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== ANOTHER HOUSING DOOM AD ==

Doomers in DC should mark Thursday October 11, 2007 on their calendars. Back by popular demand — Alex Pollock, Nouriel Roubini, and the whole gang are doing a repeat performance. For details see AEI’s event site for "Deflating Housing Bubble II: Not Just Subprime".
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AEI’s March 28, 2007 Subprime Seminar - VII

The payoff quote from AEI Resident Fellow Desmond Lachman’s presentation to AEI’s March 28th seminar on the Subprime Mortgage Crisis [1] occurred right at the end of his talk.

"… But I don’t really need that in my case just to say that we are in for a pretty rough ride, and I’d be as bold as to say that I think that this issue [the subprime mortgage crisis] is going to be the issue in the 2008 election campaign." [0:22:36]

 

That sounded a little wild back in March, but if last Sunday’s Realtor prediction of 2 million potential defaults [2] is anywhere near the mark, he could well have been right on the money. Yesterday’ s WaPo Op-Ed [3] by widely syndicated columnist Robert Samuelson would also tend to support the idea.

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Previous partial transcripts of the March 28th event:

 

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I’ve provided the places Lachman refers to his slides [4] during the talk. Following the slide deck on another window while going through the transcript would probably prove helpful. As usual, the times are from the audio version of the seminar.

Alex Pollock (end of introductory remarks): … Desmond, you have the floor. [slide 1] [4]

Desmond Lachman [0:06:25]: Thank-you very much, Alex. Thank-you for inviting me and before I make my remarks, I should just commend Alex for the timing of this seminar. When we discussed this sometime in December, most people hadn’t heard about subprime mortgages. And Alex’s timing was so great that even this morning he managed to orchestrate Ben Bernanke to give testimony before Congress [5] indicating that subprime mortgages might be a bigger problem than the Feds originally thought. [slide 2] [0:07:03]

What I want to do is put the subprime mortgage mess, as I would call it, into some kind of context. I’m wanting to talk about other things going on in the housing market, and I do this not because I think that the subprime mortgage problem is a minor problem, that after all it had, what something like 20 percent of all loan originations in 2006, and we have a mere 1.3 trillion dollars of subprime mortgages outstanding, which looks rather dubious. To put that into perspective that’s some 10 percent of United States GDP. But the reason that I put it in context is that we’ll see that there’s a whole bunch of adverse factors operating in the housing market, and when you connect the dots it’s very difficult to buy the sell-side line that has been given on Wall Street and elsewhere that the worst of this crisis is behind us. [0:08:10]

My view is that we’re … I’m not even sure that we’re in the first innings of a long drawn out process in which we’ll see housing prices drop by a considerable amount before this is all over, and we’ll see this as being a big drag on the United States economy. [0:08:27]

Before one prognosticates, it’s always good to know where one’s coming from. So the way in which I’m going to organize my remarks is first asking where have we come from? Next — where are we? and then finally, where are we going? [0:08:45]

Now I think that what best encapsulates where we’re coming from is this chart [slide 3] by Robert Schiller, looking at housing prices over the last hundred years in constant terms. And what is really very striking is what we see between 2000 and 2006 is something that’s got absolutely no historic precedent in the United States. It’s that we see house prices increasing by something like 80 percent in constant dollar terms. [0:09:12]

If we look at just the post-War period, since World War II, house prices generally oscillate in a very narrow range and don’t really move much in constant terms. As I say, until you get to 2006. What this does is it’s really pushed housing affordability way beyond the reach of most, and the point that I would emphasize is that here we’ve got a boom of incredible proportions. So I’m not too sure that previous busts are that great a guide. I think that we are in new territory — that this is a bust that’s going to be of greater magnitude and I think that therefore you should be expecting the fallout to be all the greater. [0:10:03]

The second chart [slide 4], which captures somewhat of a mirror image of the first, which encapsulates what has been going on, is that homeownership, which used to hover around about 64 percent, the rate of homeownership in the United States for much of the period between the 60s and the mid-90s suddenly moves up to pretty close to 70 percent. So essentially what’s occurred is a whole lot of people have been brought into the market, driving the prices to very high levels. [0:10:41]

I would submit that though demographic factors or fundamental factors of that sort can’t explain the tremendous boom in house prices of the last 6 or 7 years. Instead of which one really has to look towards financial factors. And I think that there’s a confluence of, in my view, around about four factors that contributed to this [slide 5]. And I don’t think that the Federal Reserve Board comes out very well in this procedure. In their wisdom in not looking at asset prices, allowing that to influence their thinking too much. I think that they were pretty much asleep at the wheel as this was all occurring. [0:11:27]

The first factor driving the house prices was the easing of monetary policy in the wake of the dot com bust in 2001. Interest rates were reduced to 1 percent by something like 2003 they were kept at very low levels. They kept at 1 percent for a long while and then they moved to neutral policy — was very gradual. So we had a bunch of liquidity created by the Fed that, I think, started the problem. But then what occurs at the same time is that I’m not quite sure what the regulators were thinking or what the regulators were doing when this was going on, but you get an explosion of subprime lending [slide 6], lending to people who really aren’t credit-worthy, so that by the time we get to 2005 / 2006, subprime lending is something like $600 billion. If you add Alt-A lending, which isn’t a whole lot better, you’ve got something like a trillion dollars each year has been lent, and this is something like 35 percent of the market. [0:12:42]

So I just don’t see this as just a niche problem, I think that this is really a very big, has been a very big driving force. The other two factors were, that I would mention, were the exotic instruments, whether they were adjustable rate mortgages, whether they were interest only loans, whether they were negative amortization mortgages, and these in fact go beyond the subprime universe, that about a third of all loans now are adjustable rate mortgages and it might have something to do with a little later on. [0:13:19]

The final factor I would like to emphasize, because I don’t think it gets sufficient attention in all of this, people look at subprime and look at the liquidity, is … There’s a certain amount of speculation in the market. I think that that might be an understatement. If I look at these numbers by the National Association of Realtors, they are suggesting that investment purchases of houses has been something like 25 percent [slide 7]. To put that into perspective, historically the figure has been something closer to 12 percent. So we’ve got a lot of froth, and what bothers me about that is not simply that this will dry up going forward, but you’ll get unwinding of positions that can really [complicate] matters [going] forth. [0:14:07]

Just to round out where we’ve come from, the legacy of all this is that the households in the United States are now stuck with a lot of obligations [slide 8], and Alex is very fond of telling me that one of the things he learned as a banker was that liabilities generally don’t shrink. It’s the assets that shrink, and that people are going to be stuck with these obligations. [0:14:33]

The other thing from a macro point of view of course, that is, dramatic, is that the boom in the housing prices coupled with mortgage equity withdrawal and all the like has induced American households to reduce their saving rates, which used to be something like 7 percent of disposable income — we’ve now got negative rates of savings [slide 9]. So we’ve really had one hell of a party going on — I don’t want to get into external imbalances and the like, because I think the story is depressing enough as it is. [0:15:10]

Where are we now? [slide 10] In a word, I would say that we are in a situation of oversupply. Whatever indicator you wanted to look at, there’s too much supply, and that is causing prices to begin to weaken. If you’ve got an overhang of inventory, what you expect is for prices to weaken. So what if you want to look at — I think that vacancy rates might be the thing to look at [slide 11]. These are houses that are just sitting vacant, nobody’s renting them, nobody’s owning them. This used to run at something like 1.5 percent. It’s suddenly gone up 50 percent and it’s now 2.7 percent. So it’s telling you that there’s too many houses on the market. If you don’t like that indicator you can look at housing inventory as supply of sales, which now have gone up to something like 7 months [slide 12]. Sales — and we’re back to the levels we were at in 1995, and I don’t think that that is all over. [0:16:15]

Another side is housing completions still run at a high rate [slide 13] – more than the fundamental demand, which could weigh on prices. And finally that I realize that there are very many different indicators of prices — whether you smooth them out or not — but they all seem to be telling the same story, that house prices that were increasing towards the end of 2005 at 15 percent annual rate are now actually declining [slide 14]. [0:16:45]

That brings me to — where might we be going? [slide 15] So, I don’t know, I took Economics 101, and the idea there was that if there was more supply than demand, generally prices fell. I’ve already mentioned that we are in a situation of excess supply, so the question you’ve got to ask yourself is — what is going to happen to demand and supply. Is demand going to operate in a way that’s going to reduce that excess supply, or are we going to get supply being reduced? And the answer that I come to is — no — that’s really what’s going to be occurring is that as the factors that drove this process go into reverse, we’re going to get demand shrinking, and what we’re going to get is because of foreclosures and because unwinding speculative positions we’re going to get supply increasing. [0:17:36]

So I find it difficult to see how this isn’t going to get worse. So the factors that go into reverse is, firstly, the Fed has brought interest rates back into a more normal level; so affordability issues are going down [slide 16] — that would be the first factor. The whole mess in the subprime issue — reflected in rising default levels [slide 17], it just means that what you’re going to get is you are either going to get a credit crunches developing the incentive of people making these subprime loans is drying up. We’ve already have something like 30 of these subprime lenders going out of business, many more down the track. And just to put it into perspective, if subprime and Alt-A is something like 35 percent of all originations in 2006, it doesn’t take much of a decline in that segment of the market to produce sales dropping by perhaps 10 percent just from that factor. [0:18:48]

Then there is the issue of the bank credit standards generally are tightening [slide 18]. The regulators suddenly realized what they were supposed to be doing. In a typical fashion they’re operating in a pro-cyclical kind of manner, so the last time that we need lending standards to be tightened, this is the time. So it’s just making sure that the demand goes down [slide 19]. I’ve mentioned that we’ve got adjustable rate mortgages that are going to be resetting because — something like 400 billion dollars of this, that resets at 2 percentage points higher, so that’s another factor restricting demand. And then finally I would just say the speculative side really does that in. [0:19:37]

Let me just conclude by just giving my two cents worth on the macro-economic impact of where this goes [slide 20]. I’m not talking about other problems that we’ve got — high oil prices, or dollar weakness, or stuff like that — just looking at the housing side. The way I would see it is you’ve got to distinguish between a direct impact of the housing market — meaning that if you’ve got lower construction that means that you are going to have less jobs in that industry, and we’ve just taken a look at housing is something like 6 percent of GDP [slide 21] – so if you’ve got a 30 percent decline in housing activity in 2007, that’s a mere 1 1/2 percent shaved off GDP right away. I think, though, that the more important factors are going to be the indirect impact, and I think that that is a little bit more difficult to quantify because there is a lot of psychology involved. American households, as I mentioned, ran down their savings from six / seven percent of disposable income to zero, because housing prices were rising at 10 or 15 percent. The question you have to now ask is — isn’t that going to operate in reverse when households figure out that their houses aren’t appreciating, but in fact are declining. [0:21:09]

Isn’t that going to freak them out, that they don’t really have savings, somehow they’ve got to restore the savings, and then the various wealth effects, 5 cents on the dollar sort of thing, would tell you that if we’re shifting from 15 percent increase in house prices to a 15 percent decline, we could easily be talking about 1 1/2 to 2 percent further shaving off. So when Greenspan’s talking about a 25 percent probability of recession, I think that’s — he might be being a little bit modest. But then I’m no Greenspan fan. I think that most of this problem really lies at his door. [0:21:53]

So just finally I should say that the other indirect impact that I find very difficult to quantify is that when I look at financial markets risk is not priced anywhere. And I’ve got no way of quantifying that when we get losses floating all over the show, how many dead bodies are going to be floating on Wall Street. And what are the ramifications of credit derivatives and all the like are. But I don’t really need that in my case just to say that we are in for a pretty rough ride, and I’d be as bold as to say that I think that this issue is going to be the issue in the 2008 election campaign. [0:22:36]

Alex Pollock: Thank-you Desmond. I thought issues were floated on Wall Street, not bodies. Ah, Nouriel. …

 

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Notes and References

[1]: "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble", Event, American Enterprise Institute & Professional Risk Managers’ International Association, March 28, 2007.

[2]: "Nation Doomed To 2 Million Foreclosures", Realty Times / Yahoo Real Estate, June 10, 2007.

[3]: "The End Of Cheap Credit?", by Robert J. Samuelson, Washington Post, June 13, 2007.

The most important price in the American economy is not the price of oil, computer chips, wheat or cars. It’s the price of money — interest rates. When rates move, they ultimately affect the price of almost everything else. Which poses some intriguing questions. Is the era of low interest rates ending? If so, what’s next? The answers will hover over the 2008 election. A shaky economy would help Democrats; a stronger economy, Republicans.
…

In this view, bad loans were made as lenders flush with cash poured money into riskier bonds and loans for private equity firms, hedge funds and developing countries. So defaults and losses mount; in effect, the "subprime" mortgage losses of earlier this year are repeated on other types of credit. The stock market sags under the weight of higher rates and all the bad news (interest rate fears sent the market down sharply again yesterday; the Dow Jones industrial average is now 3.4 percent below its recent peak).

 

[4]: "Mortgage Credit and Sub-prime Lending: Implications of a Deflating Bubble" (PDF slide deck), by Desmond Lachman, AEI, March 28, 2007.

[5]: "The Economic Outlook", Testimony of Chairman Ben S. Bernanke Before the Joint Economic Committee, U.S. Congress, March 28, 2007.

Developments in subprime mortgage markets raise some additional questions about the housing sector. Delinquency rates on variable-interest-rate loans to subprime borrowers, which account for a bit less than 10 percent of all mortgages outstanding, have climbed sharply in recent months. The flattening in home prices has contributed to the increase in delinquencies by making refinancing more difficult for borrowers with little home equity. In addition, a large increase in early defaults on recently originated subprime variable-rate mortgages casts serious doubt on the adequacy of the underwriting standards for these products, especially those originated over the past year or so. As a result of this deterioration in loan performance, investors have increased their scrutiny of the credit quality of securitized mortgages, and lenders in turn are evidently tightening the terms and standards applied in the subprime mortgage market.