Monday, November 12, 2007

Roubini on Home Equity Extraction

by Calculated Risk on 11/12/2007 04:53:00 PM

In his most recent post, Professor Roubini commented on the impact of less homeowner equity extraction on consumption.

Note that Roubini calls equity extraction HEW (Home Equity Withdrawal) and I usually refer to it as MEW (Mortgage Equity Withdrawal). MEW has been used for years, but HEW is a more accurate description.

Roubini writes:

... there is the effect of home equity withdrawal (HEW) on consumption. There is some debate in the literature on whether the effect of HEW is a proxy for the wealth effect or an additional and separate effect. Again the literature has a variety of estimates ranging from 50% of HEW being consumed according to Greenspan-Kennedy to 25% of it being consumed according to other studies. The appropriate measure of HEW is also important: gross or net, overall or active. HEW peaked at $700 billion annualized in 2005 and has dropped to about $150 billion by Q2 of 2007. So, the fall in consumption – assuming unrealistically no further fall in HEW from now on – would be $275 billion based on the Greenspan-Kennedy estimates or about $140 billion according to the more conservative estimates. Evidence suggests that this effect of HEW on consumption occurs with lags; that is why we have not yet seen its full effects on consumption as late as Q3. Rather, we will see its effects in the next few quarters. Another interpretation – according to Zandi – is that HEW (measured in a different way) has started to fall only in the recent quarters; so again the effect of falling HEW on consumption will be observed mostly in 2008.
First, for those that want to follow along, here is a copy of the Kennedy-Greenspan data for Q2 in Excel. NOTE this request from the Fed:
These data are the product of a research project undertaken by James Kennedy and Alan Greenspan. The data are not an official publication or product of the Federal Reserve Board. If you cite these data, please reference one of the two papers that Jim wrote with Alan Greenspan. For example, a reference might read something like this:

"Updated estimates provided by Jim Kennedy of the mortgage system presented in "Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences," Alan Greenspan and James Kennedy, Federal Reserve Board FEDS working paper no. 2005-41."
Here are the Seasonally Adjusted Annual Rate (SAAR) Kennedy-Greenspan estimates of home equity extraction through Q2 2007, provided by James Kennedy based on the mortgage system presented in "Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences," Alan Greenspan and James Kennedy, Federal Reserve Board FEDS working paper no. 2005-41.

Kennedy Greenspan Mortgage Equity Withdrawal For Q2 2007, Dr. Kennedy calculated Net Equity Extraction as $494.4 Billion (SAAR), or 4.9% of Disposable Personal Income (DPI).

This graph shows the MEW results, both in billions of dollars quarterly (not annual rate), and as a percent of personal disposable income.

Roubini is suggesting the MEW has declined significantly in Q2. I think this is incorrect. Roubini wrote:
HEW peaked at $700 billion annualized in 2005 and has dropped to about $150 billion by Q2 of 2007.
According to Dr. Kennedy, MEW was about $140 Billion in Q2 2007 (or a seasonally adjusted annual rate of almost $500 Billion). So MEW hasn't fallen very far yet! This actually makes Roubini's argument even stronger. So I'd argue the following sentence is also incorrect:
So, the fall in consumption – assuming unrealistically no further fall in HEW from now on – would be $275 billion based on the Greenspan-Kennedy estimates or about $140 billion according to the more conservative estimates.
In fact I expect MEW to fall signficantly starting in Q4 2007. As of Q2, 2007 the consumption impact of falling MEW (using 50%) would be closer to $25 Billion per quarter ($100 Billion annualized), and even though there appears to be a lag from equity extraction to consumption, most of the decline in equity extraction is still ahead of us.

In fact it appears MEW was strong in Q3 based on my advance estimate. Using the Q3 GDP data from the BEA, my advance estimate for Mortgage Equity Withdrawal (MEW) is approximately $520 Billion (SAAR) or 5.1% of Disposable Personal Income (DPI). This would be slightly higher than the Q2 estimates, from the Fed's Dr. Kennedy, of $494.4 Billion (SAAR), or 4.9% of Disposable Personal Income (DPI).

The actual Q3 data for MEW is released after the Flow of Funds report is available from the Fed (scheduled for December 6th for Q3).

Advance Mortgage Equity Withdrawal Estimate Click on graph for larger image.

This graph compares my advance MEW estimate (as a percent of DPI) with the MEW estimate from Dr. James Kennedy at the Federal Reserve. The correlation is pretty high (0.90, R2 = 0.81) but there are differences quarter to quarter. This does suggest that MEW was at about the same level in Q3 as Q2. We will have to wait until September to know for sure.

MEW will probably decline precipitously in the Q4 2007, with a combination of tighter lending standards and falling house prices. The impact of less equity extraction on consumer spending is still being debated, but I agree with Roubini that a slowdown in consumption expenditures is likely.