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News : International Last Updated: Dec 19th, 2007 - 13:17:15


Two top US economists present scary scenarios for US economy; House prices in some areas may fall as much as 50% - Housing contraction threatens a broader recession
By Finfacts Team
Sep 3, 2007, 07:01

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Martin Feldstein is the George F. Baker Professor of Economics at Harvard University and President and CEO of the National Bureau of Economic Research (NBER). From 1982 through 1984, Martin Feldstein was Chairman of the Council of Economic Advisers and President Reagan's chief economic adviser. He served as President of the American Economic Association in 2004. In 2006, President Bush appointed him to be a member of the President's Foreign Intelligence Advisory Board. He is a member of the Business Cycle Dating Committee of the NBER, which like Harvard is located in Cambridge, Massachusetts

US homes may lose as much as half their value in some US cities as the housing bust deepens, according to Yale University professor Robert Shiller. Meanwhile, Martin  Feldstein of Harvard University says that experience suggests that the dramatic decline in residential construction provides an early warning of a coming recession. The likelihood of a recession is increased by what is happening in credit markets and in mortgage borrowing. Feldstein says that most of these forces are inadequately captured by the formal macroeconomic models used by the Federal Reserve and other macro forecasters.

“The examples we have of past cycles indicate that major declines in real home prices — even 50 percent declines in some places — are entirely possible going forward from today or from the not too distant future,” Shiller said in a paper presented last Friday at the Federal Reserve Economic Symposium in Jackson Hole, Wyoming.

Falling real-estate values may undermine consumer spending by spurring households to save more and by preventing them from tapping home equity.

Because price gains were larger and more widespread this time compared with past speculative booms, the risk of “substantial” price declines is greater, wrote Shiller, who is also the chief economist and co-founder of MacroMarkets LLC. Shiller is also the author of Irrational Exuberance, in which he forecast the end of the tech boom in 2000.

Last week the S&P/Case-Shiller Home Price Index posted a record annual decline in Q2 2007 - the worst since 1987.

“The implications of this boom and its possible reversal in coming years stands as a serious issue for economic policy makers,” Shiller said on Friday.

He said that 50 percent declines in the worth of some cities’ homes wouldn’t be unprecedented. Prices in London and Los Angeles fell by almost that amount from the late 1980s to mid-1990s.

Robert J. Shiller is the Stanley B. Resor Professor of Economics, Department of Economics and Cowles Foundation for Research in Economics, Yale University
US house values, in constant or real dollar terms, rose 86 percent from the end of 1996 to early 2006, the peak of the most recent housing boom, Shiller said. Economic factors such as rents and construction costs don’t appear to explain the jump in prices, suggesting “speculative thinking” and a “boom psychology” was at work. “Extravagant” expectations for future price increases since the late 1990s fueled the bubble, Shiller said.

Harvard University Professor Martin Feldstein, who is a member of a group that calls the timing of recessions, said that the housing contraction threatens a broader recession, and the Federal Reserve should lower interest rates.

"The inability of credit markets to function adequately will weaken the overall economy over the coming months. And even when the credit market crisis has passed, the wider credit spreads and increased risk aversion will be a damper on future economic activity.

Even with the best of policies to increase liquidity, future aggregate demand is likely to be depressed by weak housing construction, depressed consumer spending and the impaired credit markets. Lower interest rates now would help by stimulating the demand for housing, autos and other consumer durables, by encouraging a more competitive dollar to stimulate increased net exports, by raising share prices that increased both business investment and consumer spending, and by freeing up spendable cash for homeowners with adjustable rate mortgages," Feldstein told attendees at the Jackson Hole Symposium on Saturday.

``The economy could suffer a very serious downturn,'' Feldstein said. ``A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome.''

Feldstein said that Shiller's analysis began with the striking fact that national indexes of real house prices and real rents moved together until 2000 and that real house prices then surged to a level 80 percent higher than equivalent rents, driven in part by a widespread popular belief that houses were an irresistible investment opportunity. How else could an average American family buy an asset appreciating at 9 percent a year , with 80 percent of that investment financed by a mortgage with a tax deductible interest rate of 6 percent, implying an annual rate of return on the initial equity of more than 25 percent?

"But at a certain point home owners recognized that house prices – really the price of land – wouldn't keep rising and may decline. That fall has now begun, with a 3.4 percent decline in the past 12 months and an estimated 9 percent annual rate of decline in the most recent month for which data are available. The decline in house prices accelerates sales and slows home buying, causing a rise in the inventory of unsold homes and a decision by home builders to slow the rate of construction. Home building has now collapsed, down 20 percent from a year ago, to the lowest level in a decade.

Ed Leamer explained that such declines in housing construction were a precursor to 8 of the past 10 recessions. Moreover, major falls in home building were followed by a recession in every case except when the Korean and Vietnam wars provided an offsetting stimulus," Feldstein said.

"Why did home prices surge in the past 5 years?" Feldstein asked. 

"While a frenzy of irrational house price expectations may have contributed, there were also fundamental reasons. Credit became both cheap and relatively easy to obtain. When the Fed worried about deflation it cut the Fed funds rate to one percent in 2003 and promised that it would rise only very slowly. That caused medium term rates to fall, inducing a drop in mortgage rates and a widespread promotion of mortgages with very low temporary teaser rates," he said.

Feldstein said that the Fed should cut the federal funds rate to 4.25 percent from 5.25 percent even though such a move would likely stoke inflation. 

Lowering interest rates may result in a ``stronger economy with higher inflation than the Fed desires,'' a scenario that Feldstein described as the ``lesser of two evils.''

"If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it succeeds in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability," Feldstein concluded.

The following is the complete text of the speech at Federal Reserve's Jackson Hole symposium by National Bureau of Economic Research President Martin Feldstein.

I'm pleased to have this opportunity to summarize what we have been hearing and reading at this conference and to offer my own thoughts about some of the implications for economic policy.

The housing sector is now at the root of three distinct but related problems:

First, a sharp decline in house prices and the related fall in home building that could lead to an economy-wide recession;

Second, a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets;

And, third, a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending.

I'll discuss each of these and then comment on the implications for monetary policy .

Falling House Prices

Bob Shiller's analysis began with the striking fact that national indexes of real house prices and real rents moved together until 2000 and that real house prices then surged to a level 80 percent higher than equivalent rents, driven in part by a widespread popular belief that houses were an irresistible investment opportunity. How else could an average American family buy an asset appreciating at 9 percent a year , with 80 percent of that investment financed by a mortgage with a tax deductible interest rate of 6 percent, implying an annual rate of return on the initial equity of more than 25 percent?

But at a certain point home owners recognized that house prices – really the price of land – wouldn't keep rising and may decline. That fall has now begun, with a 3.4 percent decline in the past 12 months and an estimated 9 percent annual rate of decline in the most recent month for which data are available. The decline in house prices accelerates sales and slows home buying, causing a rise in the inventory of unsold homes and a decision by home builders to slow the rate of construction. Home building has now collapsed, down 20 percent from a year ago, to the lowest level in a decade.

Ed Leamer explained that such declines in housing construction were a precursor to 8 of the past 10 recessions. Moreover, major falls in home building were followed by a recession in every case except when the Korean and Vietnam wars provided an offsetting stimulus.

Why did home prices surge in the past 5 years? While a frenzy of irrational house price expectations may have contributed, there were also fundamental reasons. Credit became both cheap and relatively easy to obtain. When the Fed worried about deflation it cut the Fed funds rate to one percent in 2003 and promised that it would rise only very slowly. That caused medium term rates to fall, inducing a drop in mortgage rates and a widespread promotion of mortgages with very low temporary teaser rates.

Mortgage money also became more abundant as a result of various institutional changes. Subprime mortgages were the result of legislative changes and of the application of statistical risk assessment models. In addition, securitization induced a lowering of standards by lenders who did not hold the mortgages they created. Mortgage brokers came to replace banks and thrifts as the primary mortgage originators. All of this had been developing since the 1990s but it contributed to mortgage problems when rates fell after 2000.

If house prices now decline enough to reestablish the traditional price-rent relation – recall Shiller's comment that a 50 percent decline in real house prices is "entirely possible" – there will be serious losses of household wealth and resulting declines in consumer spending. Since housing wealth is now about $21 trillion, even a 20 percent nominal decline would cut wealth by some $4 trillion and might cut consumer spending by $200 billion or about 1.5 percent of GDP. The multiplier consequences of this could easily push the economy into recession.

A 20 percent national decline would mean smaller declines in some places and larger declines in others. A homeowner with a loan to value ratio today of 80 percent could find himself with a loan that exceeds the value of his house by 20 percent or more. Since mortgages are non-recourse loans, borrowers can walk away with no burden on future incomes. While experience shows that most homeowners continue to service their mortgages even when the loan balances slightly exceed the value of the home, it is not clear how they would behave if the difference is substantially greater. The decision to default would be more likely if house prices are expected to fall further. .

Once defaults became widespread, the process could snowball, putting more homes on the market and driving prices down further. Banks and other holders of mortgages would see their highly leveraged portfolios greatly impaired. Problems of illiquidity of financial institutions could become problems of insolvency.

Widening Credit Spreads

I turn now to the second way in which the housing sector is affecting our economy: the impact of subprime mortgages on credit spreads and credit availability.

For several years now, informed observers have concluded that risk was underpriced {in the sense that the differences in interest rates between U.S. Treasury bonds and riskier assets (i.e., the credit spreads) were very much smaller than they had been historically.}

Some market participants rationalized these low credit spreads by saying that financial markets had become less risky. Better monetary policies around the world have reduced inflation and contributed to smaller real volatility. Securitization and the use of credit derivatives were thought to disperse risk in ways that reduced overall risk levels. LDC governments now avoid overvalued exchange rates and protect themselves with large foreign exchange reserves. There was also the hope based on experience that the Federal Reserve would respond to any market problems by an easing of monetary policy.

Many of us were nevertheless skeptical that risk had really been reduced to the extent implied by existing credit spreads. It looked like the very low interest rates on high grade bonds were incenting investors to buy riskier assets in the pursuit of yield. Many portfolio managers were enhancing the return on their portfolios by selling credit insurance – i.e., by using credit derivatives to assume more risk – and by using credit to leverage their investment portfolios on the assumption that the basic portfolio had relatively small risk. Investors took comfort from the apparent risk transfer in structured products. And less sophisticated investors were buying such structured products without actually recognizing the extent of the risk.

Most institutional investors who thought that risk was mispriced were nevertheless reluctant to invest on that view because of the cost of carrying that trade. Since virtually all such investors are agents and not principals, they could not afford to take a position that involved a series of short term losses. They would appear to be better investment managers by focusing on the short term gains that could be achieved by going with the herd to enhance yield by assuming increased credit risk.

But these investors also shared a widespread feeling that the day would come when it would be appropriate to switch sides, selling high risk bonds and reversing their credit derivative positions to become sellers of risk. No one knew just what would signal the time to change.

The crisis in the subprime mortgage market provided the shock that started the wider shift in credit spreads and credit availability.

Borrower with subprime credit ratings took adjustable rate loans with low teaser rates because they wanted to get in on the house price boom that was sweeping the country. Many of those who originated the loans were mortgage brokers who sold them almost immediately at a profit to the financial market.

The sophisticated buyers of the subprime loans could then bundle them into large pools of mortgages and sell participation in that pool. Often the pool was "tranched" to offer different degrees of risk to different buyers.

{In a simple case, the highest risk tranche might represent the first 10 percent of the mortgages to default and would carry a correspondingly high interest rate. Buyers of the next tranche would incur losses only if more than 10 percent of the mortgages defaulted. The highest quality tranche, which would incur losses only after 90 percent of the mortgages had defaulted, was regarded as so safe that the rating agencies would give it a better than AAA rating.}

In retrospect, the riskiness of individual tranches was often underestimated by the rating agencies and by those who bought the participation in the risk pool. These were nevertheless combined with other more traditional bonds and commercial paper in structured notes and even money market mutual funds that had high ratings and attractive yields.

This was clearly an accident waiting to happen. The subprime problem unfolded quickly with very high default rates on subprime loans.

Because subprime mortgages are a relatively small fraction of the total mortgage market and therefore an even smaller fraction of the total global credit market, many experts and government officials initially claimed that the subprime problem would have only a very limited effect on capital markets and the economy.

But the subprime defaults and the dramatic widening of credit spreads in that market triggered a widespread flight from risk, widening credit spreads more generally and causing price declines for risky assets. When those risky assets were held in leveraged accounts or when investors had sold risk insurance through credit derivatives, losses were substantial.

As credit spreads widened, investors and lenders became concerned that they did not know how to value complex risky assets. Credit ratings came under suspicion when failures exceeded levels associated with official credit ratings. A result was a drying up of credit for risky investments, including private equity acquisitions.

Loans to support private equity deals that were already in the pipeline could not be syndicated, forcing the commercial banks and investment banks to hold those loans on their own books. Banks are also being forced to honor credit guarantees to previously off-balance-sheet conduits and other back-up credit lines. These developments are reducing the capital available to support credit of all types. One result has been that hedge funds have been forced to sell stocks (or buy back short positions) because they could not obtain credit to maintain their portfolios.

It will of course be a good thing to have credit spreads that correctly reflect the actual risks of different assets. But the process of transition may be very costly to the overall economy.

Declining Mortgage Credit for Consumer Spending

This brings me to the third way in which the housing sector now contributes to the adverse outlook of the American economy: the potential for a substantial decline in consumption in response to declining home equity withdrawal through home equity loans and mortgage refinancing.

An important feature of the US mortgage system is that most borrowers can repay at any time without penalty. When interest rates fall, the borrower can replace the existing mortgage with a new one at a lower interest rate. If the value of the property has increased since the existing mortgage was obtained, refinancing also provides an opportunity to withdraw cash – the so-called mortgage equity withdrawal (or MEW).

Starting in 2001, the combination of lower mortgage rates and the rapid rise in house prices led to widespread refinancing with equity withdrawals, a practice heavily promoted by banks and mortgage brokers. { Someone who obtained a mortgage at 7.7 percent in 1997 could refinance at 5.8 percent rate in 2003 and extract substantial cash at the same time. }

{A massive amount of such refinancing and equity withdrawal occurred.} In 2005 40 percent of existing mortgages were refinanced. The Flow of Funds data imply that the

mortgage equity withdrawals between 1997 and 2006 totaled more than $9 trillion, an amount equal to more than 90 percent of disposable personal income in 2006.

This new borrowing was used to pay down other non-mortgage debts, to invest in financial assets, and to finance additional consumer spending.

There is a vigorous professional debate about the extent to which MEWs did lead to additional consumer spending, as Mishkin and Mullbauer indicate in their papers for this meeting.

{Alan Greenspan and James Kennedy concluded from an analysis of survey data that substantial fractions of the MEW funds were used to finance general consumption expenditures or used for home improvements. It is significant in this context that home improvements would generally be treated in the national income accounts as a form of consumer spending rather than investment.

{Mishkin and others are skeptical about the Greenspan interpretation, pointing out that individuals may undertake mortgage refinancing when they want to increase their spending or undertake home improvements. While that may be true in some cases, I believe that the combination of rapidly rising home prices that more than doubled the value of owner occupied housing between 1999 and 2006 – an increase of more than $10 trillion dollars – and the substantial fall in interest rates were the primary drivers of the large rise in mortgage equity withdrawals.

{The relatively long time series evidence on the relation between mortgage equity withdrawals and consumer spending is inconclusive, with some studies pointing to substantial effects of mortgage equity withdrawal and others the opposite. I am quite skeptical about this evidence because variations in national home values only became substantial after the year 2000.

Some economists argue on theoretical grounds that MEW should not change consumer spending, since consumption should be a function only of income (including expected future income), wealth, and the rate of interest. If so, the transformation of housing wealth into cash should not affect consumption. The extra cash should be used to reduce debt or invest in financial assets. I'm not convinced for two reasons. First, as Mullbauer notes, individuals who are liquidity constrained will consume more in response to an increased opportunity to borrow. Second, consumers can regard the increased spending on home improvements and major consumer durables as a form of investment that will provide services for years to come even though the national income accounts classify these outlays as consumer spending.

{The recently revised national income accounts show that personal saving fell sharply from 2.1 percent of disposable income in 2003 and 2004 to less than 0.5 percent in 2005 and 2006, a decline equal to about a $160 billion annual rate. I believe that a substantial part of that decline was due to the concurrent rise in MEW that resulted from low mortgage interest rates and increasing home prices.

My own judgement is that a substantial part of the decline in household saving over the past four years is the result of increased mortgage equity withdrawals.

The potential implication of this for the future is clear. A decline in housing prices and a rise in mortgage interest rates should shrink MEW and cause the household saving rate to return to a more normal level. This is clearly good in the long term, permitting increased investment in plant and equipment and reducing our dependence on capital from abroad.

But in the short run a rise in the saving rate and a decline in consumer spending would mean less aggregate demand. Whether this would be big enough to push the economy into recession depends on the magnitude and speed of the adjustment in mortgage equity withdrawals, the impact of the MEWs on consumer spending, and the state of aggregate demand as this occurs.

The mortgage refinance index has begun to decline in recent months and the level of revolving home equity loans has been declining since the beginning of the year. The household saving rate has started to rise {increasing from 0.4 percent of disposable income in 2006 to about 0.8 percent in the first half of 2007.} We will have to wait to see the impact of the sharp reduction in available mortgage credit that occurred in recent weeks.

Implications for Economic Policy

The three housing sector problems that I have discussed point to a potentially serious decline in aggregate demand and economic activity.

What are the implications for current Federal Reserve policy? It is widely agreed that neither the Federal Reserve nor the government should bail out individual borrowers or lenders whose past mistakes have created losses. Doing so would simply encourage more reckless behavior in the future. But it would be a mistake to permit a serious economic downturn just in order to avoid helping those market participants.

But what should be done about the frozen credit markets and the possible insolvencies that could result from mortgage defaults?

The Fed and other central banks have stressed their roles as lenders of last resort, providing liquidity to member banks against good collateral at rates that exceed the federal funds rate. There are of course many important financial institutions – including the investment banks and large hedge funds – that do not have access to the Fed's discount window. The Fed has encouraged the commercial banks to lend to them against collateral with the ability to rediscount that collateral at the Federal Reserve.

It is not clear whether this will succeed, since much of the credit market problem reflects a lack of trust , an inability to value securities, and a concern about counterparty risks. The inability of credit markets to function adequately will weaken the overall economy over the coming months. And even when the credit market crisis has passed, the wider credit spreads and increased risk aversion will be a damper on future economic activity.

Even with the best of policies to increase liquidity, future aggregate demand is likely to be depressed by weak housing construction, depressed consumer spending and the impaired credit markets. Lower interest rates now would help by stimulating the demand for housing, autos and other consumer durables, by encouraging a more competitive dollar to stimulate increased net exports, by raising share prices that increased both business investment and consumer spending, and by freeing up spendable cash for homeowners with adjustable rate mortgages.

Yet, at the same time there remains a risk of rising inflation because of slowing productivity growth (with unit labor costs up 4.5 percent from the second quarter of 2006 to the second quarter of 2007), the falling dollar, and higher food prices that have pushed market based consumer prices up at a 4.6 percent rate in the second quarter.} How should the Fed now balance these two goals?

There is of course a need for adjustment – not only to bring credit spreads back to realistic levels but also to reduce spending by American consumers in order to raise the national saving rate and shrink the U.S. current account deficit. The challenge is to bring about this adjustment without the hardship of a deep economic downturn.

What does this mean in practice? We know that there is no long-run trade-off between price stability and achieving full employment and growth. But how should policy makers interpret the short run relation between price stability and employment?

One view is that monetary policy should focus exclusively on achieving price stability because that is the best way to achieve full employment and maximum sustainable growth as rapidly as possible. If that view is correct, there is no reason to change current monetary policy. The existing 5.25 percent nominal federal funds rate is relatively tight in comparison to the historic average real fed funds rate of about two percent. The problems that I have discussed will simply reinforce this tight monetary policy and speed the decline in inflation.

But there is an alternative and more widely held view that the Federal Reserve should give explicit weight to unemployment or unused capacity in the short run as well as to inflation. That is the view that underlies all variants of the Taylor rule. If that view is accepted, there are two reasons for a major reduction now in the federal funds rate – possibly by as much as 100 basis points.

First, experience suggests that the dramatic decline in residential construction provides an early warning of a coming recession. The likelihood of a recession is increased by what is happening in credit markets and in mortgage borrowing. Most of these forces are inadequately captured by the formal macroeconomic models used by the federal reserve and other macro forecasters.

Second, even if all of the evidence does not add up to a high probability of an unacceptable decline in economic activity, the Fed could adopt the risk-based "decision theory" approach in responding to the current economic environment. If the triple threat from the housing sector materializes with full force, the economy could suffer a very serious downturn. A sharp reduction in the interest rate – in addition to a vigorous lender of last resort policy – would attenuate that very bad outcome.

But what if the outcome in the absence of a substantial rate cut would be more benign and yet the Fed nevertheless cuts the federal funds rate? The result would be a stronger economy with higher inflation than the Fed desires, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it succeeds in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability.


© Copyright 2007 by Finfacts.com

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