International Perspective, by Marshall Auerback

Housing Bubble Deflating: Will The Us Consumer Follow?

September 10, 2002

U.S. consumer profligacy has persisted for so long that it is has become hard to envisage what would stop it in its tracks. All traditional determinants of spending have pointed to an imminent decline in consumption, yet none of these indicators have thus far been validated by sharp declines in expenditures. A historically anomalous willingness of US households to increase their rate of debt accumulation in order to stay on a rising path of consumption has been one of the most striking features of the US economy as have come into the 21^st century.

Through Q2 2002, the financial balance of the US household sector remains in its worst position since the hoarding wave prior to the Korean War. The duration, if not the depth of household spending in excess of income flows during this past business cycle, is simply unprecedented. Declining stock wealth has not curbed the consumer?s animal spirits, despite record public participation in the equity market. Nor have record high debt levels per se because it is argued that lower interest rates have served to cushion the consumer?s debt burden (even if aggregate debt service to income is at an all time high). Consumer spending has risen despite declines in the various measures of consumer sentiment, so this appears to be yet another unhelpful indicator.

The consumer?s perverse debt-laden rush toward the cliff face has really found only one cogent explanation, which has drawn the attention of an increasingly large number of analysts ? namely, the housing market bubble and the corresponding impact of mortgage refinancings. Until recently, the persistent appreciation in house prices has enabled the US consumer to treat his home virtually like a cash point machine. Higher valuations have enabled American households to extract increasing equity from their respective homes, whilst declining interest rates through multiple mortgage refinancings have also helped to buttress consumer expenditures by lowering their interest rate bills. This has been made possible by very low nominal interest rates and aggressive policies of mortgage finance, orchestrated through the Federal Reserve and Government Sponsored Enterprises (GSEs), such as Fannie Mae and Freddy Mac. US fiscal policy has also been very stimulative ? in a year and a half the fiscal balance has swung by a full 5 per cent of GDP.

But there are some crucial differences today. Evidence is mounting that housing prices are peaking (thereby diminishing the scope for further equity extraction on the basis of higher valuations), and the comparatively low existing interest rate environment means that future cuts will give the consumer less bang for his buck in terms of savings on the interest rate bill. Generally speaking, Fed funds declining from 4.75 per cent to an existing 1.75 per cent will have a much greater impact than falls from 1.75 per cent to zero.

There is an equally germane consideration: previous refinancing booms took place against the backdrop of an expanding economy, in which the one-off boost from mortgage refinancing occurred in the context of other cumulative dynamics of economic expansion, including rising house prices. This is precisely the opposite of current conditions which pertain today. In addition to intensifying recessionary pressures (reflected by substantial falls in the equity market), we are also confronted with an environment overlaid with the imminent prospect of war with Iraq, an event that has the potential for a further exogenous shock to expenditures. In today?s post bubble environment, the fear of default must surely be viewed as an implicit cost that is now getting factored in to household portfolio decisions, especially given the deflation of equity wealth and the increasing signs that the housing bubble is losing altitude. Thus, the long-awaited rebuild of US household savings may be upon us ? a necessary precondition for future growth, but with wrenching adjustment implications today for the American economy, given the extent to which growth has hitherto been fuelled by private household consumption and the issuance of debt.

Figures from the House Price Index from the Office of the Federal Housing Enterprise Oversight show that since 1995 house prices have risen far in excess of the rate of inflation. Over this seven year period, home sale prices have risen by more than 47 per cent in nominal terms, an amount that is nearly 30 per cent above the rate of inflation. This run-up in housing prices has translated into an additional $2.7 trillion in housing wealth, more than $35,000 per average American home owner, compared to a scenario in which house prices had only kept pace with underlying inflation.

What has this meant in terms of US consumption? There have been some attempts to quantify the extent to which the housing market has shaped consumer expenditure patterns. According to Alan Greenspan, 10% to 15% of the rise in housing wealth is consumed whereas only 3% to 5% of the rise in stock market wealth is saved. Since US households now have almost 50% more assets in housing than equity, then the ratio is about 4.5: 1. That is, a 1% rise year-on-year in house prices offsets a 4.5% year-on-year fall in equity prices). Based on this analysis, the current 7.1% median US house price inflation offsets a 33% year-on-year decline in equity prices. More optimistic still, a 2001 NBER paper by Shiller, Quigley and Case conclude that the housing wealth effect is 11% to 17% (internationally) and 9% to 11% in the US while the stock market wealth effect was just 2% (and with no statistical significance on the regression).

This analysis would certainly help to explain why the debt laden US consumer has not yet demonstrated a greater propensity to save. Quite simply, when consumers see their own homes appreciating in value, they feel less inclination to put aside income for the future. Largely as a result of this run-up in home prices, consumption has remained high and savings rates have remained miniscule, even though all other determinants of consumption (e.g. debt, falling equity prices, etc.) suggest that the opposite should be occurring at this juncture.

It is fascinating to us that so many people are finally ready to accept the crucial importance of housing in fuelling this buying binge. For many years, Doug Noland?s assertion that the housing market and the concomitant mortgage refinancing boom was a key, yet substantially overlooked, determinant of consumer expenditures was a hugely controversial position. But as evidence has mounted that this has indeed been the case, it has metamorphosed into a simplistic axiom to the effect that when mortgage refinancings rise, so automatically do consumer expenditures. And mortgage refinancings have again been strongly on the rise since July. Does this imply that another consumption boom lies ahead?

Ironically, just as this idea has become received wisdom, there are signs that consumer expenditure is finally faltering despite the increase in refi activity. Having previously minimized the importance of such activity, most of the analytical community on Wall Street now tends to view such activity in an isolated context, failing to observe such refi activity previously was taking place in the context of rising house prices and growing employment. There are many statistical and anecdotal signs, however, to suggest that housing prices have begun to roll over: softening prices of vacation homes, lengthening of houses on the market before sale, and a substantial build-up in housing ?inventory?. Consider the following excerpt from a Rocky Mountain News story on the Denver housing market, which is typical of many municipalities:

'For sale' signs not adding up

Record 22,910 homes available; July report was off mark by 56%

By John Rebchook, Rocky Mountain News
August 29, 2002

If you think there are a lot more homes for sale in your neighborhood than
reported, you're probably right.

A record 22,910 unsold single-family homes and town homes are on the market
this month. A computer glitch discovered this week revealed a whopping 56
per cent discrepancy from the 14,717 unsold homes reported in July.

Because the glut of unsold homes is so much greater than previously
believed, it could force sellers to lower the asking price of their homes.
Combined with some of the lowest mortgage rates in nearly 40 years, falling
prices on a huge inventory of unsold homes could make this an ideal time to
buy.

"It is, if you have a stable income," said Byron Koste, head of the
University of Colorado Real Estate Center at the Leeds School of Business.
"If you don't, you're playing Russian roulette."

In July, 20,005 unsold homes and town homes were actually on the market,
according to a calculation by a veteran real estate agent, Norm Waugh...

While home prices are hovering at record levels, Jerry McGuire says they're
heading lower.

A report to be released today will show the average price of a single-family
home sold in August is $274,802, slightly off the record $274,904 set in
July.

Ed Jalowsky, a broker with Classic Advantage Realty, said the glut helps
explain why so many houses are languishing on the market.

"If I knew there were 50 percent more homes on the market than being
reported, I would have told my clients to lower their prices faster,"
Jalowsky said. "You have to. It's the law of supply and demand. The supply
is going up, and the demand is going down."

Waugh said it's hard to say how much of an impact the incorrect reporting of
the numbers has had on the market.

We have heard comparable anecdotes in markets as diverse as San Francisco, Tampa, and the Northeast. (To be sure, there are obviously going to be regional disparities within a country as large and geographically diverse as the US and, by extension, those regions that have not experienced anything like a housing bubble, will clearly not suffer from comparable deflationary after-effects.) A recent report by Merrill Lynch has highlighted another risk which threatens to undercut the strength of the housing. The report notes a surge since year end 2000 in home equity loan loss rates. Rob Parenteau of Dresdner RCM notes the ominous implications for the housing market (and, by extension, US consumption trends):

?If it becomes harder to securitize home equity loans in asset backed vehicles, banks will not be able to get these loans off these books as fast as they used to. They in turn are likely to become less willing to make home equity loans, or, at a minimum, are likely to engage in more serious credit analysis before making new home equity loans if it becomes harder to securitize them off their balance sheets. Quantity credit rationing to the household sector would be the result, which would seriously confound Chairman Greenspan's earnest efforts to sustain if not accelerate a housing bubble in the US. While it is too early to say this credit tripwire has been triggered, it bears close monitoring, since any threat to a US housing bubble is equally a threat to global economic recovery and so begs the double dip question.?

Needless to say, a consumer boom predicated on mortgage refinancing presupposes an ongoing ability to service one's mortgage. Even that is now coming into question. The percentage of first mortgage loans more than 30 days past due rose by 12 basis points in the second quarter to 4.77 per cent, the Mortgage Bankers Association of America said yesterday. The percentage of FHA loans that are delinquent rose to a record high 11.81, the trade group said. The group's quarterly survey also showed the number of home loans on which foreclosure was started rose to its highest quarterly rate ever at 0.4 per cent. That this is occurring with mortgage rates at forty year lows provides eloquent testimony to the parlous state of the American consumer's personal balance sheet.

Why have people focused so much on the refinancing issue? According to one estimate of CSFB economist, Paddy Jilek, the refinancing wave in the US could add as much $250bn to $300bn to consumers' discretionary cash flow (up from $150bn last year). At this stage, however, the more germane question is what consumers will actually do with the incremental cash. For there is increasing evidence to suggest that acute debt distress, coupled with an apparent peak in many regional housing markets, is leading to an increased propensity to save, rather than spend. Certainly, the deceleration in revolving credit growth from double digit year on year growth rates last year to near 25 year lows (around 2.5%) indicates that consumers are finally paying back debt.

Of course, one could make the contention that just as analysts underestimated the impact of mortgage refinancings on past consumption trends, so they are guilty of overestimating its impact this time around. Mortgage refinancings give households a one shot opportunity to cash out and spend. When the refinancing surge reverses, all things being equal, consumer spending should fall. But those optimistic about the US economy might still seek to argue that one should not necessarily view this fall as an ominous portent for future US economic growth, because in the past once the effects of such refi booms have been passed on, the economy did not collapse.

It is true that prior historical episodes with refinancing surges do not reveal immediate subsequent significant declines in consumer spending. A recent study on US consumption by Frank Veneroso explains why:

?The Fed lowers rates and refinancings surge. And stock prices rise. And firms hire and employment expands. And firms need more capacity and have the profits to finance more capacity and so capital spending rises in turn. The Fed ease that triggers the refinancing surge sets into motion the cumulative dynamics of an economic expansion. Consumer expenditures derived solely from cash outs from mortgage refinancings do abate. But in the many other ways associated with cumulative expansions consumer incomes and sentiments are lifted and so consumption expenditures are kept on an upward path... Consumer spending growth seems to track employment growth more closely than refinancings, suggesting that the impact of the cumulative dynamics of an economic expansion impact consumer spending in large part via employment conditions.?

Veneroso highlights a crucial point overlooked by many: most mortgage refinancings in the past took place in the context of a strong economy, coupled with reasonable employment growth. Today?s current round of refi activity is happening in an economy in which the cumulative dynamics of an economic expansion are not taking place; quite the contrary in fact. Stock prices have been falling. Capital expenditure is still being cut back. Corporate profits are still falling. And (despite last week?s employment report), the trend toward higher unemployment is unmistakable. Today?s refi activity in fact looks more like a desperate attempt by the consumer to build a liquidity net egg, akin to Minsky?s description of Ponzi-finance in which one uses the flows of further debt issuance (as opposed to cash flow) to service existing borrowings. This is inherently unsustainable; clearly one cannot continue to borrow at 6.75 per cent and stick the money in savings accounts yielding less than 2 per cent. The US consumer, laden with debts taken on in the euphoria of the late 1990s, therefore remains exceedingly vulnerable to further retrenchment if these adverse trends continue. If the urge to save replaces the consumer?s unsustainable willingness to splash out, the US recovery, indeed, much of the global recovery, will be sunk. If this occurs against the backdrop of sharply rising oil prices and a war, another global economic downturn would be all but certain.

The Japanese economy experienced simultaneous bubbles in its housing and stock markets in the late eighties. The collapse of these two bubbles has left Japan?s economy nearly stagnant for more than a decade. The United States faces the same sorts of risk from the collapse of its stock market and housing bubbles (both of which are symptoms of the larger credit bubble). The evidence suggests that it is far too simplistic to presuppose that a refinancing boom will usher in another period of booming consumption in the absence of further cumulative dynamics of economic expansion, particularly rising employment. It was poor economic policy to allow these bubbles to develop in the first place. Yet policy makers in America continue to display a curious reluctance to acknowledge past errors; they appear more interested in rewriting history to exculpate themselves. This leaves one less hopeful that the right policy mix to deal with the collapse of these bubbles will be found any time soon.

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