Tuesday, January 8, 2008

How Bad A Recession?


More and more observers are turning gloomy regarding the economy’s outlook. If they are correct, and the economy faces recession, how bad will it be and how long will it last?

Yesterday’s blog drew your attention to the collapse of new-home sales by reporting November’s 647,000 sales rate. Update the chart below with that number and you’ll have an idea of the seriousness of the housing debacle.

New Home Sales

(Click on chart to enlarge)

Recessions shaded

Yesterday’s blog also commented on the disproportionate size of the 1995 – 2005 housing boom. The boom raises the question: “Were too many homes built, and how long before we can reasonably expect a construction revival?” It seems clear that low interest rates and risky financing encouraged speculation that put more homes on the market than the nation could afford. Now that the mania is over and the bubble is deflating, a related question is: “By how much must home prices fall to encourage renewed growth?”
Two recent articles in The New York Times and The Wall Street Journal indicate that the housing slump may be protracted and it will be a long time before we see a strong housing recovery. The New York Times article, by Peter Schiff on December 26, 2007, pulls no punches: http://www.nytimes.com/2007/12/26/opinion/26schiff.html

“We are suffering from a home value crisis, not simply a credit crisis….A recent study by the Federal Reserve Bank of Boston found that most foreclosures result from falling home prices, not from the resetting of mortgage rates…..

“Whether or not their payment levels are frozen, borrowers with loans that are greater than the values of their homes will have few incentives to keep paying their mortgages or to maintain their properties. Why spend more on a home in which they have no equity and which they may lose to foreclosure anyway?

“Everyone seems to agree that a return to traditional lending standards is a good idea, but no one seems willing to accept a return to rational prices as a consequence..…

“While the bubble was inflating, self-serving explanations were offered for why traditional formulas of home valuation no longer applied. As it turns out, the laws are still in effect. These traditional measures, like the relationship between home prices, rents and income, indicate that prices need to fall at least 30 percent more nationally. The sooner this balance is achieved, the sooner lenders will again commit capital. “

Why pay off a $400,000 mortgage on a home that is worth only $300,000? As long as people have an incentive to walk away from their homes, it is hard to see why prices should stop falling.

Moreover, as Greg Ip said in the January 3, 2008 Wall Street Journal, home prices must fall much further to reclaim their traditional relationship to rental payments: http://online.wsj.com/article/SB119931831334463571.html

“U.S. house prices "likely would have to fall considerably" to return to a normal relationship with rents, says a study by one former and two current Federal Reserve economists.

“…. the rent/price ratio is about a third below its long-term average. To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade.

“Mr. Davis said the authors postulated a five-year horizon for the rent/price ratio to return to normal by looking at previous downturns. "When a downturn begins, it will last for a while."

Since it’s hard to imagine rents will rise rapidly if there is a glut of homes on the market, home prices must fall considerably. That price decline reduces the incentive to buy, and therefore build, residential real estate.

This observation bears repeating. It may be true that home prices must fall to attract renewed buyer interest, but it is also true that falling prices scare-away buyers. That’s the problem with asset inflations and deflations and why bubbles form and deflate. Rising prices attract speculators until the fundamentals become unbearable. Falling prices repel buyers until the fundamentals are undeniable. That’s why it takes a while for the bubble to inflate, and may take equally long to deflate.

That creates a grim prognosis for the residential construction industry and the entire economy. This may be no ordinary housing bust. Lending practices and speculation may have super-sized it.

(The chart is taken from http://www.beyourowneconomist.com/. [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of Economic Indicators.)

© 2008 Michael B. Lehmann

No comments: