Sustainable Debt and the Housing Bomb

Yesterday's appearance by Alan Greenspan before the Joint Economic Committee was highlighted by discussions of the health of the economy, interest rate policy, causes and implications of a potentially inverted yield curve, and everyone's favorite subject today - the housing boom. Most financial media initially reported the story with headlines using the phrase "firm footing", which appeared in the conclusion of the prepared statement:

In conclusion, Mr. Chairman, despite some of the risks that I have highlighted, the U.S. economy seems to be on a reasonably firm footing, and underlying inflation remains contained. Accordingly, the Federal Open Market Committee in its May meeting reaffirmed that it "... believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."

There are those who say that what is actually said in the prepared remarks is not as important as what topics are discussed - that the relative weighting of the topics in the official release provides a better insight into what concerns Federal Reserve members, rather than what is actually said in the official release. With that in mind, let's take a closer look at the prepared statement. Excluding the introduction and conclusion, there are 12 paragraphs, broken down as follows:

1 - Savings, Trade Balance
1 - Oil
1 - Economic Performance
2 - Yield Curve
7 - Housing

If this is a valid indicator of what concerns the Fed, the results are very clear. All seven housing paragraphs are quite interesting - here are the highlights:

The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern.

Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications.

Moreover, a substantial rise in bankruptcies would require a quite-significant overall reduction in the national housing price level because the vast majority of homeowners have built up substantial equity in their homes despite large home equity withdrawals in recent years financed by the mortgage market.

Rep. Paul Asks if We Are Fooling Ourselves

The question and answer session following the reading of the prepared remarks went on for over two hours - the entire clip is available over at CSPAN under the video/audio section of the main page. Two segments stand out and the transcript is provided here - the first is with Representative Ron Paul of Texas:

Paul: My second question has to do with debt and you have frequently talked about us having too much debt and too many deficits here in the Congress. But I'm really concerned about it when you look at the unfunded liabilities in Medicare, the problems we're faced with Social Security, and now we have evidence that our private pension funds, backed up by the U.S. government probably have the characteristics of a ponzi scheme similar to social security in that their reporting requirement have not required that they report their true assets, but just their cash flow.

But we have a current account deficit that you talk about frequently and also a foreign debt that's into the trillions of dollars and I just wonder if we might not be fooling ourselves about our prosperity, because you know, if I could borrow a lot of money, if I could borrow a million dollars every year, I would have pretty good prosperity but eventually it would come to an end. A nation probably has an end point as well.

And I think this has been magnified by the fact that the efficiency of the central bankers, which you have explained that you have gotten fiat money to act as if it is gold and in some ways I think that is true that people do accept our money, and this encourages us to have more deficits, it encourages us to buy more than what we pay for, buy more than we save and contribute to the current account deficit.

So, it's the combination of the monetary system and the acceptance of our money that has contributed to this huge debt, but most people say, most economist recognize that there is a limit to how far we can go on the accumulation of this debt. It's almost a catch-22 - the more efficient you are in convincing the world to take our money, the worse the problem gets and the bigger the bubble.

Instead of us borrowing that money to build our manufacturing base, which we're not - everybody knows that's dwindling, we're using it for consumption. So why is it that we should be reassured that our prosperity is sound and we don't have to worry about paying this debt back?

Greenspan: Well, I think we learned very early on in economic history that debt, in modest quantities, does enhance the rate of growth of the economy and does create higher standards of living, but in excess, creates very serious problems.

First of all I would think that one way to address the question you're raising with respect to unfunded liabilities is that we need to do a good deal more of accrual accounting in the federal government, which would automatically pick that up and get a realistic size of what we are dealing with.

But there is no question that the amount of debt that is out there has to be serviced, and, so that debt per se can grow indefinitely, but ... if we ... and can ... can grow indefinitely and is sus-sustainable - if we assure a means of servicing that debt, which is essentially what we try to do, but we may not be doing it as well as we should and in the past we've not always done it well.

This segment finishes at 1 hour and 11 minutes. That last paragraph is well worth the trip over to CSPAN to hear it and see it as it happened. The combination of the words "debt" and "sustainable" seem to have caused some sort of temporary short-circuit somewhere, and a rare moment of grasping for words ensued, only to be followed by a quick recovery, and then an honest assessment of past performance.

Rep. Sanchez Asks About a Housing Slowdown

The second segment was with Loretta Sanchez of California, where she wonders about what is going on in her district in Orange County, California:

Sanchez: Let me ask you another question, this is with respect to housing because I represent Orange County California, probably the hottest housing market right now where the mean value of a resale 1500 square foot forty year old home is running about $600,000. You say in your testimony that you do not think that ... you say these declines were they to occur likely would not have substantial macro economic implications, you're talking about maybe declining housing in certain markets.

When I look at what's going on in Orange County, I see interest-only loans, lots of them, I see ARMs that people are just beginning to understand are going to choke them in the next year or two and I see a lot of people who took equity out of homes that grew with the housing boom, but which ... if housing stops, they're not going to be able to recover.

How can you say, when the brightest spot in the economy has been housing and refinance, how can you say that you don't believe that if there's a slow down in even some of these markets, that it will not have substantial macro economic implications.

Greenspan: It really gets to the question of what I mean by substantial. Clearly if you get a flattening out of prices, not even a decline, and you gradually reduce the realized capital gains and unrealized capital gains on homes, equity extraction, which is a very significant contributor to personal consumption expenditures will go down.

And I have no doubt as this boom begins to ... basically defuse, we will see the rate of increase of mortgage debt, largely driven by equity extraction, slow down. Since a significant part of personal consumption expenditures is financed by equity extraction, one would presume we will also be observing a slowing in consumption expenditures - higher savings, but slower economic growth, at least as far as the consumer is concerned.

The reason I don't suspect that there will be "substantial" macro economic effects, is that I envisage as that is occurring, that capital investment will begin to take up the slack in growth to a greater or lesser extent. So, I'm really not saying that it has no local effect. Remember what happened to Silicon Valley which is just up the state from you - that had a really severe "local" effect, but it was not a national macro economic effect. What I was referring to was basically, not that it will have no effect, but I don't perceive it, on net, to be a major macro economic effect.

This segment starts at about 1 hour and 21 minutes. For just a second there, it looked like something very interesting might be uttered - "as this boom begins to ... basically defuse", but alas, no slip ups today - surely the markets would have reacted differently if other more colorful words were used in place of "defuse", but, then again what do you think of when you hear "defuse"?

Is the housing boom now a bomb that is somehow going to be defused?