Unconfirmed Sightings of my Skeletal Remains

Now that problems in mortgage lending are front page news, Stephen Roach at Morgan Stanley appears once again to be hitting his stride in providing thoughtful commentary regarding the ultimate fate of the latest asset bubble.

For some time last year he seemed fixated on another bubble that hasn't exactly unfolded as he once thought. With prices for base metals now rebounding strongly amid steady demand from Asia as noted here back in September, he should have just stuck with what he knew best in 2006.

Nevertheless, in his most recent commentary he once again hits the mark while maintaining the humble sensibilities that have always made him an interesting read.

The bursting of two bubbles seven years apart – dot-com and housing – holds the key to the macro outlook. While different in many respects, these sharp swings in asset markets share one thing in common – the initial belief that any spillovers would be limited and that the rest of the economy and financial markets would remain unscathed. Just as that view turned out to be wrong in the early 2000s, I fear a similar outcome today.
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Today it’s subprime mortgages – a relatively small segment of the home loan market that accounts for only 11% of total outstanding securitized mortgage debt. The consensus view is that the other 89% of the mortgage market is in good enough shape to weather any storm. On the surface, the relative dispersion of delinquency and default rates seems to support this contention. According to the Mortgage Banker’s Association, subprime delinquencies rose to 13.3% in 4Q06 – the highest reading since mid-2002. By contrast, for prime loans, the past-due portion stood at just 2.6% in late 2006 – the highest since mid-2003 but literally one-fifth the delinquency rate in the subprime sector. In terms of the asset effects, the key issue is whether the credit problems will spread up the quality spectrum – reminiscent of the contagion from dot-com to broader equities some seven years ago. It’s obviously too soon to know with any certainty, but the latest results of the Fed’s Senior Loan Officer Survey on Bank Lending Practices are not exactly comforting. In early 2007, the portion of respondents that were tightening overall mortgage-lending standards rose sharply – exceeding the readings hit in the 2000-01 recession and returning to levels last seen in the 1991 recession. Moreover, this latest tally represents sentiment as of January 2007 – before the full force of the subprime carnage broke out into the open. This is a fairly clear indication, in my view, that the problem is spreading.

Since Morgan Stanley's chief economist has been talking about the nation's real estate market as the next asset bubble, another in a series of asset bubbles, for quite some time now, he must permit himself at least a little snicker or two as mortgage lenders struggle to keep their doors open and the credit flowing.

The "spillover" effect on the broader economy all comes down to the psyche of the American consumer and how those individuals who've spent some of their home equity in recent years, but who haven't gone to excess, respond to news of a faltering housing market.

As in the employment statistics, where it's much more important how the 95 percent of the population that have jobs spend their money than the 5 percent that don't, the important effects of the bursting of the housing bubble will come from the response of ordinary homeowners who've tapped their home equity just a little bit, rather than from wild-eyed Donald Trump wannabes saddled with condos in Florida.

Counting out the American consumer is risky business.

The forecasting landscape has long been littered with carcasses of those who have been dumb enough to bet against the American consumer. From time to time, there have been unconfirmed sightings of my skeletal remains in that heap. The lesson for the bruised and battered forecaster is to pick your spots carefully in betting against the American consumer. I strongly believe this is one of those times. For over a decade consumers have been spending well beyond their means, as those means are delineated by the US economy’s income generating capacity.
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In a framework that allows for consumers to draw support from both income and wealth effects, the implications of a bursting of the housing bubble are painfully simple: Consumers should respond to diminished wealth-based saving by rebuilding long-depleted income-based saving rates. And there is almost no way for that to incur without a meaningful retrenchment of the growth in personal consumption expenditures.
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The Federal Reserve now seems to be preparing itself for just such a possibility. By changing its risk assessment at the March policy meeting, it is in better position to provide support to the cumulative weakening imparted by a consumer spillover... As bubble follows bubble, it has become exceedingly difficult to disentangle fluctuations in asset markets from shifts in asset-dependent real economies. To the extent an inflation-targeting Fed uses growth risks as a proxy for inflation risks, a monetary easing may seem to make a good deal of sense if spillovers come into play. Yet in the end, of course, a monetary easing that is tied to a deteriorating growth outlook for an asset-dependent economy also turns out to provide support to the underlying asset class itself.

That’s the “Fed put” in a nutshell – a de facto targeting of asset-dependent growth risks. It would take a Volcker-like toughness to bring this insidious process to an end. Yet both Greenspan and Bernanke seem to be cut from a very different cloth.

Bring back Paul Volcker!

ooo

This week's cartoon from The Economist: