by Calculated Risk on 8/29/2005 01:54:00 AM

Dr. Krugman writes in the NY Times about Greenspan and the Bubble:

At the conference, Mr. Greenspan didn't say in plain English that house prices are way out of line .... What he did say ... that "history has not dealt kindly with the aftermath of protracted periods of low-risk premiums." I believe that translates as "Beware the bursting bubble."

But as recently as last October Mr. Greenspan dismissed talk of a housing bubble: "While local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely."

Wait, it gets worse. These days Mr. Greenspan expresses concern about the financial risks created by "the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages." But last year he encouraged families to take on those very risks ...

Then Dr. Krugman asks the question we've all been asking: How bad will it be?

The U.S. economy is currently suffering from twin imbalances. ... domestic spending is swollen by the housing bubble, which has led both to a huge surge in construction and to high consumer spending, as people extract equity from their homes. On the other side, we have a huge trade deficit ...

One way or another, the economy will eventually eliminate both imbalances. But if the process doesn't go smoothly - if, in particular, the housing bubble bursts before the trade deficit shrinks - we're going to have an economic slowdown, and possibly a recession. ...

A housing slowdown will lead to the loss of many jobs in construction and service industries but won't have much direct effect on the trade deficit. So those jobs won't be replaced by new jobs elsewhere until and unless something else, like a plunge in the value of the dollar, makes U.S. goods more competitive on world markets, leading to higher exports and lower imports.

So there's a rough ride ahead for the U.S. economy ....

by Calculated Risk on 8/29/2005 12:14:00 AM

My most recent post is up on Angry Bear: Housing and Recession

Every time I sat down at my computer today, I found myself checking on hurricane Katrina. I am in shock. The residents of New Orleans are in my thoughts tonight. A couple of days ago I thought this storm might impact the already tight gasoline supplies, but I didn't think it would become a potentially catastrophic storm.

Hopefully the storm will weaken before landfall.

Best to all.

by Calculated Risk on 8/28/2005 09:22:00 AM

The LA Times has two related articles this morning on borrowing and bankruptcy. From "Equity Is Altering Spending Habits and View of Debt":

People are cashing out so quickly that the term "homeowner" may soon be inaccurate. Fifty years ago, Americans owned, on average, three-quarters of their house and the lender owned the rest. These days, it's approaching an even split.

This spend-now-rather-than-save-for-later phenomenon has produced undeniable benefits. Experts attribute much of the nation's economic growth to cash-out refinancings, home equity loans and other methods of tapping rising home values.

This is behavior is being encouraged by industry "experts":

"If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years," said David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?" "It's as if you had 500,000 dollar bills stuffed in your mattress."

He called it "very unsophisticated."

Anthony Hsieh, chief executive of LendingTree Loans, an Internet-based mortgage company, used a more disparaging term. "If you own your own home free and clear, people will often refer to you as a fool. All that money sitting there, doing nothing."

The financial services industry is doing all it can to avoid letting consumers be foolish. Ditech.com touts home loans as a way to pay off credit cards, and Morgan Stanley says they're a good way to fund education expenses. Wells Fargo suggests taking a chunk out of your house to finance "a dream wedding."

The entire article is fascinating, but this anecdote shows poor financial planning:

He bought his condo in expensive Marin County, north of San Francisco, for $510,000 in April 2004. The bank offered to finance the whole thing, but he decided to be a little conservative and put 5% down.

By January, the condo was worth $555,000, and Levy refinanced. He took out $25,000 in cash, less than the bank offered to give him. The money paid off what he describes as "really ugly" credit card debt.

The interest rate on the credit card had been more than double the rate on his mortgage, so he saved about $600 a month. Furthermore, his mortgage interest is tax-deductible; his credit card interest was not.

"It used to be that all debt was created equal and all debt was evil," Levy said. "But the tax breaks alone make a pretty compelling case to use home equity to finance just about everything."

Although money is fungible, paying for short term assets with long term debt is poor financial planning. Imagine going to a fast food restaurant and buying a hamburger on your credit card. Then you borrow money against your house to pay off your credit card debt. Now you are financing lunch for 30 years!

The other article in the LA Times, "A fresh calamity?", fits nicely with the first.

Under the new bankruptcy regulations, homeowners will no longer necessarily be able to hand the keys to the bank and move on. Lenders will, in many cases, have the option of coming after them for virtually everything else they've got -- income, money in bank accounts and other assets.

Homeowners who have refinanced may have unwittingly put themselves at the greatest risk. State regulations will still offer financial protections for buyers who have their original mortgages.

"There is no doubt this law will make it harder for some people to walk away," said Gary Painter, a professor at the USC School of Policy, Planning and Development. "It definitely could hurt homeowners."

For homeowners that are heavily in debt, and have refinanced or used a HELOC (Home Equity Line of Credit), this might be their future.

I wonder who is going to look "foolish" and "unsophisticated" in the coming years.

by Calculated Risk on 8/27/2005 06:38:00 PM

From FED Chairman Alan Greenspan's closing remarks at Jackson Hole, Wyoming:

"... the housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home price increases will slow and prices could even decrease. As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures. The estimates of how much differ widely."

Emphasis added. I believe prices will decrease. And the following, on the relationship between home equity extraction and the currenct account (mostly trade) deficit, is important in how the imbalances will unwind:

"The surprisingly high correlation between increases in home equity extraction and the current account deficit suggests that an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports, and a corresponding improvement in the current account deficit."

And part of Greenspan's conclusion is a little scary:

"Surely difficult challenges lie ahead for the Fed, some undoubtedly of our own making, and others that will be thrust on us by market or other forces."

by Calculated Risk on 8/27/2005 12:03:00 AM

Gasoline stocks have continued to drop and are now near the bottom of the normal range.

Click on graph for larger image.

This graph is from the DOE.

It is possible that we might see a regional spike in gasoline prices unrelated to the price of oil. With possible major hurricane Katrina bearing down on the gulf coast, a drop in the already tight supply might occur.


The National Hurricane Center provides frequent updates on tropical storms. Although the exact location of landfall and intensity are difficult to predict, it appears Katrina will pass over extremely warm waters and make landfall in the Gulf Coast late Monday. This could disrupt several refineries including the 300,000 barrel-a-day Chevron Pascagoula, Mississippi facility.

Meanwhile demand for gasoline has remained strong.


This graph shows the Year over Year % increase in demand for:

1) Year to date.

2) Last 8 weeks compared to similar period last year.

3) Last 4 weeks compared to similar period last year.

(SOURCE: DOE)

Year to date demand for gasoline remains strong. For the shorter periods there is some normal variability, but there is no clear evidence of weakening demand for either period: the last 8 weeks and the last 4 weeks compared to 2004.

This is an update to an earlier post that discusses how the US economy has become more dependent on oil for transportation purposes as opposed to other uses of petroleum.

by Calculated Risk on 8/26/2005 05:20:00 PM

From an interview with FoxNews, Dr. Leamer Director of UCLA Anderson Forecast:

... the housing market appears to have peaked "in California and elsewhere. It will take more than a year for this weakness to turn into job losses and to affect the economy in general.

Dr. Leamer believes the housing slow down will lead to a recession and will be felt everywhere:

And contrary to what a lot of so-called "experts" are predicting, Leamer, believes the pain will be felt on a national level, not just locally. As an economist he’s much more concerned about the broader implications of a slowdown in the housing market than about the price bubbles some areas are experiencing.

"We’ve had ten economic downturns since World War II and eight of them started in the housing sector. It’s the first component of gross domestic product that starts to weaken," says Leamer. He keeps a close eye on what consumers spend on housing because it has a ripple effect, pointing out that a decline will lead to layoffs in construction, banking, and the real estate industry, to name just a few areas.

And its not just housing - Dr. Leamer is concerned about the auto industry too:

Leamer lays the blame squarely on the Federal Reserve for leaving interest rates too low for too long. Now, he says, we’re not only heading for trouble in the housing sector, but in the auto industry — another market that got drunk on historically low rates.

Low borrowing costs accelerated future sales by enticing consumers to trade up to bigger homes and new vehicles sooner than they might have done otherwise. ... As a result, car dealers lose the sale they would have gotten two years from now.

As rates creep higher, consumers happily driving their new cars or living in their larger homes have no motivation to purchase additional ones. Since consumer spending drives two-thirds of our economy, when consumers close their wallets, the impact is far-reaching.

While the real estate bubble itself may be all about "location, location, location," in Leamer’s view the coming housing slowdown will have national implications, although areas that have benefited most from the housing boom are likely to be hit hardest. For example, Southern California, where Leamer lives. He says the strong housing market "created a lot of jobs — in construction, in banking, in real estate. If that disappears, a basic driver for the local economy disappears." ...

Leamer's advice:

If you’ve been shopping for a home, Leamer says you "need to recognize the risk and do some hard-nosed thinking" ... he suggests you add up all the monthly costs and benefits (such as tax deductions) of owning versus renting. If buying still makes sense, his advice is: "Think long term — seven to 10 years. Avoid adjustable rate mortgages. Lock in a low, fixed interest rate." ... "If you’re not sure you’re going to be living in the home in two to three years, don’t buy it."

by Calculated Risk on 8/26/2005 03:33:00 PM

Dr. Duy discusses a wide variety of topics in today's Fed Watch. Dr. Duy thinks it is very likely that the FED Funds rate will reach 4.25% by the December FOMC meeting:

"... I see the calendar as supportive of another 75bp this year - which will come close to cutting the yield curve to zero unless long term rates start to move - and I see no indications from Fed officials to tell me that this story is wildly wrong."

And Duy cautions that the markets may not be prepared:

"... one has to wonder if financial market participants are not entirely convinced that the Fed will continue to raise rates and narrow the spread, or, if the Fed did so to the detriment of the economy, it would quickly reverse course to support financial markets - the "Greenspan put." To me, the latter is not a given this time, especially in an environment of rising energy prices."

Duy concludes:

"... regardless of the possibility of a recession in 2006, I still see the Fed as laying the groundwork for continued monetary tightening, even as they see the possibility that financial markets are not entirely prepared for that outcome."

As usual, a very insightful look at the Fed's World View.

Dr. Duy's post: Fed Watch: Forecast Calls For More Rate Hikes

by Calculated Risk on 8/26/2005 11:02:00 AM

Greenspan spoke this morning at Jackson Hole, Wyoming. This weekend will see many stories on Chairman Greenspan, but here are a few relevant comments (My emphasis added):

The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.

The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.

Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.

The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

by Calculated Risk on 8/26/2005 01:03:00 AM

Bill Maher writes in the LA Times: But don't let me burst your bubble

You don't have to remember history, but you do have to remember Thursday. The bursting of the Nasdaq bubble was only five years ago. People lost a trillion dollars. And here we are today with real estate prices across the country that could aptly be compared to Courtney Love: irrationally high and about to collapse.

I don't want to say there's a housing bubble, but I had a refrigerator delivered this morning and a homeless guy offered me $3 million for the box. Not to burst your bubble, but all bubbles do burst. And we learned this recently. It's not just that grandma was alive the last time it happened. You were alive. Eminem was on the radio. Just like now because, again, it wasn't that long ago.

Enjoy!

by Calculated Risk on 8/25/2005 06:52:00 PM

Floyd Norris, chief financial correspondent of The New York Times, has an interesting take on the housing market:

If housing prices fall, will mortgages cushion the downfall, or make it worse? Put another way, will more overstretched homeowners be forced to sell?

At issue is whether financial innovations that have made it easier for Americans to buy homes have also made the system less stable and more vulnerable to shocks that could drive many of them from their homes, having lost all they invested in them.

Mr. Norris reviews previous housing slowdowns and contrasts housing, bought with mortgages, to stock, bought on margin. I recommend reading his comments.

The interesting and somewhat novel observation is that Mr. Norris believes we can tell, when housing starts to slow down, if it is an ordinary housing slowdown or a possible disaster by whether or not transaction volumes decline significantly for existing home sales.

But if and when a fall comes, watch the volume of home sales, particularly of existing homes. Back in 1978, almost four million sales of such homes were counted by the National Association of Realtors. By 1982, amid recession and rising interest rates, the figure was under two million.
...
If [then number of transactions] falls rapidly, that will be an indication that not much has changed, and the damage is likely to be limited.

But if sales volume stays high, that could indicate that the mortgage innovations are hurting. Then we could see rising numbers of foreclosures as homeowners discover they cannot sell their homes for what they owe but also cannot pay their suddenly higher monthly mortgage bills.

I've been expecting volumes to drop significantly (what Mr. Norris suggests is normal). Of course the "limited damage" would be a slow down in GDP growth or a mild recession.

If volumes stay high while prices drop, Mr. Norris argues we are in for tough times.