paulbissett.com

I have become a real fan of the CalculatedRisk blog.  This article summarizes some of the headwinds faced by new home builders.

Figure 1. Total New and Existing Home Sales and the gap between them (source: The CalculatedRisk blog).

1) The stimulus funding for home buyer tax credits has generated demand for homes, at the expense of draining the pool of future home buyers.  There does not appear to be any political will to extend these credits.  Short-term demand for total homes is likely to fall (Figure 1).

2) Foreclosures and distressed pricing of existing home sales will continue to increase in the mid- to high price ranges, but appear to have peaked overall in 2009.  They will continue to remain at higher than historical levels in the lower price ranges (Figure 2).

Figure 2. California foreclosures (source: The CalculatedRisk blog).

I am personally concerned about the possibility of a double dip recession.  While economic demand is increasing off of last year’s lows, we are not growing top line economy-wide revenues as would have been expected for recessions of this size.

This period looks remarkably like the 1974-1976 period; and the key to housing, and the economy in general, is unemployment. If we stay above 9% through the end of this year, I believe that the economy, and therefore housing, will remain (at best) at anemic levels.

3) The continued high levels of foreclosures, combined with high unemployment, will continue to drive pricing in housing to low levels.  These levels will probably be below replacement costs, and we will continue to see low levels of new homes to existing homes sales ratios (Figure 3).

It took 4 years to reach this level of lows in the new home to existing home sales ratio.  Given the current economic (and political) environment, I would expect that it will take a similar amount of time for new home sale to recover to the long-term average of ~15-20% of existing home sales.  However, return to this level would also be commensurate with a return to total new home sales of about 600,000 to 800,000 units, which is nearly half of the peak in 2005 (Figure 1).

This, of course, is a national average.  Places like Florida, California, Nevada, and Arizona may have a longer recovery period.

A recovery of the new home housing market, to half of its peak, in 4-6 years, will not feel like much of a recovery.  It will feel more like survival.

I read Paul Krugman’s columns on a regular basis. A frequent topic of his columns is his perceived need to pursue Keynesian solutions to our current economics problems. Keynsesian solutions propose that government should spend liberally during times of economic troubles in order keep the economy operating efficiently until such time that private segment spending and investment can “get back in the game.” Public spending should act as a governor to business cycles, spending more in times of recession, and spending less during economic booms. This article (and this one and this one) suggests that the Obama administration erred in not being more aggressive in their stimulus efforts, and that the economy will suffer without more deficit spending by the government.

It may be an extreme act of hubris to critically comment on the rhetoric of a Nobel Prize winner in Economics. However, he seems to ignores the fact that public stimulus can come in two forms, one through direct government spending (e.g. spending on infrastructure) and transfer payments (e.g. unemployment benefits), and the other through the monetary policy of the federal reserve.

There are several problems with direct governmental spending to support Keynesian goals. First, is that it takes a long-time to get bills through Congress, so by the time the money actually starts flowing, the economy has typically worked through its issues. Second, Congressional priorities are typically not the same as those priorities required to get the economy back on its feet. Thus, the money is inefficiently spent with respect to helping the economy. Third, a true Keynesian spending program would be reduced when the economy is doing well. However, Congress has yet to reduce real spending during any period since 1960 (see chart.)

A much better approach to stimulate the economy is through the monetary operations of he Federal Reserve. As this previous post suggests, the Federal Reserve has made a huge bet on monetary stimulus, to the tune of $13 trillion, far in excess of that requested by Mr. Krugman. This stimulus continues today, and is not just through low interest rates (which may be leading to asset inflation in other countries through the dollar carry-trade), but also through direct purchases of mortgages from Freddie Mae and Fannie Mac (and here). This stimulus is huge. In addition to the direct Federal Reserve purchases for these bonds, the government guaranteed 98% of the residential mortgages in the third quarter, providing an “off-the-balance sheet” stimulus that is not included in any of the accounting for governmental or federal reserve actions.

Mr. Krugman obviously knows the importance of the continued easy money policy of the Federal Reserve. However, it is not clear to me why Mr. Krugman continues to write on the importance of another direct stimulus effort from the government, which would only be a small fraction of what the Federal Reserve and off-the-balance-sheet efforts have already committed to the economy. An expansion of direct spending seems to be more of a political desire for increased top-down control of the economy, than any true desire for more economic stimulus.

Or the road to hell is paved with good intentions

So the housing market is to get some direct help. First, by recapping Freddie Mae and Fannie Mac with $200 billion. They are effectively creating at least $4 trillion in new mortgage money if the 20X leverage ratio for these monstrosities holds. More if the leverage ratio is allowed to increase (at the end of 2008 these ratios were 20X and 70X for Fannie and Freddie, respectively). This will continue the path of nationalization of the mortgage industry. Will someone please show me one example where the nationalization of an industry provided the long-term benefits it was meant to secure?

In addition, the administration will now back “cram-down” legislation. This will force the rewriting of mortgage contracts in a bankruptcy filing. The effect of this legislation will be to increase the mortgage spreads to treasuries, as issuers will demand more risk premium for issuing the mortgage. This will insure we will all pay more for our mortgages in the future.

A possible solution to the increasing mortgage spreads will be to “fix” mortgage rates. The administration will be able to do this because they will have effectively nationalized the mortgage market (see above).

Price fixing always fails in the effective distribution of goods and services. It creates winners and losers by subjective rules that have no relationship to individual incentive.

In this perverse case here, Congress forced Freddie and Fannie to underwrite sub-prime mortgages in an effort “increase” home ownership. This led to price dislocation (i.e. a bubble) from too many people chasing too few houses. The pricing bubble led to a misallocation of resources in the housing industry, which built too many houses because of the excess demand caused by the excess available credit.

A tremendous amount of those bubble home purchases are now underwater. And since the owners never could afford the homes in the first place, they find bankruptcy their only option to relieve them of their contractual obligations. The same people in government who set these homeowners up for failure now want to penalize the rest of the housing market with more expensive mortgages.

Look for this severe warning sign, price fixing of mortgages. Either explicitly via mortgage rates, or implicitly via a “credit worthiness” criteria outside of the true bill paying capability of the borrower that helps some buyers over others get mortgages from our national mortgage providers. If you see this happen, our troubles are just beginning.

I must be channeling the editorial staff at the Wall Street Journal.  We must have both heard the same NPR show this Thursday morning.  In this article they discuss the recent idea to limit mortgage rates to 4%.

They point to some of the problems with this proposal, but there are other problems with the government trying to qualify borrowers.  The manipulation of lending standards at Freddie Mae and Fannie Mac for the purpose of trying to expand the ranks of home ownership are what got us into the mess in the first place.  However, imagine if the government errs on the other conservative side of the credit markets (which is exactly what the federal regulators are doing to commercial banking right now).  While interest rates may be 4%, very few people will be able to qualify, and the credit markets will remain frozen.

The Great Depression did not result from the Crash of ’29, but rather the regulatory and monetary practices that followed in response.  Price fixing and regulatory limitation of market are what produced 25% unemployment.

The recent economy was highly leveraged, which resulted in asset inflation.  The over-leverage resulted from lots of reasons, not the least of which was poor regulation rather than the absence of regulation.  The process of de-leveraging the economy will cause asset deflation and economic dislocation, but it does not necessarily have to cause extensive price deflation for other goods and services.  Bad regulation, bad fiscal policy, and bad monetary policy will give us the exact problem they are trying to solve.