Monday, January 08, 2007

Downside Risk: A Mixed Bag from the Fed

The last two speeches given by Federal Reserve members Cathy E. Minehan, President and CEO of the Federal Reserve Bank of Boston, and Donald L. Kohn, Vice Chairman of the Federal Reserve shed further light on the Fed’s recent cautious yet somewhat mixed stance on the housing downturn and it’s possible effects on the overall economy.

Last Friday, Minehan offered an interestingly conflicted outlook seemingly remaining sanguine yet tentative.

Initially, Minehan frames the key concern of the “spillover” effect that the housing downturn could have on consumption quite nicely by stating:

“In the nonfarm business sector, inflation adjusted compensation growth fell short of productivity by 2 percentage points or more for several years until 2006. This slow wage growth occurred even as business profits were at historically high levels, causing worry that workers are not getting their fair share of the pie. Indeed, median household income fell in real terms in every year from 1999 to 2004, and even though it rose slightly in 2005 -- the latest year for which we have data -- it was still only at about 1998 levels. All of this begs the question -- could some combination of housing downturn and pressures on consumers produce a much slower rate of growth than now expected?”

While many local housing markets in the country saw median home prices start to diverge fairly dramatically from median household income in the 1997 – 2000 time frame, as Minehan points out, real median household income fell all the way through to the peak of the bubble in 2005.

This is important since household income is probably one of the most important fundamental long term factors that drive home prices and clearly hasn't played a key role in the price run-up seen in this cycle.

It takes only a little investigation to discover that the main impetus to the startling run-up in home prices during this period was a dramatic decline to real lending rates coupled with unparalleled access to capital through loose lending practices.

But are are unusually low rates and loose lending grounds for "fundamental" change in home prices?

Consider this, if the average 30 year fixed rate were to rise close to or even slightly exceed a 7.0% nominal rate in the next year or so, what do you think would be the outlook for the housing market then?

Not good I would imagine.

With prices in the stratosphere and income flat to declining, a simple 1% notch up in rates could easily bring affordability to its knees for most Americans.

Interestingly though, Minehan answers her own prior question with the following response:

“While possible [housing downturn putting pressure on consumption], in my view this is not likely for a number of reasons. First, a nationwide drop in house prices [as reported by OFHEO] fairly measured would be unprecedented, at least for any extended period of time. Indeed, as I noted before, there are signs that the real estate market may be bottoming out and prices firming, though residential investment growth is likely to be negative for some time. Second, employment trends remain solid, and equity markets upbeat, counteracting the impact on consumer wealth and spending from flattening or even falling home prices in some areas.”

Here, Minehan’s personal outlook seems to show some simple logical flaws.

Firstly, whether or not the OFHEO index registers a drop in home prices nationally seems to be a bit of a Non sequitur in that the OFHEO index is already showing declines to the Massachusetts, New Hampshire, Rhode Island, Michigan, and New York housing markets and significant decelerations to price appreciation in many more markets all resulting in the most dramatic deceleration in the index’s history.

Will the OFHEO index eventually register a decline for the first time in history? I think it will and sooner than many may be anticipating, but is the fact that that event is “unprecedented” grounds for adopting an outlook that the housing downturn is “unlikely” to cause significant spillover on the consumer? I don’t think so.

Additionally, Minehan supposes that the current strong employment situation and stock market gains will “counteract” the impact that rapidly deprecating home prices will have on the consumer.

On this point, I think Minehan is seriously underestimating the widespread and fundamental shock that loss of housing wealth will have on the ordinary American.

Home ownership is now at an all time high with nearly 70% of all Americans owning a home but as we all are well aware, significant percentages of "homeowners", especially in the last five years, have little to no or even negative equity in their homes as they desperately stretched to match the ever dwindling affordability by both foregoing deposits and resorting to the use of unusual and volatile lending products.

Many homeowners, who got in early and resisted the temptations presented by cash-out refinancing and HELOCs, may continue to feel confident, but with every 5% decline to home prices there are whole classes of more recent and low equity “owners” that are going underwater fast.

Furthermore, the employment picture has been strong (unusually strong) all through 2005 and 2006 and it failed prevent the massive declines to home sales and construction spending just as it will fail to support the home prices that were artificially inflated by many years of speculative mania.

Today, on the other hand, Vice Chairman Donald Kohn offers a more uncertain outlook:

“My expectations for 2007 quite naturally rest on an assessment of how recent trends are likely to play themselves out. How long will the decline in housing activity hold back overall economic growth? What about spillovers from housing to other sectors? What are we to make of the recent weakness in manufacturing activity? Will the recent good news on inflation persist? Before venturing some guesses on these questions, I need to issue two caveats. First, events will probably unfold differently than currently seems likely, and the range of uncertainty around any forecast is considerable. That uncertainty does not, however, diminish the value of having and discussing an outlook. Monetary policy must be based on our best estimate of future developments, and the effectiveness of policy is aided when the public understands the outlook of policymakers. But the uncertainty does underscore the value of monitoring the incoming information closely, as we always do, and of being prepared to adjust our expectations accordingly. Second, the views that I will express today are my own and not necessarily those of my colleagues on the Federal Open Market Committee (FOMC)”

Furthermore, Kohn adds:

“Home sales appear to have flattened out since midyear, mortgage applications have been increasing, and consumers' perceptions of homebuying conditions, as reported in the Michigan survey, have improved. Nonetheless, even if the demand for housing is leveling off, housing activity may not yet have found a floor, given the sizable overhang of unsold houses.”

“Uncertainty about where we stand in the housing cycle remains considerable. In part, that is because this housing downturn has differed from some of those in the past in important ways. It was not triggered by a restrictive monetary policy and high interest rates; indeed, relatively low intermediate and long-term interest rates are helping to support the stabilization of this sector. But the current contraction in housing did follow an unusually large run-up in sales and construction and, even more so, in prices relative to the returns on other financial and real assets.”

“In my own judgment, housing starts may be not very far from their trough, but the risks around this outlook still are largely to the downside. Although house prices nationally have decelerated noticeably and appear to have fallen in some markets, they are still high relative to rents and interest rates. Building permits decreased substantially again in November, and inventories of unsold homes have only started to edge lower. We also do not know whether the possible stabilization that seems to be taking hold would be immune to a rise in longer-term interest rates should term premiums increase or the federal funds rate fail to follow the downward path currently built into market expectations. Even if starts stabilize at close to current levels, those levels are sufficiently low that overall construction activity would remain a negative for the growth of economic activity in the first half of this year.”

For my money, Kohn presents a more realistic outlook leaving open many opportunities for more additional downside risk for housing in 2007.

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