Figuring out the direction of interest rates is a daunting task. You cannot press a button on a mathematical model and get the answer. Interest rates are historic phenomena. They depend crucially on forces peculiar to the economy at the time. Interest rates hit modern highs in 1981 because Federal Reserve Chairman Paul Volcker needed to turn the corner on double-digit inflation. Tight money did the trick. Interest rates hit multi-decade lows in 2003 as Chairman Alan Greenspan eased monetary policy to take out insurance against a Japanese style deflation. Today the economy is in a wholly different configuration. The largest housing bubble in U.S. history has burst, with serious repercussions for credit markets and economic growth. A credit crunch of indeterminate proportions is underway. The cat of falling interest rates is out of the bag.
The Great Home Price Collapse
As recently as the 1990s, the median-income family was able to afford the median-priced home. From 2000 on though, until the market peaked in 2006, home price appreciation outstripped income growth. The Office of Federal Housing Enterprise Oversight (OFHEO) price index rose 38% more than per capita disposable income during the boom. If income keeps growing at 4%, while home prices ratchet lower at a 7% rate, it will take two years or more before the pre-boom equilibrium is restored. Case-Shiller futures prices and Radar Logic index return swaps imply the housing downturn may extend three years. The crux of the matter is markets need to get back to where people can comfortably afford to make principal and interest payments out of ordinary income. As falling home prices move in that direction, they are delivering a one-two punch.
Spillover to Consumer Spending
Consumer spending is taking the first blow. For the past six years, consumers outspent their paychecks by borrowing against rising home values. During that time home equity rose by over $3 trillion. People felt wealthier and spent more. The housing price bubble facilitated this. Homeowner equity peaked a year ago. If home prices follow the track envisioned, equity will fall by $1 trillion over the next two years. All types of homeowners–not just those with mortgages–will feel poorer and the rate of consumer spending will fall well below income growth. Since consumer spending is 72% of gross domestic product, this will seriously slow the overall economy.
The Credit Crunch
The other blow is to credit markets. Initially the problem was thought to be limited to rising defaults in the residential subprime arena. It now looms far larger. Though the bubble had many causes, the quintessential contributor was securitization. Scrambling to get in on the boom, households took out mortgages with brokers who sold them into pools that were securitized and then (in many cases) re-securitized into collateralized debt obligations (CDOs) which were then sold around the globe to investors hungry for investment grade securities with attractive yields. Originators did not pay sufficient attention to borrowers’ ability to make repayment; and investors did not fathom the risk they were taking when buying such complex, opaque securities. Due diligence was abrogated to the rating agencies’ stamp of approval. If it was AAA, it was OK. Rating agencies and investors got it wrong. Leveraged securitization and loose regulation allowed entities (structured investment vehicles and asset-backed commercial paper conduits) that were off balance sheet to their large bank sponsors to spring up. Along with CDOs and other structured credits these burgeoned into what Paul McCauley of PIMCO calls the shadow banking system. Leverage in this multi-trillion dollar unregulated system is now unwinding with dire implications.
Magnitude of the Crunch
These complex securities trade in very thin markets making their values difficult to determine. FDIC Chairman Shelia Bair says the root of the problem with structured credit like CDOs is their lack of transparency. Last summer, money center banks recognized the problem. As rising subprime defaults began to affect securities prices, banks were no longer able to accurately access counterparty creditworthiness. The interbank lending market froze up. The European Central Bank and the Federal Reserve hurriedly stepped in and injected liquidity. At present count, large banks have written off over $120 billion. Write-offs erode capital and thus constrain the ability to lend. Reduced credit availability to both corporate and household sectors is going to stifle the ability and willingness to spend. Estimates of losses due to home foreclosures are as high as $400 billion. These estimates do not factor in the effects of a recession. And the losses will go far beyond residential. All categories of lending will experience losses in proportion to their degree of over-leverage and the severity of the economic downturn.
A Sliding Economy
Stocks are in a bear market. The technical signal came in July. Key leading indicators gave a recession signal in November. Nearly all the usual signs of impending downturn are present. Moreover, there are atypical forces this time: the housing bust–which has a long way to go–and a credit crunch unlike any we’ve ever seen. The huge leverage of the new securitization makes it so. In the past three years, global issuance of CDOs exceeded $1 trillion. We do not yet know what will happen in the $50 trillion credit default swap market as underlying credits default. The federal government must pull out all stops and inject monetary and fiscal stimulus to head off a severe recession. Otherwise–to the extent that income falters–getting home prices back in alignment with incomes will take longer and be more painful.
Dr. Jim Hagerbaumer is President of Hagerbaumer Economics, Inc. He can be reached at 813-792-7624 or hagerbm
