Today Shiller – like Krugman last Friday – comes only one notch short of predicting a housing-led recession; he believes that there is a severe housing bust coming but he is not certain yet that it will provoke an economy wide recession. But he – like Krugman – is only one step away from that view. He indeed concludes his column by saying:
“Unfortunately, there is significant risk of a very bad period, with slow sales, slim commissions, falling prices, rising default and foreclosures, serious trouble in financial markets, and a possible recession sooner than most of us expected. Deterioration in that intangible housing market psychology is the most uncertain factor in the outlook today. Listen hard and watch out.”
Two points are important here regarding the views in Shiller’s op-ed.
First, like me Shiller is concerned about the broader financial markets implications of the housing bust; I suggested in my previous blog that a housing bust may lead to a systemic banking and financial crisis; his intimations of “rising default and foreclosures, serious trouble in financial markets,” are consistent with my concerns. The way I put it:
The scariest thing is that the gambling-for-redemption behavior and problems of WaMu are not the exception in the mortgage industry; they are instead the norm. There are good reasons to believe that this is indeed the norm as lending practices have become increasingly reckless in the go-go years of the housing bubble and credit boom.
If this kind of behavior is – as likely – the norm, the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. The recent increased financial problems of H&R Block and other sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg – and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. You can then have millions of households with falling wealth, reduced real incomes and lost jobs being unable to service their mortgages and defaulting on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a credit crunch as lending standards are suddenly and sharply tightened with the increased probability of defaults; and finally mortgage lending institutions – with increased losses and saddled with foreclosed properties whose value is falling and that are worth much less than the initial mortgages – that increasingly experience financial distress and risk going bust.
One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs – that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.
The main, still unexplored issue, is where the risk from mortgages is concentrated: among the sub-prime lenders (as i worried about and as the WSJ reports today; see also this Dow Jones story) or among commercial banks or among hedge funds and other financial intermediaries that purchased mortgage backed securities(MBSs) or among the GSEs (Fannie and Freddie)? Commercial banks claims that they have transferred a lot of their mortgage risk to other financial intermediaries – such as asset managers, hedge funds or insurance companies – who purchased large amounts of MBSs. But banks have still lots of mortgages on their books and, on top of it they have tons of consumer debt exposure (credit cards, auto loans, consumer credit) that may go really bad in a recession. If part of the housing risk has been off-loaded to hedge funds, the risk is not just of some of these hedge funds going bust but also their prime brokers (i.e. large investment banks) getting into trouble; counterparty risk will become serious once the hot potato of mortgage risk is pushed from one counterparty to the other. And finally, a large part of the housing risk is also in the hands of Fannie and Freddie. How much are the GSEs at risk is a complex issue that we will cover in a forthcoming RGE brief this week. For now, you can see the RGE coverage of the housing risks for the commercial banks, for the rest of the financial system and for the GSEs in three separate RGE Spotlight issues (here and here and here; these links require a free registration to the RGE Monito
r).
Either way, a serious housing bust followed by an economy-wide recession implies serious financial risks for the entire financial system, not just risks for the real side of the economy. A systemic risk episode triggered by a housing bust cannot be ruled out as I discussed in detail in a recent blog of mine.
Second, Shiller confirms – as I discussed in detail before – that futures markets on housing are now predicting a 5% fall in home prices in 2007. But then he makes the argument that, based on the S&P/Shiller-Case home price index, prices have peaked but not fallen yet.
“According to the Standard & Poor’s/Case-Shiller Composite Home Price Index, based on 10 major metro areas, housing inflation reached 20.4% in the 12 months ending in July 2004. Now, the latest numbers announced yesterday show only an 8.2% increase in the 12 months ending June 2006, and most of that increase was in 2005. Six of the 10 cities actually fell between May and June. By simple extrapolation, if housing price changes continue to decline as they have, inflation will turn into deflation, and 12-month price changes might be squarely in negative territory by some time in 2007.”
The 8.2% increase in June – on a year-on-year basis – is quite different from the National Association of Realtors data that show – for July 2006 – a year on year increase of only 0.9% for existing homes and 0.3% for new homes. Those NAR data also show that, in three out of four regions- the exception being the South – home prices are actually falling already. Relative to a year ago housing prices have already fallen in the North East (-2.1%), Mid-West (-0.6%) and the West (-0.3%). So, not only housing prices are falling in the bubbly two coasts; they are also starting to fall in the Mid-West, the region where the conventional wisdom was that there was no housing bubble. The fact that home prices are falling in the Mid-West where prices did not skyrocket in the bubble years is a scary signal of how much the housing bust and glut in supply will lead to a sharp fall in housing prices in the quarters ahead with painful effects on the wealth, and thus consumption, of households.
The current – current not future – fall in home prices is worse than the official data suggest for three additional reasons:
- Home prices are already sharply falling in many formerly bubbly cities, especially those in bubble regions of the US;
- as the NYT recently reported, home sellers are now providing a variety of financial benefits (seller paid closing costs, buyer-side realtor bonuses, and seller subsidized mortgages, even $30K swimming pools free) that effectively reduce the price of a sold home, even if the headline price is officially not reduced: “The typical incentive package from a home builder consists of upgrades to the house — granite countertops instead of humdrum tiles, stainless-steel refrigerators and stoves instead of plain white models and wood blinds instead of plastic. At the extremes, some have thrown in $30,000 swimming pools.” Estimates of this effective price cut – via side benefits to buyers – are in the 3% to 8% range. So, while officially median home prices are “only flat” relative to a year ago, the effective median price has already sharply fallen;
- if you were to control for CPI price inflation – now running above 4% – home prices are even lower in real terms relative to their nominal value. More ominously, futures contracts for home prices predict a 5% fall in home prices in 2007, and even a larger percentage fall in a number of key cities.
It is thus now clear that, for the first time since the Great Depression, even actual – i.e. not fudged by side incentives and subsidies – median home prices are already falling – on a year on year basis – and will be falling even more in the next months; the typical lag in the adjustment in home prices to a gap between supply and demand and the massive unprecedented increase in inventories of unsold homes will be the trigger for this home price bust. On a year on year basis, real home price may fall as much as 10% or even more in the next 12 months, even more than currently predicted by the illiquid futures market.
In conclusion, a housing hard landing will lead to a sharp and severe recession: the fall in real residential investment and its effects on aggregate demand will be larger than the 2000-2001 tech bust; the employment effects of the housing bust will be larger than the tech bust as – directly or indirectly – 30% of recent employment growth has been housing-related; the wealth effects of a bust in housing will be large and larger than those of the tech stock bust as homeownership is widespread and housing is a significant fraction of households’ wealth; a housing-related recession can occur if triggered by a housing bubble bursting in the same way in which the bursting of the tech bubble in 2000 led to a recession in 2001; households are now at a tipping point and in a foul mood (as evidenced by the sharply falling consumer confidence level) being buffeted by slumping housing, high and rising oil and energy prices and the delayed effects of rising policy rates while experiencing falling real wages, negative savings and high and rising debt and debt servicing ratios; and Fed attempts to prevent the recessions via a cut in interest rate in the fall or winter will fail to avoid the recession as an unprecedented glut of housing and of consumer durables – starting with cars, home appliances and furniture – will make the demand for housing and durables insensitive to changes in short term and long term interest rates; the housing bust may lead to a banking and financial crisis that may be more acute – and cause a more severe credit crunch – than the S&L crisis of the 1980s and early 1990s that led to the 1990-1991 recession.
Finally, for continued coverage of the developments in housing, check out the RGE Monitor and our page on Housing Bubble and Bust. We cover three possible scenarios about the housing slump and the US economy in “Scenario 1: U.S. Housing Has Soft Landing, and Growth Continues,” “Scenario 2: U.S. Housing Tanks, But the Rest of the Economy Has a Soft Landing” and “Scenario 3: U.S. Housing Tanks, the Economy Lands Hard in a Recession.” Also we do a tour of the world’s housing markets. Our neighbor to the north is dealing with a regional housing bubble; see “How Vulnerable is Canada’s Western Housing Boom?” Turkey’s housing sector was booming up until June; see “How Long Will the Real Estate Sector Drive Economic Growth in Turkey?” India might be seeing a slowdown in its property market; see “Is the Indian Property Sector Boom Deflating?” Also look in on housing markets and bubbles in Latin America, China, Spain, the UK and Australia.