Housing Doom

Here is Housing Doom’s second installment of our unauthorized annotated transcript of the American Enterprise Institute’s October 30, 2008 seminar "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?" [1] This is the presentation by AEI Fellow Desmond Lachman. He made use of a slide deck [2] and about one week before the event added newspaper articles to the site that he had written on the subjects of the future of banking regulation [3] and prospects for world-wide deflation.[4] The event site has both a video and an audio recording of the seminar.  No official transcript yet exists, but AEI has recently added a summary.[5]

Highlights

• "This is almost a once in a hundred year kind of event that is very likely to crush growth."
• "It looks to me as if it’s baked in the cake that you’re going to be getting the recession, rising unemployment, and that’s not too good for house markets. "
• "… the fact that the Fed is reducing interest rates to 1 percent in my view is neither here nor there."
• "… So you get somewhat in a vicious cycle, and that’s the reason why I think that you’ve got to get some sort of intervention to stop it."
• "What we’re going to need is we’re going to need stabilizing of the housing market through unorthodox means, coupled with a massive fiscal stimulus package, coupled with monetary policy accomodation, and then we might have a chance …"

Desmond Lachman: [12:38] Thank you very much Alex, and thanks once again for arranging this, and I really have to give you credit again, you and Chris, for having foreseen this as long ago as March of 2007. [slide 1 -- refer [2] below] You saw this coming in a big way and I recall at that time Ben Bernanke was just beginning to figure out that there might be a minor problem with subprime mortgages.

I’ve got very mixed feelings being on a panel like this that has been right, and I’m reminded very much of the story in England when Edward Heath rather angrily looking figure was elected Prime Minister, not the most competent. They asked a cartoonist what was his reaction. And his reaction was that as a private citizen he mourned, but as a cartoonist he rejoiced. And I feel the same way as a forecaster.

I’m not going to leave you in any suspense about the basic question as to where I am on the issue. I’ve entitled this "Far from a Housing Market Bottom." I guess I take issue with Alex in looking at a trend and expecting that we’re just going to be returning to the trend. I would just make the argument, and I’m just going elaborate it going forward, that in the same way as we could have overshot fundamental values by perhaps 80 percent, there’s no logical reason why we’re not going to under-shoot.

And what I’ll try to explain is that there’s a dynamics involved here that can really just take us to the lower side. And my view is that unless there’s government intervention of a big scale in the housing market we’re really not going to bottom. This thing is just going to keep melting down, and has really by now it should be clear that this has really got grave implications for asset price deflation and the deleveraging process that we’re in.

Now the reasons that I’m rather sure that the housing market doesn’t bottom any time soon [15:00] is that there are many factors forcing it down. The first of the factors that I say is just the economic conditions. [slide 2] Since we’ve met last there’s no question now that the economy’s going in for a deep recession, that unemployment’s going to be rising above 8 percent probably by the end of next year. So the basic conditions for housing demand aren’t there. At the same time there’s a huge amount of inventory overhang that is weighing on this market; the market’s not clearing.

[slide 3] The third reason that I’m going to be substantiating is that we’ve now got a massive problem with foreclosures, and that the market’s not that stable in the sense that as prices go down we get negative equity, we get foreclosures, foreclosures drive the price lower and we’re just in another one of these vicious cycles.

And the last point that I’ll be making is that mortgage finance has certainly dried up in the private sector and even Fannie and Freddie, what’s occurring is that mortgage rates, if you can get mortgages, are at higher rates than before, so I see no reason why house prices don’t continue falling.

Let me just take each one of those points in turn, just in terms of the recession that — I think the process as I see it is that we are in the grips of a major asset price deflation which you can see in the first chart that I put up there [slide 4] is the equities down globally — are down by something like 50 percent from their peak — if I look at the next chart, [slide 5] that looks at it in relation to GDP, what we’ve done is we’ve just wiped out something like 50 percent of GDP in wealth just through the housing, and through the equity market.

If I add to that the amount of wealth that has been destroyed through housing and though lower bond prices, I come up with a figure something like 80 90 percentage points of GDP has been wiped out. If I applied the usual Fed model that is something like 4 cents on the dollar, that’s something like 3.5 percentage points of GDP reduction in consumption right there, but I don’t believe in those kind of models, I think that we’re out of sample, and I think that when you get such a dramatic reduction in wealth I’d be very surprised if you don’t get a more severe downturn in consumption than the 4 cents on the dollar is worth.

At the same time that we got this asset price deflation we’ve got a major problem in the financial sector, and just to put in into perspective, I thought this chart from one of the IMF reports is rather instructive. [slide 6] It’s telling you — they’re looking at the US — they’re now looking at $1.4 trillion of losses by the time that this is all over and if you look at it even in relation to GDP it dwarfs anything that we saw in the Savings & Loan; that we’re looking at something that’s becoming very comparable to what we saw in Japan. So this is a major credit market event. This is almost a once in a hundred year kind of event that is very likely to crush growth.

You see it as well in this chart. [slide 7] It’s just showing — that this is before the October event that bank credit, already was contracting at the fastest rate in the post-war period, and I’m sure John Makin will tell me that that’s irrevelant when you look at the whole of the securitization market. It’s totally bust, so that the shadow banking system’s not pumping out credit as well, so if you’re getting your credit crunch at the same time as you’re asset price deflation you’ve got to expect the economy to really decline. It looks to me as if it’s baked in the cake that you’re going to be getting the recession, rising unemployment, and that’s not too good for house markets.

Just the last thing is you’re just getting the spreads on — corporate bonds are just blowing out. [slide 8] So the fact that the Fed is reducing interest rates to 1 percent in my view is neither here nor there. If the spreads are so high and if people can get credit they’re having to pay higher rates than they were before, that’s hardly supportive of the economy.

So that’s the first reason that I think house prices fall. [slide 9] The second is — this is the Case-Shiller index, it came out yesterday. [slide 10] When I look at a chart like this I don’t see any sign — this goes through August — I don’t see any sign that the second derivative is moving in the right direction — that this just looks to me like fairly much in free-fall and while that is occurring that we might be coming back to the trend that Alex [20:00] is mentioning.

This red line is what the Fund prices show. [slide 11] The Fund prices are telling you — on the Case-Shiller — is that house prices are going to be falling another 15 percent, [slide 12] but I’m not sure that I would buy that, I think we’re going to see more, because what is occurring — that even though housing starts, that’s the green line, [slide 13] are going down a lot, at the inventories of unsold houses are now at something like 11 months supply, so you’ve probably got a million houses overhanging the market at a time that demand is declining.

Next let me just quickly go to the foreclosure story. [slide 14] That ran about the various estimates, but something like about 1 in 3 households by now have got negative equity in their homes, [slide 15] so they don’t really have an incentive to service the mortgage. And what we are just seeing is, we’re seeing delinquencies. These are different vintages [slide 16] of prime, Alt-A and subprime — you’re just looking at line under the extreme is 2007 — the amount of delinquencies are just literally double what they were before the stage at which they’re in right now. And what you’re getting , you’re just getting foreclosures surging, [slide 17] so that foreclosure procedures initiated now are running at something like 3 million units a year. So I would think that what’s occurring is that those houses come back on the market, they push the prices down, you get the negative equity increasing, so you get more foreclosures. So you get somewhat in a vicious cycle, and that’s the reason why I think that you’ve got to get some sort of intervention to stop it.

Lastly the mortgage financing has dried up. [slide 18] You’re just not getting lending by the private sector, [slide 19] and then the mess that we’ve had with Fannie and Freddie going back and forward, doesn’t look like there’s much lending coming out of them either, and when I look at the mortgage interest rates — the black line is for the Jumbo loans [slide 20] – it’s rising at a time that economic conditions are crumbling. So bottom line is I think that there needs to be intervention on the house. [slide 21] And I think the only really interesting question is: how do you do that intervention? Do you change contracts? Do you buy the mortgages like the Home Loan Corporation?

I’ll just end with one last thought is that I think that stabilizing the housing market — I think this is a point that Marty Feldstein keeps making and I think that he’s right about it. Stabilizing the housing market is a necessary condition for stabilizing the economy, but I would be very quick to add that it’s nowhere near a sufficient condition. What we’re going to need is we’re going to need stabilizing of the housing market through unorthodox means, coupled with a massive fiscal stimulus package, coupled with monetary policy accomodation, and then we might have a chance of not having what I think is baked in the cake for the 1st and 2nd quarters of next year morphing into something a lot more horrible to contemplate.

Alex Pollock: Thank-you. Nouriel. [23:34]

Notes and References

[1]: "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?", AEI Event Homepage, October 30, 2008.

[2]: "Far From a Housing Market Bottom" (PDF Slide Deck), by Desmond Lachman, AEI, October 30, 2008.

1. Front Title
2. Deteriorating Housing Market Fundamentals
3. Adverse Feedback Loops
4. Equity markets almost 50% down
5. Back to the 1980s
6. Comparison of Financial Crises
7. Bank Credit: All Commercial Banks
8. US corporate bond spreads
9. Housing Market is Not Clearing
10. S&P/Case-Shiller Home Price Indices
11. House Prices
12. House Price Declines Implied by Case-Shiller Future Contracts
13. U.S. Housing Starts and Months Supply of Existing Homes
14. Foreclosures Add to Supply
15. Falling Prices Leave Homeowners with Negative House Equity
16. U.S. Mortgage Delinquencies by Vintage Year
17. Foreclosures Surge…
18. Mortgage Financing has Dried Up
19. FRB Sr Loan Survey: Res Mortgages: Net Share, Banks Tightening
20. Mortgage Rates Decline Slightly After Quasi-Nationalization of Housing GSEs
21. Government Intervention is Needed

[3]: "A New Era for Global Banking" (PDF), by Desmond Lachman, Handelsblatt, October 20, 2008.

[4]: "Deflation Bound" (PDF), by Desmond Lachman, Washington Times, October 24, 2008.

[5]: "Bottom of the Housing Bust Nowhere in Sight, Economists Say", by Chad Hill, AEI, November 12, 2008.