the direction of all housing
indicators – like any economic indicator - is an upward trend line. Thus, even after we
had a nasty housing bust this year and next year, the level of housing indicators will be
higher than they were in 2000 or 1990 or 1980 or 1970 as you got trend growth and trend
population growth; this is basic Economics 101 that I teach daily to my students. And, as
any student of Economics 101 well knows, what matters for busts and recessions – when
you have trend growth - is not the level of a variable compared to past historical levels:
what matters is the direction of change: a protracted fall in the level of a variable
represents a bust in that sector and, if that bust is at the aggregate level, you call that a
recession.
Jim Hamilton at Econobrowser takes on the same spin arguments about the level of
activity in housing still being high in spite of the recent falls. He says: “Dave Altig at
Macroblog [1], [2], another source that's always worth reading, thinks the gloom and
doom has been overdone. Dave notes that even with a drop back to 2003 levels, home
sales per person are still at historically high levels, a point also noted by Bizzyblog and
some Econbrowser readers. I must say that I don't take much comfort in that. The bigger
the preceding surge in construction, the bigger the overhang that might now have to be
worked off. I certainly don't see much in the historical record to suggest that the more
dramatic the prior boom, the more modest was the subsequent bust. Just the opposite--
1929 (the year the Great Depression began) started out as a tremendous boom, as did
1973, which preceded the biggest U.S. recession since World War II.”
In summary, beware of misleading charts and arguments allegedly showing that housing
indicators are still at high levels, even when the tail of these charts looks like a free
falling death-defying sky slope with a slope close to 90 degrees.
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Spin
#4: If the housing bust gets ugly, the Fed will ease rates and rescue us from a
recession.
This spin-masterful wishful dream pins its hope on the Fed coming and rescuing the
economy from a recession if the housing bust were to affect the broader economy.
Indeed, as I have been arguing from an out-of-consensus line, the next move by the Fed –
this fall or winter – will certainly be a Fed Funds cut, certainly not an increase. This cut
will be triggered by signals that the economy is experiencing a hard landing and risking a
serious recession. Indeed, even before such a cut, the changed market mood about the
Fed next actions – so far a change in expectations from a Fed “pause” to a full “stop” –
has already led to a meaningful reduction in US long rates and in mortgage rates that
could, in principle, dampen the recession risks.
However, as I have argued before, such Fed easing will not rescue the housing market
and will not rescue the economy from a now unavoidable recession. The Fed easing will
not prevent a recession for the same reasons why the Fed pause and easing in 2000-2001
did not rescue the collapse in investment in the tech sector. The reasons why the Fed
cannot rescue housing and the economy are clear. First, Fed policy in 2001-2004 fed an
unsustainable housing bubble in the same way in which the Fed policy in the 1990s fed
the tech bubble. Now, like then, it payback time: with huge excess capacity in housing
(then in tech capital capacity) even much lower short and long rates will not make much
of a difference to housing demand. Real investment fell by 4% of GDP between 2000 and
2004 in spite of the Fed slashing the Fed Funds rate from 6.5% to 1.0%. Does anyone
believe or can show that a 50bps or even 100bps easing by the Fed will undo the housing
investment bust that is coming in the next two years? No realistic way: when there is a
glut of excess supply of capital goods or housing stock or consumer durables, the demand
for such durable consumption or investment becomes interest-rate insensitive. When
there is a glut of capital goods or consumer durables or housing as there is one now,
easing monetary policy becomes ineffective as it is like pushing on the proverbial string.
Second, a Fed easing in the fall may be too small - at most 50bps cut by Q1 of 2007 - and
will have too little of an effect on long rates to be able to affect the debt servicing ratios
of debt over-burdened households. Also, long rates will not be affected much by a Fed
ease for the same reasons – the global conditions that determined the 2004-2005 “bond
conundrum” – why a Fed tightening did not affect long rates in the recent experience.
Some easing by the Fed will have a little downward effect on long rates; indeed, long
rates have recently fallen as markets have started to price in the fact that the Fed is done
with tightening. But, if inflation were to actually rise further because of oil and other
stagflationary shocks, long rates may actually go up if an excessive Fed easing would
likely cause increases in long term inflation expectations. Since we are still facing
potentially stagflationary shocks, while the Fed will cut the Fed Funds rate during the
coming hard landing, the Fed can ill afford to ease too much as too much easing will be
counterproductive for bond rates and for housing. Thus either way households, burdened
with ARMs and overburdened with increasing housing debt at the time when housing
prices are slumping and now falling, can expect little relief from lower short rates or long
rates. The Fed just cannot rescue housing; it can only very modestly dampen its
protracted multi-year free fall.
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Indeed, in 2000 the Fed stopped tightening in June 2000 (after a 175bps hike between
June 1999 and June 2000). That early pause/stop did not prevent the economy from
slowing down from 5% plus growth in Q2 2000 to close to 0% growth in Q4 2000. Also,
the Fed started to aggressively ease rates – in between meetings in January 2001 – when
it dawned on the FOMC that they had totally miscalculated the H2 2000 slowdown (they
were worrying about rising inflation more than about slowing growth until November
2000 when it was too late). And this aggressive easing in 2001 did not prevent the
economy from spinning into a recession by Q1 of 2001. This time around you will get
into the same pattern: today’s 5.25% Fed Funds rate reflects the effects on the economy
of a Fed Funds rate closer to 4% given the lags in monetary policy and the effects of past
tightenings in the “pipeline” (as Bernanke and Yellen put it recently). So, pausing or
stopping now will not help (like the June 2000 pause/stop did not help) and easing in the
fall will be too late, in the same way in which the aggressive easing in early 2001 did not
help.
Spin
#5: Credit conditions in the housing market are not tight. Credit growth is still
perky and there is no credit crunch. So, unlike the past, there will be no hard
landing
A further spin is the argument that a housing bust and a wider economy-wide recession
requires tight credit conditions, while current credit conditions, in the housing market and
more generally in the economy, are not that tight. It is true that past recession have been
usually caused – in part – by a sharp tightening in monetary policy and tighter credit
conditions: the Fed tightened by 175bps between 1999 and 2000 for example; by that
standard, the current 425bps tightening by the Fed in the last two years is larger even if,
of course, what matters is the level of nominal – or even better – real interest rates.
Using a core measure of inflation, real rates are not so low for borrowers – even in
comparison to conditions in 2000. And for homebuilders now facing falling prices of the
goods they are selling – i.e. homes – the real borrowing rate is now extremely high as
home prices are now falling. Thus, the reduction in the real price of housing is a severe
credit crunch for homebuilders and contractors who are facing a fall in the relative price
of what they are selling at a time when there is a glut of new homes: no wonder that
building permits housing starts are in free fall (-21% and -13% respectively relative to a
year ago).
More importantly, you do not need a credit crunch in order to get an investment bust; if
an investment bubble has led to an excess supply of an real asset relative to its
fundamental demand, eventually the bursting of such a bubble will lead to a fall in the
speculative and fundamental demand for such an asset, regardless of a credit crunch: a
modest monetary tightening is enough to burst such a late-stage bubble (a bubble at the
late stage when overpricing is so excessive that small shocks are enough to prick the
bubble) and trigger a sharp fall in the real investment in such a capital good. The perfect
example was 2000-2001 when a 175bps tightening by the Fed between June 1999 and
June 2000 was enough to first prick and then burst a tech stock price bubble – that had
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led to the overinvestment in tech capital goods - and lead to a sharp fall in real investment
(by 4% of GDP between 2000 and 2004). The same is happening now with housing: the
425bps tightening by the Fed has finally burst an overinflated housing bubble that was
getting out of control with ever rising rate of increase of housing prices.
The crucial conceptual point - that is essential to understand why the housing bust will
lead to an economy-wide recession - is that it is not necessary to have a severe monetary
tightening or a severe credit crunch in order to have the bus of an investment boom that
was initially triggered by easy money and an unsustainable bubble. Once a modest
monetary tightening - or any other shock that prick the bubble - does occurs, the
investment bust can occur even without a credit crunch. That is what happened in 2000-
2001 with the tech stocks and the tech goods real investment; and that is what is
happening today with the bursting of the housing bubble.
In other terms, a housing-led recession can well occur even without a credit crunch. In
the case of a bursting bubble, the demand for credit – rather than the supply of credit – is
most important and a reduction in the demand for credit can be associated with a bust.
Indeed, recent lending indicators - both for housing and consumer loans - are also headed
south. While the supply of credit is not getting tighter based on recent surveys, the
demand for credit by firms and households is sharply slowing. Of course, the slowdown
in the demand for home mortgages is related to the housing slump. But now you are also
seeing lower demand for C&I loans; this suggests that investment spending may be
falling ahead, as already signaled by Q2 data on real investment in equipment and
software. The fall in the demand – rather than the supply - of mortgage financing is also
very clear in the data: while overall mortgage applications are still up in the latest figures
published this past week, due to sustained refinancing applications, applications for
purchase applications have fallen 1.0% during the last week, for the fifth time in the last
six weeks. Moreover, there is a large amount of evidence that suggests increasing
cancellations of initial mortgage applications, as the slump in the housing market and in
the economy is now scaring households considering buying a home. Thus, the official
data on purchase mortgage applications are very likely to exceed actual home sales as
cancellations increase over time.
Also, note that the demand for home equity withdrawal (HEW) will be sharply down
soon enough as the housing price flattening is turning into an outright fall in average
housing prices (as such prices already falling in most of the U.S. regions). And with
lessened HEW, the ability of households with negative savings to consume more than
their incomes - as they have been doing for two years with negative savings - will be
severely curtailed.
Finally note that, soon enough, credit conditions in the housing markets will become
tighter as an increasing number of homeowners – pinched by falling home prices, rising
mortgage servicing obligations and weak income growth - will be unable to service their
mortgages and will end up defaulting on them. Indeed, H&R Block stock price plunged
on Friday by 8.7% on news of large losses and loan liabilities related to rising mortgage
delinquencies at its Option One Mortgage unit: the problems result from an increase in
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mortgage customers who have fallen behind on loan payments. Not surprisingly, other
sub-prime mortgage lenders’ stock prices got a beating on Friday following the H&R
Block news and the news that a California home lender reported higher default rates.
These news are ominous as the housing bust will very soon lead to a sharp increase in
default rates on mortgages (see more on this below) and will, in short order, lead to a
credit crunch in the housing market. Thus, while until now there has been no credit
crunch and most of the action has come from a falling demand for housing credit, once
default rates start to skyrocket - and they will soon – you can expect a widespread credit
crunch in the housing sector that – like in the late 1980s – may eventually spread to the
rest of the economy. Indeed, there is a meaningful risk that – like in the S&L crisis of the
1980s – the housing bust will lead to the collapse of a large number of mortgage finance
institutions and a broad banking crisis (more on this risk below).
Spin
#6: Given the increase in housing prices there is still so much net wealth
(equity) in the housing sector that most households are richer, will keep on feeling
richer and will keep on spending more.
The “there is still trillions of untapped equity in housing” spin goes along the following
lines: “Doom & Gloom Eeyores worry about all the debt – now well above their incomes
- that households have been piling up in the last few year with new mortgages,
refinancing and consumer credit but, in spite of this larger debt, the increase in the value
of their housing, has led to a sharp increase in households’ net wealth; so, there is still
tons of untapped equity in housing and this untapped wealth will support home equity
withdrawal and consumption; so there is little risk that the housing bust will lead to a
consumption bust and a recession”
This spin can be deconstructed in many ways. First, is the increase in housing prices a
true positive wealth effect? Or just a factor that leads to a loosening of the credit
constraints that then allows households to use their homes as an ATM machine or as a
credit card? The wealth effects of an increase in housing values are more ambiguous than
the wealth effects of capital gains on financial assets, as households also consume the
services of such housing.
An example may suffice to clarify the problem of treating housing price increases as a
true wealth increase. I bought a loft in downtown NYC three years ago whose value has
gone up by 125% (an exact figure – not a guess- as it is based on the recent purchase of
an identical loft above me by a celebrity). Do I feel richer and should I consume more as
I am wealthier by 125%? The simple answer in no: if I wanted to cash the capital gain I
would have to sell the loft and buy another one with the same amenities and features; but
I will be paying the same higher price for the new loft to get the same housing services;
so no wealth effect. So, I am not wealthier in spite of a lofty 125% alleged “capital gain”:
what has happened is that the price of my consumption of housing services has increased
by 125% in the last three years; I am not richer: I am just paying more for the same
housing services in my now overpriced loft.
www.rgemonitor.com12
There are two counter-arguments to my argument that rising home price are not a true
positive wealth effect. First: “You could sell at the high current price, move to Idaho, buy
a much cheaper home and enjoy the capital gain; so you are richer!” Of course, that
counter-argument is nonsense: I want to live in NYC and enjoy the amenities of this city
life; so I am paying more for my housing service when the value of my loft goes up; I am
not richer. Indeed, the recent sharp increase in “owner equivalent rent” – after years in
which this contribution to CPI inflation was biased downward – is a reflection of the fact
that - as home prices have skyrocketed and made housing unaffordable to first time
buyers and forced them to rent homes rather than buy them - now rents are rising and this
implicit increase in the real prices of housing services is, finally, correctly reflected in our
CPI measure of inflation.
Second counter-argument: “If home prices are so high relative to rents – and indeed the
home price rental ratio was sharply up in the last few bubbly years – you should sell, rent
a home with similar features and then enjoy the capital gain; so you are indeed riche!r”
This argument is also flawed in many ways: a) it is true that many non-owners who could
not afford the crazy and rising home prices of the last few years have decided to rent
rather than buy and this is now pushing rental prices sharply higher; so the disequilibrium
in the relative returns and costs between owning and renting is now shrinking as rents are
adjusting upward; so this ownership-renting arbitrage is disapperaing; b) it is hard to find
for rental a home with the same amenities and features of a home that you purchase; c)
there are a lot of sunk costs involved in owning a home and thus selling and moving to
rental does not make sense: home ownership has psychic benefits and it also has positive
social externalities’ benefits that many studies suggest; also, buying a home includes
investing a lot in home-specific durable good purchases (furniture, home appliances,
décor and design of a home) that are not easily and costlessly transferable to a rented
unit. So, in practice – given all these sunk costs and benefits of owning - almost all of the
homeowners do not sell and move to rentals when the home-price to rental ratio is in
disequilibrium and out of line. They rather pay a higher price for their consumption of
housing services. So, they are not richer: in some sense, they are poorer as they are
paying more for the consumption of the same housing services.
Of course, I do not want to argue that all increases in housing wealth coming from an
increase in home prices are not a true wealth increase. Some of it may be truly perceived
and be an increase in net worth; I am just saying that it is not conceptually so clear that
most of it is a true positive wealth effect as housing is an asset whose return is
represented by the consumption of its own services. Also, some older households
eventually retire and go to cheaper housing location or sell and downsize the size of their
home to a smaller one when their children have left home; so they can benefit of some of
the capital gain. But for many households – including myself – the recent increase in
housing prices is not a true increase in wealth.
So, the next question becomes: why would households borrow so much more – as they
have done in recent years - against their increased housing wealth when home prices go
up – and spend it on consumption - if most of this price increase is not a “true” wealth
effect? The answer is twofold: first, there may be some degree of wealth illusion and
some households that downsize are actually able to benefit from a “true” capital gain;
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second, even if a household is not truly wealthier, a paper increase in the value of the
home allows a households to reduce its credit constraint in the capital market: i.e. a
household is able to borrow more against this alleged increased “home equity”. So, what
an increase in home prices does it to loosen the credit constraints of households, both
how much they can borrow as well as the interest rate at which they can borrow as the
collateral of housing wealth reduces the cost of such borrowing relative to the cost of
uncollateralized borrowing (say credit card debt).
Thus, households that are credit constrained and whose incomes are not rising fast
enough to keep up with their increased consumption patterns re increasingly borrowing to
be able to keep on spending above their incomes. Indeed, as households’ savings rates
having been negative for the last two years the only way households could consume more
than their incomes was to use their homes as their ATM machines, i.e. running their debts
via refinancing and other increases in consumer debt. Note that running down assets
rather than increasing debt – to finance an excess of consumption over income - does not
work for most US households as their liquid assets are small and as most their assets are
in highly illiquid forms (housing and investments in 401k plans and other retirement
savings plans that – given their tax-deferral advantages – are effectively highly illiquid).
Indeed, in 2005 out of the $800 billion of Home Equity Withdrawal (HEW) at least $150
or possibly $200 billion was spent on consumption and another good $100 billion plus
went into residential investment (i.e. house capital improvements/expansions). The rest
of it was used – most likely – to manage household assets (increase buffers of liquidity)
and liabilities, i.e. reduce the stock of uncollateralized high-interest debt in exchange of
lower interest rate housing-collateralized home equity loans or refinancings. But this
massive amount of recent refinancing and HEW means that it is enough for house price
to flatten, as they already have done recently, let alone start falling as they are right now
in major US housing markets, for the wealth effect to shrink and for the ability to borrow
to be reduced; then, the HEW will dribble down to much lower levels than in the recent
past and consumption growth will sharply fall and possibly stall.
Would the fact that households still have a large amount of untapped housing wealth
untapped imply that they can and want to further withdraw such equity and sustain their
previous consumption patterns? No for several reasons: First, note that this year there
will be large increases in the borrowing costs for $1 trillion of ARMs that will be repriced
and this figure for 2007 will be $1.8 trillion. As short-term interest rates have
sharply increased in the last two years, this repricing of low interest rate ARMs will
imply sharply increasing payments on past mortgages and refinancing loans. Thus, debt
servicing costs for millions of homeowners will sharply increase this year and next as
$2.8 trillion of mortgages will be repriced.
Second, many households do not have much housing equity to begin with. In fact, as
recently argued by Lon Witter in Barrons (hat tip to Ritholtz for this), 32.6% of new
mortgages and home-equity loans in 2005 were interest rate only, up from a figure of
0.6% in 2000; 43% of all first-time home buyers in 2005 put no money down and thus
www.rgemonitor.com14
had no initial equity in their homes; 15.2% of 2005 buyers owe at least 10% more than
their home is worth (in other terms they have negative equity); and 10% of all home
owners with mortgages have no equity in their homes (in other terms, they have zero
equity).
Moreover, the expected fall in home prices that is currently occurring implies that the
existing home equity is actually shrinking over time. Worse, a combination of increased
debt, increased interest rates on these home mortgages, falling real wages – especially for
poorer households – and shrinking home equity (that for many may actually mean
negative equity) will imply that it will become increasingly hard for millions of
households to service their mortgages. Many of these households will end up defaulting
on such mortgages and thus be subject to foreclosure of their homes. Notice that for
households with negative home equity that are unable to service their debt obligations it
is a rational choice to default as the costs of default will become smaller than the benefits
of continuing to service a liability on an asset for which they have negative equity. So,
the likelihood of default by households with negative home equity will be large.
But even households with positive but low amounts of home equity may decide to default
if they cannot service the increased payments on their mortgages: these households may
become liquidity constrained when low income and increasing debt servicing on the
principal and interest on the mortgage produces a binding credit constraint. Ability to
refinance or extract equity at low interest rates will disappear and, only under conditions
of financial distress and near default, some households may be able to restructure their
mortgage liabilities and avoid outright default and foreclosure. Either way it will be very
ugly for millions of households who will outright default or restructure their debt
obligations. And the increases in delinquencies that H&R Block and other sub-prime
mortgage lender are already observing now is only the tip of this delinquency iceberg that
will become much worse when the economy slows down further and falls into an outright
recession. Note that you do not need a fully fledged recession to have this severe
pressure and rising delinquencies: a growth slowdown and rising debt obligations will be
enough to tip over the cliff millions of weaker mortgage borrowers. Moreover, with the
recent changes in personal bankruptcy laws, that make it more painful for individuals to
default, the negative income and consumption effects of default will be more severe: the
new law – by making the costs of default higher – will leave defaulting households
poorer and with less resources for consumption. Thus, the consumption and demand hit
from default will be more severe than in the past.
Note also that, even for households with meaningful amounts of untapped home equity,
the slowdown and then outright fall in home prices together with higher debt servicing
ratios and flat or falling real wages and negative savings, the ability and willingness to
further extract home equity will sharply shrink. Indeed, for US households to continue to
consume at a rate that is 2% higher than their incomes – as they have done on average
since 2005 - implies a significant persistent reduction over time of their remaining home
equity; obviously, this Ponzi game of running down one’s own assets to finance an
excess of consumption over income cannot go on forever and is not even a optimal path
that rational households will take. More rationally, with the housing bust and falling
prices, households are been pinched by a negative wealth effect and are starting to cut
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back on consumption and reduce the rate at which they are dissaving. Indeed, based on
the experience of countries such as the UK, Australia and New Zealand, it is enough for
home prices inflation to slow down – let alone to outright fall as they are now in the US –
for HEW to sharply fall. And since household savings in the US are negative – unlike the
US, Australia and New Zealand – this sharp slowdown in HEW will have much more
severe effects on consumption than in the other countries where the fall in HEW did
indeed lead to a sharp slowdown – but not outright fall - in consumption.
Thus, the coming US housing bust and fall in home prices will have a significant and
severe effect on consumption and will be a key transmission factor that will trigger a
broader consumption retrenchment and a recession.
Spin
#7: Banks and mortgage lender are still very sound and there is no risk of
systemic banking crisis.
The other spin that one hears over and over again is that, unlike the 1980s when we had a
systemic banking crisis (the famous Savings & Loans (S&L) crisis) today banks and
mortgage finance institutions are very sound and with low delinquency rates: default rates
on mortgages are still low if rising.
The reality is quite different and much uglier: the housing bubble of the last few years
may have planted the seeds of another nasty systemic banking crisis that could be more
severe and costly than the S&L crisis of the late 1980s. First, notice that the housing
boom of the last few years has led to a credit boom that is quite unprecedented for the US
in recent history. Credit boom and excessive overlending episodes – based on cross
country experience – often lead to credit busts that cause both banking and financial
crises as well as economic recessions.
Second, not only we have had in the last few years a massive credit boom associated with
the debt financing of the housing bubble; this lending boom has also been associated with
an extreme loosening of credit standards that allowed the boom to continue and feed an
ever more unsustainable housing bubble. Indeed, many mortgage lenders have gambled
for redemption during the bubble years and engaged in extremely risky and reckless
lending practices that may eventually lead to financial distress, or even their outright
bankruptcy; we may be soon facing the same mess and systemic banking crisis that we
had in the 1980s with the S&L crisis. The lending practices of mortgage lenders became
increasingly reckless in the last few years: indeed, in 2005 a good third of all new
mortgages and home equity loans became interest rate only; over 40% of all first-time
home buyer were putting no money down; at least 15% of buyers had negative equity;
and an increasing fraction of mortgage came with negative amortization (i.e. debt service
payments were not covering interest charges, so the shortfall was added to principal in a
Ponzi game of accumulating debt). Finally, at least 10% of all home owners with
mortgages currently have zero equity.
www.rgemonitor.com16
This reckless lending scam was fed by ever loosening lending standards, the massive
growth of sub-prime lending and over-inflated valuations of homes to justify new
mortgages and refinancings (when significant equity extraction was occurring). It was a
vast and growing lending scam where lenders’ behavior was distorted by serious moral
hazard incentives driven by poorly priced deposit insurance, lax supervision of lending
practices by regulatory and supervisory authorities, slipping capital adequacy ratios, toobig-
to-fail distortions and the distortions created by the financing activities of the too-bigto-
fail government sponsored enterprises (Fannie Mae and Freddie Mac). Indeed, you can
expect the WSJ op-ed page soon to blame the entire coming housing and banking crisis
on the activities of these GSE’s (on top of blaming on the Greenspan and Bernanke put).
Citing the recent article by Lon Witter in Barrons, Barry Ritholtz clearly describes the
reckless lending practices of many lenders:
Traditionally, Mortgages have been low risk lending, as the loan is securitized by the
underlying property. When banks were lending less than the value of the property (LTV),
to people with good credit, who also were invested in the property (substantial down
payments) you had the makings of a very good business: low risk, moderate, predictable
returns, minimal defaults. That model seems to have been forgotten. THIS IS
REMINSCENT OF THE S&L CRISIS -- where lenders did not have any repercussions for
their bad loans!
As bad as the above numbers look, the thinking behind them is worse:
"Lenders have encouraged people to use the appreciation in value of their houses as
collateral for an unaffordable loan, an idea similar to the junk bonds being pushed in the
late 1980s. The concept was to use the company you were taking over as collateral for
the loan you needed to take over the company in the first place. The implosion of that
idea caused the 1989 mini-crash.
Now the house is the bank's collateral for the questionable loan. But what happens if the
value of the house starts to drop?"
A good example of how this is unfolding at lending institutions comes from Washington
Mutual: You may recall Washington Mutual laid off 2500 employees in their mortgage
broker department earlier this year. As LTV went above 100%, and then as property
values decayed from recent peaks, the collateralized aspect of these mortgages suddenly
is at risk.
Here's how this has played out over the past few years via WaMu's ARM loans (data via
Washington Mutual's annual report):
www.rgemonitor.com17
- 2003 year end, 1% of WaMu's option ARMS were in negative amortization (payments
were not covering interest charges, so the shortfall was added to principal).
- 2004, the percentage jumped to 21%.
- 2005, the percentage jumped again to 47%. By value of the loans, the percentage was
55%.
So each month, the borrowers' debt increases; Note there is no strict disclosure
requirement for negative amortization -- Banks do not have an affirmative obligation to
disclose this to mortgagees.
Thus, a large part of our housing system have become credit cards. And according to
Witter, "WaMu's situation is the norm, not the exception."
Even worse, Witter notes that negative amortization is booked by the banks as earnings.
"In Q1 2005, WaMu booked $25 million of negative amortization as earnings; in the
same period for 2006 the number was $203 million."
This situation is unsustainable. Witter's housing and market forecast is rather bearish:
"Negative amortization and other short-term loans on long-term assets don't work
because eventually too many borrowers are unable to pay the loans down -- or unwilling
to keep paying for an asset that has declined in value relative to their outstanding
balance. Even a relatively brief period of rising mortgage payments, rising debt and
falling home values will collapse the system. And when the housing-finance system goes,
the rest of the economy will go with it.
By the release of the August housing numbers, it should become clear that the housing
market is beginning a significant decline. When this realization hits home, investors will
finally have to confront the fact that they are gambling on people who took out nomoney-
down, interest-only, adjustable-rate mortgages at the top of the market and the
financial institutions that made those loans. The stock market should then begin a 25%-
30% decline. If the market ignores the warning signs until fall, the decline could occur in
a single week."
As Witter puts it and Ritholtz concurs, the scariest thing is that the gambling-forredemption
behavior and problems of WaMu are not the exception in the mortgage
industry; they are instead the norm. There are good reasons to believe that this is indeed
the norm as lending practices have become increasingly reckless in the go-go years of the
housing bubble and credit boom.
If this kind of behavior is – as likely – the norm, the coming housing bust may lead to a
more severe financial and banking crisis than the S&L crisis of the 1980s. The recent
increased financial problems of H&R Block and other sub-prime lending institutions may
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thus be the proverbial canary in the mine – or tip of the iceberg - and signal the more
severe financial distress that many housing lenders will face when the current housing
slump turns into a broader and uglier housing bust that will be associated with a broader
economic recession. You can then have millions of households with falling wealth,
reduced real incomes and lost jobs being unable to service their mortgages and defaulting
on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a
credit crunch as lending standards are suddenly and sharply tightened with the increased
probability of defaults; and finally mortgage lending institutions - with increased losses
and saddled with foreclosed properties whose value is falling and that are worth much
less than the initial mortgages – that increasingly experience financial distress and risk
going bust.
One cannot even exclude systemic risk consequences if the housing bust combined with a
recession leads to a bust of the mortgage backed securities (MBS) market and triggers
severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly
scenario that Greenspan worried about may come true: the implicit moral hazard coming
from the activities of GSEs - that are formally private but that act as if they were large
too-big-to-fail public institutions given the market perception that the US Treasury would
bail them out in case of a systemic housing and financial distress – becomes explicit.
Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial
and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to
the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change
compared to the trillions of dollars of implicit liabilities that a more severe home lending
industry financial crisis and a GSEs crisis would lead to.
Spin
#8: Housing may be getting into a slump but such a limited sectoral slump
cannot and will not cause a broad economy-wide recession.
The last and most delusional spin that one often hears is the view that the housing
problems will not lead to a broader economy-wide recession. There are two variants of
this spin: the first is that housing slowdown will be, at worst, a modest slump or
slowdown with no severe housing sector bust; thus, a limited housing slowdown cannot
lead to a wider economic recession. The other variant of this spin is that housing may
experience a more severe slump or even a sharp and painful hard landing but – for a
variety of reasons – such sectoral hard landing will not lead to an economy-wide hard
landing, i.e. it will not lead to a recession. Why could the overall US economy decouple
from a housing hard landing? The arguments are the trite and concocted ones that one
hears over and over again: real residential investment is only 6% of GDP and housing
indicator levels are still high in spite of their recent fall; very few people are directly
employed in housing; homeowners have still trillions of untapped equity; the US
consumer has always been resilient; HEW will continue at sustained rates and consumers
will keep on borrowing to finance consumption above their incomes; the labor market is
doing well; corporations are flush with liquidity and profits; monetary conditions are still
www.rgemonitor.com19
easy even after 17consecutive Fed Funds hikes; credit growth is still buoyant, there is no
credit crunch and mortgage lenders are sound; the Fed will come to the rescue and cut
sharply rates if the slowdown becomes excessive; we will have a soft landing like in
1994-95; there has never been and there cannot be a housing-triggered recession.
The long discussion above – and my previous analysis of the housing bust - has already
dissected and refuted one by one these arguments and shown why a housing hard landing
will lead to a sharp and severe recession: the fall in real residential investment and its
effects on aggregate demand will be larger than the 2000-2001 tech bust; the employment
effects of the housing bust will be larger than the tech bust as – directly or indirectly –
30% of recent employment growth has been housing-related; the wealth effects of a bust
in housing will be large and larger than those of the tech stock bust as homeownership is
widespread and housing is a significant fraction of households’ wealth; a housing-related
recession can occur if triggered by a housing bubble bursting in the same way in which
the bursting of the tech bubble in 2000 led to a recession in 2001; households are now at
a tipping point and in a foul mood (as evidenced by the sharply falling consumer
confidence level) being buffeted by slumping housing, high and rising oil and energy
prices and the delayed effects of rising policy rates while experiencing falling real wages,
negative savings and high and rising debt and debt servicing ratios; and Fed attempts to
prevent the recessions via a cut in interest rate in the fall or winter will fail to avoid the
recession as an unprecedented glut of housing and of consumer durables – starting with
cars, home appliances and furniture – will make the demand for housing and durables
insensitive to changes in short term and long term interest rates; the housing bust may
lead to a banking and financial crisis that may be more acute - and cause a more severe
credit crunch – than the S&L crisis of the 1980s and early 1990s that led to the 1990-
1991 recession.
These are the reasons why I have argued that the developing housing bust – together with
the other shocks that are buffeting the US consumer and the US economy – will cause an
ugly, sharp, painful and protracted economic recession in 2007 that will be deeper and
nastier than the previous two recessions in 1990-1991 and 2001. The dynamics and
triggers of this recession will share the features of the reckless real estate lending boom
excesses that lead to the S&L crisis and ensuing credit crunch of the 1980s and
eventually caused the1990-1991 recession together with the bubble excesses – then of the
tech sector, now of the housing sector - of the late 1990s whose bursting starting in 2000
triggered the recession of 2001. In all three cases, you had the toxic combination of three
factors that made – and will make in 2007 – a recession unavoidable.
First, investment excesses, loose monetary policies, reckless credit booms and financial
bubbles that led to massive real overinvestment in capital goods: in real estate in the 80s;
in tech goods in the 90s; in housing in the 00s.
www.rgemonitor.com20
Second, politically-triggered oil price shocks: the Iraqi invasion of Kuwait in 1990; the
second intifada in 2000; the terrorist threats, geostrategic tensions and geopolitical
constraints to increased oil supply in Iran, Iraq, Nigeria, Venezuela, Russia and the
Middle East since 2003.
Third, a tightening of monetary policy resulting from rising inflation concerns – the Fed
tightening and the S&L related credit crunch in the late 1980s; the 175bps Fed Funds
hike between 1999 and 2000; and the 17 consecutive Fed Funds hikes leading to a
cumulative increase of 425bps in the Fed Funds rate since 2004.
In those previous two episodes – and even in the recession of 1974-75 and 1980-82 – this
triple whammy of shocks – an investment bust, an oil shocks and monetary tightening
following inflation threats - led to a recession. It is up to the perma-bull supporters of the
“soft landing” view to explain in some detail why the current cycle will be different and
why the US economy – as they argue – will avoid a hard landing. All the relevant macro
signals and indicators and an analysis of comparative factors suggest that this time
around we will not have just a hard landing; we will have a painful, ugly and protracted
recession in 2007 that will be deeper and more severe than the moderate recessions in
1990-91 and 2001.
For more details and discussion, follow RGE Monitor’s (
www.rgemonitor.com)continued coverage of the US and global economy and of developments in the housing
market.
#008800">256,12 (1,59%)
(Alzheimer?)
Salut! 
