Housing Doom is pleased to present the second installment of our unauthorized annotated transcript of the American Enterprise Institute’s March 17, 2009 seminar "The Deflating Bubble, Part V: Forecast and Policy Recommendations for the Next Six Months." [1] This is the presentation by AEI Fellow Desmond Lachman. The event site has several resources, including both an audio and a video recording of the 2 hour proceedings. There is a brief summary, but as yet no official transcript.
Lachman’s presentation makes use of a slide deck.[2] He also contributed a copy of some recent Congressional testimony he gave [3] on these issues to the event site.
Highlights
back to AEI Subprime V transcript links
PREVIOUS: Pollock Introduction
Desmond Lachman [10:14]: Thank-you very much Alex. [slide 1 -- refer to the slide deck at note [2]] Thank-you for arranging this. I’m always struck by you foresight, having done this 2 years ago, to pick up that this was going to be the key topic, and you’ve done well this afternoon to start with Ireland.
There’s a joke circulating on Wall Street … Iceland, of course you know, had a huge financial crisis, and there’s a joke circulating now on Wall Street about what the difference might be between Ireland and Iceland. And the answer is: One consonant and six months. [laughter] So Ireland is one of the few places that causes me to be optimistic about the United States economy.
When we gathered last time I think that it was very clear-cut where the housing market was going to go. It was quite unambiguous, everything was pointing in a very negative direction. I think now, 6 months later, you can see that there are certain signs of improvement that one really wants to make note of, and that does indicate that this is going to pass like everything else. Maybe not in 2009, but you could see a bottoming sometime in the middle of 2010.
So there is some good news. The trouble in my view is that the bad news really dominates. And the bad news of course is the state of the United States economy, where we’re heading. And with a bad economy, one really can’t expect the housing market to be vigorous and rebound in any rapid or quick way.
The first point I’d like to make — and I think that this is crucial — is that there’s a very close interconnection between the housing market and the economy. [slide 2] And it works in both directions. I think that this is something that analysts missed at the start. They thought that the housing market, residential construction, only represented 5 percent of the US economy. And what they missed was that housing is a major component of household wealth, and the second point that they missed was that it’s a very important part of the balance sheets of the banks. This is a $10 trillion loan market, and if you get impairment on that, that can really cause real problems.
So what we see is, in the first point of view, first point about the wealth, is the red line is housing wealth as a percentage of GDP, and you see it peaks at about 170, and now it’s gone down to 140. [slide 3] So roughly 30 points of GDP got wiped out in wealth, and it coincided with the stock market tanking, which wiped out another 50 / 60 points of GDP, so the net story is that US household wealth has dropped by something like $12 trillion, or close to 80 percent of GDP. [slide 4] And that has a massive impact on consumption.
That’s not good for the US economy, 70 percent of it is consumer spending. If that gets hammered in a hard way, you get a deep recession.
The second point — the second slide that I present is the size of the financial crisis. [slide 5] This is a chart taken from the IMF and what it does is the column to the most right indicates what this current crisis is costing. This could be something like $1.4 trillion, and the yellow dot shows that that is roughly 10 percentage points of GDP. If you see — it dwarfs anything that we’ve had before. It’s something like 4 times the size of the Savings & Loan crisis. It’s beginning to get proportions like Japan.
So when the two of these things occur simultaneously, we get the US economy going into a steep recession.
So what is very important is you need stabilization of the housing market if you are going to be getting some sort of meaningful recovery in the United States.
Now it works the other way, that with a very weak economy it doesn’t matter if housing market fundamentals might be improving. [15:00] That is really going to really dampen any pickup in housing. And you see that in this chart, [slide 6] and I’m going to come back to this point a little bit later is that the orange line is housing affordability, and what’s occurred is because interest rates have come down on mortgages, house prices have come down as Alex noted, housing affordability has risen, but a measure of confidence — how much traffic you’ve getting in house markets — has totally plummeted, because people are losing their jobs, their income insecure, their wealth being hit. They’re not about to go and buy houses. So that is the central point that there is a close interrelationship between the two.
Let me turn now to the good news, [slide 7] and then I want to talk about the bad news. The good news is — three pieces of good news that I would suggest:
So you’ve got to regard that as rather good news, or putting it another way, if you look at this chart, the blue line, which is indicating residential construction in relation to GDP, we’re at lows that we’ve never seen before, something like it’s down to 2.8 percent of GDP. [slide 12] So this can’t do too much more damage, and what it does is it helps to get supply and demand back into balance, it helps us work off the excess inventories.
So much for the good news. [laughter] The bad news is that the economy is, to use a technical term that Warren Buffett used recently — the US economy has fallen off a cliff. [slide 13] I don’t want to make this too depressing, so I’m not going to talk about the global economy — I’m not going to talk about Europe imploding or Japan declining at a faster rate, or the rest — so we put a really very bad backdrop for housing.
And you see this in the employment numbers. Unemployment has just surged. [slide 14] We’re at 8.1 percent. Reasonable people on Wall Street, for instance Goldman Sachs forecasters — I don’t disagree with them — unemployment’s going to peak at something like 9 1/2 percent, we could go to 10 percent. That’s not a very conducive environment for people to be buying houses.
If you look at this chart, which is showing how employment is contracting, and this is in relation to previous cycles, this is rather alarming. [slide 15] This is at a rate that we haven’t seen. So this is a great degree of insecurity, so I wouldn’t expect to see a housing recovery of any significance until we stabilize the US economy.
So the first thing is that you’ve really got a bad economy, …
Alex Pollock: John and I want to know what the blue, red and green lines are.
Desmond Lachman: Ok, the blue — that is previous recessions. The blue line is the 1990 recession, the red line is the 2001 recession — and these are months, so this is … the recession began, was dated in December 2008 by the people whose job it is to do that, the NBER. And what you’re seeing is 12 months later, is we’ve lost something like close to 4 million jobs, whereas in the previous recessions it began turning at around about 2 1/2 million, and sadly we’re not finished with this process. That is why I’m not very optimistic, if that point hasn’t been clearly enough made [laughter] about housing turning around [20:00] very quickly.
The other negatives of the housing are that you’ve got an inventory overhead, so that the market hasn’t really cleared. [slide 16] We have seen inventories come down some, but by some measures — and this is supposedly one of the better measures of excess supply in housing — this is the excess stock of vacant homes. The black line is the trend, the red line is how many vacant homes are there in relation to what the trend is, and we look like you’ve got something like a million homes too many sitting there vacant, weighing down on the market.
The other point that is of really concern is what’s happening with foreclosures. [slide 17] That foreclosure starts are at something like a million units, should I say something like 1 percent of total supply, and the inventory has risen to the equivalent of 3 percent of the total housing stock. So you’re talking about a huge amount of foreclosed properties that are going to be coming on the market.
To be sure, the government has done something that I think is positive in a way, but my view is it doesn’t go far enough, because what it doesn’t do is it doesn’t deal with, for instance, the negative equity problem, the fact that as house prices go down, people are upside-down, where they’ve got negative equity, in that the house is worth less than the mortgage. So there’s every incentive for these people to walk from the mortgages.
Also people losing jobs. They’re going to not be in a position to benefit from all of these government programs. So what you’re going to see … you’re going to see foreclosures continuing to rise, perhaps not at the same rate as before, but that’s another negative on the housing market.
How do we fix this? [slide 18] What needs to happen to make me come here next time and be more optimistic? I think that the government has diagnosed it correctly, that Larry Summers, who I wouldn’t want to mess with, has really indicated what needs to be done, and there needs to be three things.
That there needs to be
Well, when I go through this check list, I don’t see a front-loaded fiscal package, and if we need all three of these things to work, in order to turn the economy around, I look at the fiscal stimulus package — it escapes me why, when we need the fiscal stimulus right now, more than half of it is back-loaded to 2010 to 2011.
It also escapes me the design of it. Some of these things like tax rebates, I thought that we just did that in 2008, and we saw that it didn’t work, but we’re doing that again. So I don’t think that the fiscal stimulus is too good. [slide 19]
I can be more brief on the banking sector, because there’s no dough. Congress has made it very clear, that they’re not prepared to provide additional money to fix the banks. So it doesn’t look, what they’re trying to do is to use leverage of the Federal Reserve’s balance sheet or the private sector balance sheet. You’re trying to do magic, you’re trying to make something out of nothing, which is generally not a good endeavor to try to do, and they’re failing miserably at that.
So I don’t see the basis for the US economy recovering any time soon, and that would make me not too optimistic about the housing market.
So just to round it out, the bottom line is I don’t see the housing market bottoming in 2009. [slide 20] I think that this chart is probably correct. [slide 21] This is what the market is telling you, that the market is indicating that future prices — this is the Case-Shiller future index — that we’re going to see something like another 12, 13 percent decline before this is all over, and maybe before the end of 2010 we get the housing market bottoming.
Alex Pollock: Thank-you Desmond. Tom. [24:24]
Notes and References
[1]: "The Deflating Bubble, Part V: Forecast and Policy Recommendations for the Next Six Months", AEI Event Homepage, March 17, 2009.
[2]: "When Will U.S. Housing Bottom?" (PDF Slide Deck), by Desmond Lachman, AEI, March 17, 2009.
[3]: "Foreign Policy Implications of the Global Economic Crisis", by Desmond Lachman, Testimony, Senate Foreign Relations Committee, February 11, 2009.
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John,
thank you for that transcript. That was very enlightening.
Chuck