Amazing insight at the Fed

After being asleep at the switch for so long, is the Federal Reserve finally starting to realize the largest threat posed by the bursting of the housing bubble?

Maybe.

Courtesy of the always interesting WSJ Real Time Economics blog comes this report on a speech made yesterday by Federal Reserve Bank of Boston president Eric Rosengren in which the impact of falling home prices on consumer spending is considered.

Further declines in housing prices could more significantly hurt consumer spending, a Fed official said Wednesday.

“The effect of the problems in housing on consumption has been muted to date,” Federal Reserve Bank of Boston president Eric Rosengren told the Portland (Maine) Regional Chamber of Commerce. However, “further and more widespread deterioration in housing prices would increase the risk of a more adverse impact on consumption.”
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Mr. Rosengren said the surge in delinquencies on subprime loans – those to customers with generally weak credit histories or lower income – has been driven by faulty assumptions that housing prices would continue to rise nationally, when in fact by some measures they are falling. Flat to falling prices have made it hard for borrowers to refinance. Moreover, many loans were made by brokers who lowered underwriting standards in order to boost volumes, rather than by deposit-taking banks.

But he said research by his bank shows that subprime mortgages have nonetheless had important regional benefits. Almost 90% of subprime mortgages made between 1999 and 2004 were “prepaid” within three years, he said. Since prepayment occurs with a sale or refinancing, “it is plausible that many borrowers who purchased homes with subprime products did benefit from the appreciation of home prices in New England that occurred over the last decade.” (Some of the mortgages that were refinanced in that period may have subsequently gone into foreclosure.)

Uh. Gee. Short term interest rates just started rising in 2004 - do you have any more recent data on the performance of subprime loans?

The first commenter put is best asking, "What is this guy smoking?"

Elsewhere online in the WSJ today, in their Developments blog, comes this keen insight by one Danilo Pelletiere, research director at the National Low Income Housing Coalition in Washington.

"If you weren’t owning in 2006, there’s a reason" and that reason wasn’t pretty. “The stigma of renting was raised to a really high level. If you were renting you were a loser.”

Is that what things were really like last year?

That the entire world, save for a few of us "renters by choice" out here in the blogosphere and a couple of brave souls like Dean Baker at the CEPR (Center for Economic and Policy Research ) were viewed as losers?

I can't tell you how many people just gave me a blank stare over the last few years when I'd bring up the possibility that a) home prices might not go up forever and, more importantly, b) they might decline significantly.

They probably felt sorry for me.

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Mark Zandi on subprime and foreclosures

Mark Zandi has been one of the more level-headed economists throughout the whole housing bubble inflation and now, its deflation. He spoke with Bloomberg earlier today:

The highlight comes by way of a comment that he expects foreclosures to increase for the next year and a half - through the beginning 2009 - and that any sort of housing rebound will be delayed at least until then.

Writing off housing in 2008 seems to be an increasingly popular thing to do these days after more and more analysts look at the ARM reset charts, the inventory of unsold homes, and souring consumer attitudes toward the once hot real estate market.

Here are a few excerpts.

On the doubling of defaults and foreclosures during the last year and how long foreclosures may continue to rise:

I think all the way through '08 and into '09. Of course it's not going to continue to double all the way through '08, but I think we'll see a rise in foreclosures all the way through the beginning of '09.

On the source of the problems with foreclosures:

There are the subprime loans that are two-year fixed and they turn into adjustable mortgages and they're hitting their first payment reset. The mortgage amount is rising considerably and that's coming at the same time that housing values are falling and lenders are tightening lending standards. It's all coming together at a very bad time.

On how many of the foreclosures are people losing their own homes and how many are investment property:

We don't have definitive data to answer that one way or another but, my sense is that, about a quarter to a third of the mortgages that are in foreclosure are to investors - either short-term flippers or even second home buyers with a longer term horizon. The other two-thirds or three-quarters are people, homeowners, who are just getting caught, unfortunately.

Remember all the criticism that was directed toward Moody's after this report last year when they predicted that home prices would decline considerably? They defined a "crash" as a drop of more than 10 percent and saw that as the probable outcome for 20 areas in their survey.

Here are the top ten on the list from October 5, 2006 -

These numbers don't seem so shocking anymore, in fact, these figures may underestimate the decline given what's happened in the last few months and what is likely to happen over the next year or so.

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State of confidence, state of credit

In this month's Central Bank Focus, Paul McCulley of Pimco writes that liquidity is really a "state of mind", a point proven all too clearly during last month's Northern Rock debacle in the U.K., according to a report($) in today's Wall Street Journal.

Before continuing the unseemly pleading for lower interest rates (a task that now appears to be part of the updated job descriptions at Pimco), the subject of John Maynard Keynes and his 70 year-old discourse on the "state of confidence" (by speculators) and the "state of credit" (by lenders) is recalled in an effort to better understand what happens after a "Minsky Moment".

A "Reverse Minsky Journey" is apparently what follows these days - where borrowers and lenders alike attempt to gather their wits and once again pour their efforts into creating the next Minsky Moment.

Paul McCulley is often asked these days:

“Where did all the liquidity go? Six months ago, everybody was talking about boundless global liquidity supporting risk assets, driving risk premiums to virtually nothing, and now everybody is talking about a global liquidity crunch, driving risk premiums half the distance to the moon. Tell me, Mac, where did all the liquidity go?”

My short answer is that liquidity is not a pool of money but rather a state of mind.
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At the macro (systemic) level, liquidity is not about how many pieces of paper with pictures of dead presidents on them we have in our wallets, but rather about how much utility we derive from having them in our wallets. Or, as the cliché went in my youth in rural Virginia, liquidity is about whether the dead presidents are burning a hole in our wallets, or our pockets, as it were.

In today’s loosely regulated, globally integrated banking and capital markets, liquidity is about borrowers’ and lenders’ collective appetite for risk, a function of:

The willingness of investors to underwrite risk and uncertainty with borrowed money and the willingness of savers to lend money to investors who want to underwrite risk and uncertainty with borrowed money.

The willingness of savers to lend money and investors to underwrite risk were brought to light last month at Northern Rock where a 19th century style "run on the bank" caused millions of Britons scratch their heads.

The nation's chief regulator, FSA chairman Callum McCarthy, commented on the liquidity crisis - the rapid deteriation of the state of confidence and the state of credit.

Mr. McCarthy echoed previous comments by Mr. King that it would have been better for the central bank to provide financing covertly to prevent a crisis of confidence, though this became irrelevant after news of the bank's emergency financing became public.

Northern Rock was forced to approach the Bank of England for an emergency loan facility Sept. 19 after the collapse of credit markets left it struggling to finance its operations. Mr. Sants said that facility may not have been needed if the announcement hadn't sparked the first run on a U.K. bank in more than 140 years. The bank run was only halted after the government stepped in to guarantee deposits.

Even with more covert financing in situations such as this to bolster confidence in the future, it is likely that there are more round-trip Minsky journeys ahead of us.

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And ... we are back

The threat (now realized) of precipitation compelled us to cut our Yosemite Valley trip short as the prospect of folding up a wet tent in the rain held little appeal for either of us.

We spent many, many nights there in the 1990s, before the 1997 flood that washed away our favorite campground, but since then have mostly avoided the area. Despite the crowds even at this time of the year, it is a breathtaking place, the scale and majesty of which simply can not be captured on film.

The ear-shattering gunshot that echoed through the valley at 2AM yesterday morning may have resulted in one of these empty containers filling up.

If not, hopefully someone had some other good reason to get thousands of peoples' hearts going from 50 to 150 in a matter of seconds.

It appears that the Fed meeting minutes were received well yesterday - like at least one Yosemite bear that was stopped in its tracks, stock market bears were similarly thwarted yesterday but seem to be gathering again today.

Maybe the Federal Reserve and some of the big Wall Street firms should invest in a goodly supply of bear traps and tranquilizer guns if they want to see stocks continue to soar.

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Oil and gold guesses - two days left

We are off to Yosemite National Park for a few days, so this should leave you plenty of time to ponder your oil and gold price guesses when you would otherwise be pondering the many varied and profound issues that are sometimes raised here at this blog.

Then again, maybe you just come here for the cartoons from The Economist.

Look for something new here in a couple days or so and don't forget that entries for the "Guess the year-end price of oil and gold" contest close Wednesday at midnight PST. Here's how the last contest ended with last week's oil and gold prices shown in the upper right.
Entries may be made in the comments section of this post or via email and the winner gets a free one-year subscription to the investment website Iacono Research. For all other particulars, see last Wednesday's post on this same subject or the original post from two weeks ago.

Note that a final decision has not been made regarding how a winner will be determined. In previous contests a simple summing of the percent differences between the guessed price and the year-end price for both oil and gold was employed, however, some readers have suggested that a more scientific approach be adopted using square roots, quadratic equations, and perhaps differential equations and that funky integration sign.

I'll have to get out my old school books before a final decision can be made.

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Health care, food service, and government jobs

For some time now, steady employment growth in the health care, food service, and government categories within the monthly report from the Labor Department has been a great source of interest here - clearly, it was time to whip up a chart or two.
Note the area circled in red. During the second quarter it was a close call, but in the third quarter of 2007, for the first time in at least a decade (maybe, much longer as data prior to 1998 was not reviewed) there was positive overall job growth with all of that growth attributable to three employment categories:

• Education and health services
• Food service and drinking places
• Government (Federal, State, and Local)

All other categories netted zero job growth in the third quarter - the major factors were hefty declines in both construction and manufacturing offsetting gains in both trade and professional services.

While job growth near 100,000 per month during the last three months is certainly better than no new jobs at all, one has to wonder what implications this new mix of job creation holds for the future.

Many hailed Friday's strong labor report as a sign that "all is well" in the U.S. economy - jobs are being created, incomes are rising, and it's safe to buy stocks again. But can an economy so highly dependent on new jobs to care for sick people, serve overweight people, and add to government bureaucracy educate a growing population really be a sign that all is well?

When looking at just these three categories as shown in the chart below, strong hiring is clear to see for education and health care - overall employment gained 292,000 during the third quarter and 167,000 positions were created in this category alone. As noted in a BusinessWeek cover story some time ago, health care has been a powerful source of job creation, particularly since the beginning of the decade.

Government jobs too have been plentiful save for two quarters of sharp cutbacks in 2001 and 2003, but, more importantly, the recent increase in waiters, hostesses, cooks, and busboys has been rather astonishing.

Even at the height of the internet boom, only about half as much restaurant help was being added as that seen during the last few years. Surely, the newfound popularity of dining out is a testament to the power of the housing boom and the "wealth effect" that it spawned - given the ubiquitous "HELP WANTED" signs that persist to this day, this habit does not appear to be fading nearly as quickly as home prices are now fading in many parts of the country.

This can't be a sign of a healthy economy (or a healthy populace given that food portion sizes have become as inflated as home prices).

If these three sectors contributing all of net job growth over the last three months were to be an indication of a healthy economy, then the source of the funds ultimately used to pay the salaries of all these new workers would be an important question to ask.

Just where does all the money come from?

Other countries may want to copy the U.S. model and, presumably, they would be interested to know how this all gets paid for.

All is not well in the labor market.

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New highs, new doubts

This week's Buttonwood column, aptly titled "To infinity, and beyond", reminds us that stocks don't always go up and for good reason.

A significant proportion of the return from equities in the second half of the 20th century came from a re-rating of shares; investors were willing to pay a higher multiple for profits. But re-rating cannot continue forever. Although ratings have fallen significantly since the heady days of 2000, that is in large part due to the remarkable strength of corporate profits, now close to a 40-year high relative to national output. If profits revert to the mean, that could act as a drag on stock market performance. And, as with Japan, investors do not have much in the way of income to fall back on; the dividend yield on the American market is just 1.7%.

If investors want a simple parallel with share prices, they need only turn to the American housing market. Back in 2005, Ben Bernanke, then an economic adviser to the president, was asked about the possibility of a decline in house prices on CNBC, a financial-television channel. He said, “We've never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilise.”

Lots of people took the same view and were willing to borrow (and lend) on a vast scale on the grounds that higher house prices would always bail them out. They are now counting their losses. Investors in equities should beware of over committing themselves on the basis of a similar belief. Just ask the Japanese.

Most people seem to forget that when Benjamin Graham wrote about stocks many years ago, it was a markedly different stock market where high dividends were the rule, not the exception to the rule.

While profits may remain high, Graham's "margin of safety" - where investors might weigh a stock's higher dividend payment along with increased stock market risk against a lower yielding, but much safer bond offering - has lost much of its relevance since dividend payments are just a fraction of what they used to be, dwarfed by share appreciation that has become a way of life for many on Wall Street and a few on Main Street.

Of course, over the last twenty years of easy money and asset inflation, investors have been conditioned to look past this reality.

To infinity, and beyond!

ooo

This week's cartoon:

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