Will Consumers (Ever) Spend Again?

Consumers account for about 70 percent of economic activity in this country, but have become extremely fickle in this downturn. They have begun to save more and spend less. But that doesn’t mean consumer spending won’t give a boost to economic growth. But banking must recover first, in order to cure the credit crisis.

Business Week’s chief economist Mike Mandel says that one portion of consumer spending has held up—spending on services has grown 3.3 percent since February 2008. Why? Because much of it is in healthcare outlays, which is up $112 billion, according to Mandel. And 85 percent of health-care spending is by government and employers and so not directly out of consumers’ pockets.

Another part of this spending is by non-profits, both religious and foundations. For example, the Gates Foundation plans to boost its spending by 15 percent this year to $3.8 billion. All this means it is mainly durable goods spending—for goods that last more than 3 years—that is the real drag on economic growth. And orders for durable goods just shot up 6 percent in February, the first increase in 6 months.

So the outline of an economic recovery is beginning to take shape. Banks are beginning to recover. Wells Fargo has just reported record profits for the first quarter due to huge mortgage volume, and Bank of America recently said it might be able pay back all of its $40 billion in government TARP funds by next year.

And one sign of a credit recovery is that mortgage rates are at record lows, with even the jumbo mortgage market showing signs of life. Jumbo, non-negatively amortized ARMs with 3 to 10 year fixed rates for multi-million dollar loans have recent quotes of 4.75 to 5.50 percent with a 1 point origination fee.

Personal savings are also soaring, as pictured in the graph, up more than 4 percent in January and February, after being close to zero since 2005. This is making consumers feel wealthier. The shaded areas in the graph are periods of recessions.

Retail sales are the best indicator of improved consumer spending, with sales up in January and February after declining for much of last year. The Commerce Dept. graph shows that auto sales are still in decline, but General Merchandise sales have risen 1 percent.

Housing will probably be the final sector to recover, once banking and the credit markets are sound again. Certain areas in California and Florida are showing signs of life, with the California Association of Realtors reporting that home sales surged 80 percent in February. This is while February’s national existing-home sales rose 5 percent, with the all-important existing-home inventory declining from 11 months to a 9.8-month supply at the current sales rate. It was in 2005 that inventories began to rise to unsustainable levels, as the last graph portrays.

What we see is the beginning of an economic recovery with consumer spending giving it a necessary boost, but it is the banks and credit markets that must recover before it becomes meaningful on Main Street.

Harlan Green © 2009

Signs of Recovery II

February could be the month real estate values hit bottom in some regions. That doesn’t mean prices pick up anytime soon, however. Though HUD reported that existing-home prices with conforming loan amounts did rise 1.7 percent for the first time in more than a year. But it does mean sales are beginning to rise and even housing starts are beginning to show signs of life.

There are other signs of economic life, as well. Retail sales have picked up for 2 consecutive months, and durable goods’ orders (e.g., autos, appliances and capital goods) rose for the first time in 6 months. Not to be outdone, the Mortgage Bankers Association reported that mortgage applications continue to soar, up 41.5 percent last week, with refinances actually up 73 percent. This is while total applications have risen 18 percent in a year

Both new and existing-home sales also rose, up 4.7 and 5.1 percent, respectively in February. This is while affordability has been steadily increasing, with the National Association of Realtors Housing Opportunity Index showing that 62 percent of all homes sold in Q4 2008 were affordable to families with a median income of $61,500, up from 47 percent at the end of 2007.

Existing home sales have been stuck at or below the 5 million unit range for almost 1 year. The problem is the large inventory of foreclosed homes that have flooded the market. Relief should come from the Housing Assistance and Sustainability Plan (HASP) that was recently introduced. More than $7 billion has been set aside to inject additional monies into Fannie Mae and Freddie Mac, and to lenders who will drop their interest rates to lower mortgage payments in order to keep more families in their homes.

There is a tremendous gap between new and existing-home sales because fewer new homes are being built. This has brought down their inventory levels as well, a sign that new-home supply is returning to historic levels.

That may be why housing construction rose 22 percent in February with a 3 percent increase in building permits. It was the largest increase in housing starts in 19 years, though most of it was new apartment units and is subject to huge monthly swings.

The S&P Case-Shiller overall price index continued to decline in January, however, down another 2.8 percent in the 20 major metropolitan areas surveyed. San Francisco and Los Angeles have declined 32.4 and 25.8 percent, respectively, in the past year and will decline further.

This means that we are already seeing a price bottom in properties eligible for the Fannie Mae-Freddie Mac loan programs. The jumbo loan market is also beginning to recover with 5-year jumbo fixed ARMs declining to as low as 4.875 percent with a 5.25 Annual Percentage Rate. This will certainly bring back the high end real estate market as well.

Harlan Green © 2009

An Early Real Estate Recovery?

Ed Leamer, Director of UCLA’s Anderson Business School, predicts that real estate will lead us out of this recession, just as it has in the past. We believe he is right; the only question is when.

The most recent Case-Shiller housing price index shows that some regions are close to a bottom such as the Boston, Denver, and New York metro areas. Unfortunately, the California metropolitan areas of San Francisco and Los Angeles are still in bubble territory.

But several real estate indicators have been improving, including a 22 percent boost in February housing construction and 3 percent increase in building permits. It was the largest increase in housing starts in 19 years, though most of it was new apartment units and is subject to huge monthly swings.

Another heartening sign was the 5.3 percent boost in February existing-home sales, with the western region up 30 percent! And affordability has been steadily increasing, with the National Association of Realtors Housing Opportunity Index showing that 62 percent of all homes sold in Q4 2008 were affordable to families with a median income of $61,500, up from 47 percent at the end of 2007.

Existing home sales have been stuck at the 5 million unit range now for almost 1 year. The problem is the large inventory of foreclosed homes that have flooded the market. Relief should come from the Housing Assistance and Sustainability Plan (HASP) that was recently introduced. More than $7 billion has been set aside to inject additional monies into Fannie Mae and Freddie Mac, and to lenders who will drop their interest rates to lower mortgage payments in order to keep more families in their homes.

Harlan Green © 2009

What are Animal Spirits?

There has been much talk of late about Animal Spirits, a term first used by British economist John Maynard Keynes, as a motivator of financial behavior. It could be a key to both the depth of this recession—that some are already calling the “Great Recession”—and its duration. This is because the underlying credit crisis has been characterized as a crisis in confidence.

Banks are afraid to lend, in other words, because they fear that borrowers won’t be able to repay their loans, or that the mortgages or mortgage backed securities already on their books won’t be repaid. This is while consumer spending, which fuels 70 percent of economic activity these days, is lower either because consumers make less money and no longer can borrow as much, and/or are afraid of losing their job and so save more.

And that is the best definition of animal spirits, the basis of so-called Keynesian economics, although Robert Shiller and George Akerlof are refining its definition in their latest book, Animal Spirits. In essence, they attempt to answer the question; what causes aggregate demand, or the overall demand generated by consumers and businesses for goods and services, to shrink or expand?

Their answer is consumers are not necessarily motivated by rational considerations. We can see that the housing bubble was caused by home buyers who didn’t want to look at the fact that housing prices might decline, or interest rates might rise to unpleasant levels. And we know that stock investors can become irrationally exuberant.

Obviously, something had to start this downturn in confidence. Some say it was the growing inequality of incomes that required middle and lower income consumers to borrow beyond their means if they wanted to maintain their standard of living. Many economists maintain it was the worldwide glut of savings that drove down interest rates to record lows that spurred such borrowing.

But regardless of the cause, excess borrowing drove up home prices to unsustainable levels. When the housing bubble burst, it caused a diminution of the ‘wealth effect’, which meant consumers and banks felt less wealthy and so cut back on their spending and lending. This in turn caused producers to cut production and jobs, which exacerbated the downward economic spiral.

So the cure has to include simulating aggregate demand, which means finding a way to put more money into those who buy the most products and services, mainly consumers. But confidence is more than giving consumers rebate checks, or tax cuts to investors, since those policies have not given us much bang for the bucks in the past.

In fact, the theory of Animal Spirits highlights a profound return to New Deal economics, which means using government as the lender and spender of last resort to kick start the private economy. Government at present is the only entity with the means to do so. Only then will businesses want to expand and begin investing in new plants, equipment, and jobs.

Harlan Green © 2009

When Will Housing Market Bottom?

The Pending Home Sales Index, a forward-looking indicator based on contracts signed in January, fell 7.7 percent to 80.4 from a downwardly revised reading of 87.1 in December, and is 6.4 percent below January 2008. The index is at the lowest level since tracking began in 2001, when the index value was set at 100.

Since it is a leading indicator of future activity, what does this mean for reaching a housing bottom? Pending sales track escrows that close in 30-60 days. The West was the only region that showed increased activity, with it seasonally adjusted pending index up 2.4 percent in a month and 13.5 percent over last January. The West includes states like California, Nevada and Arizona that have seen the greatest price declines.

Lawrence Yun, NAR’s chief economist, said the downturn in the economy also weighed heavily on the data. “Even with many serious potential home buyers on the sidelines waiting for passage of the stimulus bill, job losses and weak consumer confidence were a natural drag on home sales,” he said. “We expect similarly soft home sales in the near term, but buyers are expected to respond to much improved affordability conditions and from the $8,000 first-time buyer tax credit.”

NAR’s Housing Affordability Index rose 13.6 percentage points in January to 166.8, a new record high. The HAI, a broad index of affordability that tracks the ability of a household with median income to buy a median-priced existing home, shows that the relationship between home prices, mortgage interest rates and family income is the most favorable since tracking began in 1970.

The HAI indicates a median-income family, earning $59,800, could afford a home costing $283,400 in January with a 20 percent down payment, assuming 25 percent of gross income is devoted to mortgage principal and interest; affordability conditions for first-time buyers with the same income and small down payments are roughly 80 percent of that amount. A year ago, the typical first-time family could afford a home costing $263,300.

The just unveiled Housing and Affordability Sustainability Plan (HASP) should also stimulate mortgage volumes for distressed borrowers with loan amounts less than $729,750. Eligible borrowers have to show either that their homes are more than 80 percent encumbered, or loan payments—including taxes and insurance—are more than 38 percent of monthly gross income. Lenders can then either cut the interest rate as low as 2 percent, forgive principal, and if that doesn’t work, extend amortization period to 40 years.

Harlan Green © 2009

WHAT LOAN PROGRAMS ARE WORKING?

The mortgage market is working, thanks to government support. Refinancing volumes of existing mortgages have soared, up 40 percent since the December 2007 beginning of this recession, according to the Mortgage Bankers Association mortgage applications survey. The purchase market has been hurting with the MBA Purchase Index down approximately 58 percent from 2007 highs. The precipitous drop in purchases began in January 2008, at the beginning of the recession.

Some 80 percent of applications are either conventional conforming or high balance conforming loans sold to Fannie Mae, Freddie Mac or FHA. Fannie and Freddie offer the full range of adjustable and fixed mortgages, but in fact the 30 and 15-year fixed rates are the most popular, since only the 5-year fixed rate ARM has a lower conforming rate.

Fixed rates have been fluctuating between 4.75 to 5.25 percent since January. They have been edging up because of the massive volume of refinancings. Part of the purchase slowdown is attributed to rumors that the new Homeowner Affordability and Sustainability Plan (HASP) will include a buy down of interest rates for a purchaser.

But in fact HASP makes no distinction between purchase and refinance transactions. HASP reduces monthly payments either by offering a lower rate to a floor of 2 percent for conforming loans with payments above 38 percent of gross monthly income, or with a principal amount between 80 to 105 percent of current home value. It can also offer a 40-year amortization period if payments cannot be brought down with the other measures. The Treasury Department will also have some assistance for those with equity line second trust deeds that need to be paid off to qualify.

New HUD Secretary Shaun Donovan, who regulates Fannie and Freddie, said in an interview that this will also apply to existing jumbo mortgages up to a high balance maximum of $729,750. Lenders who participate will be required to offer the Treasury’s plan to all of its mortgages that fit the criteria, not just its worst.

The consensus is that this should help to bring down interest rates even further. Both the Treasury Department and Federal Reserve are also working to bring down rates by buying up Mortgage Backed Securities. These are the securities that pool mortgages sold to Wall Street, many of which have become toxic, or non-performing.

All of these efforts have caused the NAR’s Affordability Index to soar to 166.8, 55 percent since its 2006 low. This means that a household with a $59,821 annual median income can now afford a home that is 166.8 percent above the current existing-home median price. Affordability has risen because of a 23 percent drop in the median home price, while the conforming 30-year mortgage rate has fallen almost 1.5 percent from 2006.

We will have to wait for the jumbo market to come back to life. Most of the non-performing assets were either jumbo subprime or negatively amortized, teaser rate ARMs. And so the Treasury is willing to guarantee up to $1 trillion of those assets in a public-private partnership with hedge funds and their like, in order to help establish a market price for them, since no one knows their value at present.

But those assets cannot really be valued until a floor has been established on foreclosure rates, which is in turn dependent on whether HASP is able to keep more people in their homes. That will in turn set a bottom to real estate values, and only then will we see a broad improvement in the real estate market.

In fact, the combination of improving affordability plus willingness of the federal government to spend what is necessary to stabilize the mortgage market is what is needed to resolve both the banking and credit crises.

Harlan Green © 2009

THE 'REAL' KEYNESIAN ECONOMICS

The debate has only begun on whether the various stimulus packages are enough to kick-start the economy. Of great help will be Animal Spirits, a new book by two well-known behavioral economists who study the psychological and sociological aspects of financial markets—Nobelist George Akerlof and author Robert Shiller. Professor Shiller is best-known for coining the term “irrational exuberance” in his book of the same name, which predicted the dot-com bubble bursting.

Get Reaganomics off our backs!—translated into layman’s terms, that’s how Akerlof and Shiller begin Animal Spirits (Princeton U. Press, 2009. It is an inquiry into the role of human psychology in economic behavior. The small-government, laissez-faire outlook that Reagan helped popularize has severely damaged the financial system. “Now, three decades after the elections of Margaret Thatcher and Ronald Reagan, we see the troubles it can spawn. No limits were set to the excesses of Wall Street. It got wildly drunk. And now the world must face the consequences.”

What in fact the Obama Administration is trying to do is not only stimulate job formation and retention that will in itself grow demand for more goods and services, but raise the confidence level of consumers and business as well. This is also at the core of British Lord Keynes economic theory. Keynes believed that the Great Depression was caused by a pervading loss of confidence in both business and government to correct the economic malaise of that time.

Animal Spirits cites the crash of 1929, for instance, when speculative exuberance and the narrative of a “new era” of continually appreciating stocks suddenly evaporated, while technical factors such as central bank protection of the gold standard worsened unemployment by causing a deflationary price spiral.

As Keynes pointed out, the fundamental problem was that bankers were too scared to loan, because they thought they would lose their money—sound familiar? And since none of the deficit spending was on a scale needed to stimulate demand, self-perpetuating hopelessness set in. Only with the emergency mobilization of World War II did the shattered national mood, and narrative, begin to change.

Might some parts of President Obama’s stimulus measure not work? Of course. Some economists, including Nobelist Paul Krugman, fear that not enough is being done to give it an immediate boost this time, either. Just put more money in people’s pockets, whether via rebates or tax cuts, say some. But history shows that doesn’t provide much bang for the buck. It doesn’t necessarily get consumers spending again, for instance.

Much of the stimulus spending focuses on increasing productivity and nurturing research and innovation in future technologies. Another part focuses on improving our educational and health care systems. The Congressional Budget Office predicts that the economy may need a boost through 2011, so the stimulus package is aimed at promoting a sustainable recovery, not a quick fix.

After touring through this grim history, our contemporary problems, as severe as they may be, don’t look quite so bad. Profs Akerlof and Shiller end on a reassuring note: “Yet we are currently not really in a crisis for capitalism. We must merely recognize that capitalism must live within certain rules.” And we must take into account that irrational behavior has a real effect on demand, necessitating government intervention.

Harlan Green © 2009

IS THERE LIGHT AT END OF THE TUNNEL?

The economic news is not all dire, though financial markets don’t yet seem to get it. Remember, headlines only capture most economic events after the fact. Though the recession began in December 2007, for instance, it wasn’t until June of 2008 that bad news began to appear in the headlines. And the recession wasn’t made ‘official’ until November 2008, when the NBER’s Business Cycle Dating Committee was sure economic activity had in fact topped out the prior December.

For the same reason, very few media are focusing on the often subtle turning points that signal when economic activity has bottomed out. This recession began only after the Federal Reserve had boosted interest rates 17 consecutive times in an attempt to combat inflation. But instead of driving down its cause—high energy and commodity prices—the Fed’s actions drove up mortgage rates on short-term Option and subprime ARMs, which made those loans no longer affordable to the marginal borrower.

The result is people are saving more and buying less. But existing real estate sales surged 6.5 percent in December, as housing prices have come back down to affordable levels. This is due to a combination of lower interest rates and the largest median price decline in 70 years, according to the National Association of Realtors. In fact, the NAR’s Affordability Index has increased more than 50 percent since 2006, meaning buyers can afford a house worth 50 percent more than the existing-home median price of $174,000.

Both the manufacturing and service sectors are also showing signs of improvement. January new orders surged 10 percent in manufacturing and 3 percent in service sector industries, according to the Institute for Supply Management. Retail sales also jumped 1 percent in January, the largest increase in 1 year.

And labor productivity is surging, because employers cut back working hours faster than they cut back on production. The resulting output per hour worked increased a large 3.2 percent in Q4, and for the year rose at the fastest pace since 2003.

Why is this good for future growth? Because high productivity growth means the economy can grow rapidly without inflation, raising living standards and theoretically allowing workers to get big raises without hurting company profits. It means companies will invest more in so-called capital expenditures that help to maintain that productivity. But it also means fewer workers will be needed as companies become more efficient in producing those goods and services.

We can also debunk one more piece of conventional wisdom. It doesn’t look like inflation will be a problem for years to come, in spite of the $2.5 billion in stimulus aid that is being injected into the economy. The Congressional Budget Office has predicted that the shortfall in output over the next 2 plus years will probably be around $6 billion, and an economy working at less than capacity does not induce inflation.

Harlan Green © 2009

WHAT IS DEFLATION RISK?

Why the urgency of putting so much money into the various stimulus plans? Treasury Secretary Geithner’s addition to TARP, a mix of public and private investments, could cost as much as $1.5 trillion. The congressional stimulus bill, called the American Recovery and Reinvestment Plan or ARRP, will cost approximately $790 billion, while the Federal Reserve could be lending and/or guaranteeing more than $1 trillion in debt, and so on.

The recent plan unveiled by Treasury Secretary Geithner highlighted the difficulty of getting banks to lend again. Its centerpiece was a public/private proposal to relieve banks of their toxic—or nonperforming—assets. But if there is no market for these assets, then banks have no idea what they are worth. This is the main reason they are hoarding their monies—bailout funds included.

And so some kind of government guarantee is needed to bolster their value(s). Otherwise, as Citibank Chairman Vikram Pandit said, they would be irresponsible to unload these assets at today’s fire sale prices. Actually, should banks do so, they might very well reveal themselves to be insolvent.

The result is a stalemate, which is causing wages and prices to begin to spiral downward. Hence the urgency of the various plans. Such a deflationary spiral is the most debilitating form of a recession. In fact, that is when a recession becomes an actual depression, as it did in Japan during the 1990s and our Great Depression.

Most Americans have no experience of one, therefore cannot conceive of its damage—when wages as well as prices are in a prolonged slump. This leads to the opposite of the wage-price stagflationary spiral experienced in the 1970s that drove the inflation rate to 14 percent—and unemployment rate above 8 percent.

Nobelist Paul Krugman is one of those sounding the alarm. He maintains that we could see a real 3 percent drop in prices if the so-called ‘output gap’, or difference between normal Gross Domestic Product growth and the negative growth during a recession/depression, is as high as the Congressional Budget Office predicts.

That is why so much money is being thrown at the deflation problem. The ARRP stimulus is targeted at creating jobs, whether by directly subsidizing industry, or indirectly with tax cuts. The Treasury plan is designed to heal the banks’ balance sheets so they will lend again. Both plans have to work before our economy will be able to recover.

Harlan Green © 2009

WILL HOMEOWNER ASSISTANCE PLAN WORK?

President Obama’s newly announced $275B mortgage stimulus program has many parts, which means it is attacking the foreclosure problem from many sides. This will certainly help to put a bottom on home values, which are at the root of the foreclosure problem.

Below is a list of key elements of the plan outlined this week by President Obama that aims to aid as many as 9 million households in fending off foreclosures:

• Allows 4 million–5 million homeowners to refinance via government-sponsored mortgage giants Fannie Mae and Freddie Mac.
• Establishes $75 billion fund to reduce homeowners' monthly payments.
• Develops uniform rules for loan modifications across the mortgage industry.
• Bolsters Fannie and Freddie by buying $200B more of their shares.
• Allows Fannie and Freddie to hold $900 billion in mortgage-backed securities — a $50 billion increase.

A separate program would potentially help 3 million to 4 million additional homeowners with jumbo mortgages by allowing them to modify their mortgages to lower monthly interest rates through any participating lender. Under this plan, the lender would voluntarily lower the interest rate, so that payments are just 38 percent of gross monthly income, and the government would provide subsidies to the lender to lower it further to a 31 percent debt to income ratio.

FDIC Chairperson Sheila Bair has also come out with her long-awaited mortgage modification program that she believes will have an effect in months. This proposal is designed to promote wider adoption of such a systematic loan modification program:

• by paying servicers $1,000 to cover expenses for each loan modified according to the required standards; and
• sharing up to 50 percent of losses incurred if a modified loan should subsequently re-default

“We envision that the program can be applied to the estimated 1.4 million non-GSE mortgage loans that were 60 days or more past due as of June 2008, plus an additional 3 million non-GSE loans that are projected to become delinquent by year-end 2009,” says the FDIC website. “Of this total of approximately 4.4 million problem loans, we expect that about half can be modified, resulting in some 2.2 million loan modifications under the plan.”

Almost one in 10 home mortgages is either delinquent or in foreclosure, and analysts estimate that at as many as six million families could lose their homes over the next three years in the absence of government action. These programs will certainly help a certain percentage of them. The foreclosure rate for single-family homes is now above 6 percent of the 100 million + mortgages outstanding, 2 percent above the historical rate of 4.25 percent, so it is not the end of the world.

The plan will take effect March 4, when the administration publishes detailed rules explaining it. Except for the provision that empowers bankruptcy judges, almost all the other elements can be enacted by Mr. Obama without further action by Congress.

Harlan Green © 2009

WHY THE FIXED RATE PREFERENCE?

Fixed rate mortgages continue to be the financing of choice, in spite of former Fed Chairman Greenspan’s attempt to sway borrowers towards adjustable rate mortgages, or ARMs. Studies from the Federal Housing Finance Board, which regulates savings and loan institutions, show that more than 80 percent of mortgages tend to be fixed-rate products versus 18 percent that are adjustable.

This puts the current adjustable rate subprime crises in proportion, since subprime loans comprise just 6 percent of outstanding mortgages, though their default rate is approaching 20 percent. The default rate for all conventional mortgages is now 6 percent.

"The fixed-rate mortgage is a cornerstone of the U.S. housing finance system and has been instrumental to the accrual of wealth on the part of many households. The low interest rates of the past two years have increasingly lured consumers seeking a predictable payment in an uncertain economy," said Stuart Gabriel, director of the University of Southern California Lusk Center for Real Estate.

The 30-year, fixed-rate mortgage is about 70 years old. The loan instrument was first offered during the 1930s after the creation of the Federal Housing Administration as part of financial reforms to combat the Depression.
Before that, most residential loans were balloons, requiring a payoff within 10 years. In addition, mortgages were made for only up to 50 percent of a property's value.

Long-term loans took off in the housing boom post World War II, when FHA and VA mortgages fueled construction in U.S. suburbs. At the same time, homeownership rates jumped once the 30-year loan became available, from 44 percent in 1940 to 65 percent in 1966; the rate is near 68 percent today.

Adjustable-rate loans have their advantages when fixed interest rates are high or rising quickly. But the subprime debacle showed us that using them when interest rates were at record lows 2003-2005, lulled borrowers into a false sense of security. The Federal Reserve under Fed Chairmen Greenspan and Ben Bernanke raised short term interest rates 17 consecutive times over 2 plus years, which burst the real estate bubble and caused the credit crunch we have today.
ARMs first became widely available in 1981, their share of the mortgage market has varied from a high of 39 percent in 1994 to a low of 12 percent in 2001, Gabriel found.

"Clearly, borrowers benefit from the availability of a wider variety of products. ARMs appeal to more mobile households, homebuyers who expect their incomes to be positively correlated with interest rate fluctuations and buyers who are down payment-constrained," Gabriel wrote. But if affordability of the monthly payments isn't a problem, "then many borrowers prefer the ongoing payment certainty of the fixed-rate loan."

There are some regional differences in the use of fixed-rate vs. adjustable-rate mortgages. Consumers in Alaska are most enamored of the fixed-rate mortgage: In 2003, 98 percent of conventional home mortgages in Alaska were fixed-rate mortgages.
Following Alaska in favoring the fixed-rate mortgage are Delaware (93 percent), Oklahoma (92 percent), Texas (92 percent), New Mexico (91 percent), Pennsylvania (91 percent) and Tennessee (90 percent.)

Homebuyers in Massachusetts are most likely to take an ARM; 32 percent did so, in part due to the higher price of homes. Other states where adjustable loans command a high percentage of the market: Colorado and Michigan, with 30 percent; California, 29 percent; and Illinois, 27 percent.

© Harlan Green

WHAT IS ‘THE SOLUTION' TO BANKING CRISIS?

The critics of the new $814 Billion stimulus have got it wrong. Lowering taxes helps the few, but spending monies on infrastructure, education, health care and state governments aids the many. The problem is that businesses are hurting because there is a lack of demand for their products. And demand comes mainly from consumers who are tapped out at present. So any programs that directly create more jobs—especially in the private sector—give the most bang for the stimulus buck.

The demand slack is now worldwide, so that even our exports are down, which has hurt many domestic industries. This is puzzling many of the 2500 economists, business and political leaders attending the annual Davos, Switzerland economic summit, according to New York Times columnist Thomas Friedman. They seem to be at a loss to find a solution to the current worldwide economic malaise.

Part of the puzzlement is due to the nature of the malaise. Such a complete breakdown in consumer spending hasn’t happened since World War II. And that is due to both the housing and credit crunches, which caused the soaring jobless rate. So any solution must also envision how to get banks lending again. But banks won’t lend, until they see a pickup in demand for products and services.

This recession is also puzzling because the old solutions aren’t working. The first half of the TARP funds went to shore up financial institutions, on the theory that they would begin to lend again. For the past 28 years the answer to any economic problem was what is called supply-side economics, which meant giving more breaks to businesses such as banks or cutting taxes of the investor class.

But that program didn’t work over the past 8 years. Only 5 million jobs were created, in spite of record corporate profits and incomes of the top 1 percent of income earners; whereas 20 million jobs were created in the prior 8 years. The result is that wages and salaries of most consumers haven’t risen at all when inflation is taken into account. And so consumers could only spend what they could borrow, and borrowing collapsed when housing values plunged.

Therefore, any solution has to boost the incomes of ordinary Americans. This was understood by British economist John Maynard Keynes during Roosevelt’s New Deal, and his theories helped the U.S. and Europe recover from the Great Depression. So what was forgotten is being resurrected, given the severity of the current recession.

There is a new twist to the solution that is missed by many economists, even, because Lord John Maynard Keynes’ economic theories continue to be misunderstood. He advocated more government spending only during the bad times. His real contribution was in the new field of behavioral economics. He was the first to take psychological factors into account to explain the behavior of individuals and the financial markets.

Keynes maintained that the Great Depression was caused primarily by a psychological depression in “animal spirits” that caused Americans to retreat into themselves, and so cease most economic activity. His most famous conclusion was that since governments already knew how to stimulate economies during wartime, they should also be able to do so during peacetime.

Many of his followers have been behavioral economists whose research has led to a greater understanding of what financial stimulus works and what doesn’t. For instance, the irrational exuberance that caused the housing bubble (and dot-com bubble before that) was predictable, since research has shown that investors and consumers are easily fooled by past history. Once home prices started climbing, for instance, there was a tendency to believe they would continue to climb.

And so part of the solution is create measures that prevent such bubbles from re-occurring. Hence the emphasis should be on better regulatory oversight of the financial markets. Such oversight not only fights fraud, but helps to establish programs that educate investors and consumers in the pitfalls of irrational exuberance.

Harlan Green © 2009

Mortgage Market Beginning Revival

When will we see an improvement in mortgage volume, and so real estate sales? This is probably the most asked question these days. Both the Fed and Congress are doing all they can to make mortgages reasonable and affordable to more borrowers. But in fact it is just Fannie and Freddie—now owned by the government—who are originating most of those mortgages.

So-called jumbo loans—those above $603,750 for a single unit in Santa Barbara County—are still not saleable on the secondary market, meaning that investors will only buy them for a tremendous premium. This has jacked up their rates into the 6-8 percent range for both jumbo ARMs and fixed rates.

But mortgage volumes are rising. The Mortgage Bankers Association (MBA) Weekly Mortgage Applications Survey for the week ending January 9, 2009 showed an increase of 15.8 percent on a seasonally adjusted basis from one week earlier. On an unadjusted basis, the Index increased 95.7 percent compared with the previous week and was up 52.4 percent compared with the same week one year earlier.

It is mostly refinances, whose volume is back up to June 2003 levels, and now comprise 85 percent of transactions. So the purchase market is still hurting, as perhaps homebuyers are reluctant to buy until they see a bottoming out in prices. That is common during deflationary times.

It is incumbent upon Realtors in particular to chart the direction of home prices in their territories. For instance, Santa Barbara and South Coast prices seem to have bottomed out in the $700 to $900,000 median price range. And that is in the range of the new high-balance conforming loan amount.

Why have mortgage volumes fallen so drastically last year? It is not only because of the credit squeeze. Housing expenses—including rent or mortgage payments as well as the cost of utilities, property taxes, insurance, and maintenance—have grown much faster than incomes from 1996 to 2006, according the Harvard’s Joint Center for Housing Study. But household incomes grew just 36 percent during that time.

In fact, Americans' incomes since 2000 have grown more slowly than at any time since the 1960s. So most consumers had to borrow to even maintain their standard of living. Therefore there has to be a push to boost the jobs that will boost the wages and salaries of working Americans to bring this economy back into equilibrium.

This is a 180 degree turn for many economists who believed that smaller government and lower taxes were the prescription that fit all economic ailments. But we now know that such a philosophy led to the excesses that government is working to fix.

Harlan Green © 2009

When Will Real Estate Markets Improve?

December existing-home sales jumped 6.5 percent, according to the National Association of Realtors (NAR) with unsold inventory falling to 9.3-month supply. The Conference Board’s Index of Leading Economic Indicators (LEI) also rose for the first time in months, which may be a sign that economic activity is beginning to stabilize.

But concerns about the faltering economy and reluctant home buyers pushed builder confidence in the market for newly built single-family homes down further in January, according to the latest National Association of Home Builders/Wells Fargo Housing Market Index (HMI). The HMI edged down a single point to a new record low of 8 in January.

Lawrence Yun, NAR chief economist, said home prices continue to fall significantly. “It appears some buyers are taking advantage of much lower home prices,” he said. “The higher monthly sales gain and falling inventory are steps in the right direction, but the market is still far from normal balanced conditions. Buyers will continue to have an edge over sellers for the foreseeable future.”

Meanwhile, builders are advocating more federal housing aid to jumpstart new home sales. Specifically, the NAHB is advocating for an enhanced home buyer tax credit and a government buy-down of mortgage rates for home purchases in 2009, moves that would rejuvenate demand for homes and trigger significant consumer spending across the board.

"Clearly, conditions in the nation's housing market aren't getting any better, and they aren't going to get any better until the federal government takes substantial action to encourage qualified buyers to get back in the market," said NAHB Chairman Sandy Dunn. Dunn noted that "The Obama Administration and the new Congress have a tremendous opportunity and responsibility to enact legislation that can spur home buyer demand and jump-start the national economy."

"Builder views continue to track with historically low consumer confidence measures," said NAHB Chief Economist David Crowe. "The fact that there has been microscopic movement in the historically low HMI and its component indexes over the last three months provides further evidence of the need for government action to rejuvenate housing demand. Qualified buyers are clearly in the wings, but they're looking for a significant signal from the federal government that now is the time to return to the market."

The Conference Board’s LEI predicts future economic activity, and “Taken together, the recent behavior of the composite economic indexes suggests that the recession that began in December 2007 will continue in the near term.”

Harlan Green © 2009

Why Did Fed Drop (short-term) Rates to 0%?

The Federal Reserve did something for the first time in its history. It dropped its fed funds overnight rate—the overnight rate it lends to banks—to between 0 and 0.25 percent. This meant in effect that it will print as much money as necessary to encourage financial institutions to begin to lend and/or invest again, which they are reluctant to do at present. But will it work without other stimulus programs?

Its FOMC press release highlighted the Fed’s concern for the economy: “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Why such a drastic measure? This is in spite of more than $1 trillion to date lent or invested in our largest financial institutions. It highlights a problem often debated by economists. How to get the most bang for the stimulus buck? Classical economists who hark back to the free market philosophy of Adam Smith believe that giving the largest financial institutions as much money as they need—either via a stimulus package, or more tax breaks—will encourage them to lend and invest in businesses.

But with consumer incomes and spending having declined more than 40 percent, there is little incentive for businesses to expand. The auto industry is just one example, with sales of both domestic and foreign cars down around 40 percent, as well. Industries are cutting jobs, not creating them at the moment.

It was the last, Great Depression that brought a new economic philosophy, named after British Lord John Maynard Keynes. And the Roosevelt Administration liked his ideas, since it wanted to stimulate consumption by directly creating jobs rather than waiting for the private economy to recover. Until then, the captains of industry and finance believed only the private sector should control resources, except during wartime. Any other economic model smelled of socialism.

But Lord Keynes, a British monetary expert thought differently in a famous essay:

“…there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment. Formerly there was no expenditure out of the proceeds of borrowing that it was thought proper for the State to incur except for war. In the past therefore, we have not infrequently had to wait for a war to terminate a major depression. I hope that in the future we shall not adhere to this purist financial attitude, and that we shall be ready to spend on the enterprises of peace what the financial maxims of the past would only allow us to spend on the devastations of war.”

As a precursor to modern economic theory that took into account the psychological behavior of consumers and investors, Lord Keynes saw that emotions (and so confidence) helped to determine how humans behaved in both good and bad times.

We are currently in a recession that began last December and could last into 2009. And this has affected how consumers and businesses see the world. That is the reason why there is such an emphasis by the incoming Obama administration on job creation, as well as providing better health care and educational opportunities. It provides aid and relief to the consumers who power this economy—with their pocketbooks.

So though 0 interest loans help to grease the wheels, it is such job creation and training programs that puts money into consumers’ pockets and will ultimately bring the U.S. economy back. Without healthy consumers, what bank will lend or business expand?

© Harlan Green 2008

Is Housing Market Beginning to Stabilize?

How close are home sales and housing values to "bottoming out"? This headline in a recent Business Week attempted to show that housing prices in many cities were already below their “correct” prices using household population, mortgage rates, and relative income levels. But, it hedged the results by saying that there was a +/- 14 percent error factor in the results!

This included San Francisco (- 16 percent), San Diego (-19 percent) in California, and Phoenix, Arizona, still 4 percent overvalued. So is there a more meaningful way to measure home values? This is crucial, as banks (other than government-owned Freddie Mac, Fannie Mae, FHA/VA) will not be ready to lend again until they are sure of future housing values.

Among the factors that directly determine housing values are household incomes, mortgage rates, population growth and the supply of housing. All else—rents, default rates, and even the credit crisis—derive from these factors.

Only some of these factors are beginning to turn positive. Perhaps the most important is household income, which has shrunk 1 percent to $50,233 from 2000-2008 after inflation, while personal household debt including mortgages ballooned from around $8 trillion to $14 trillion over that time. The main factor that will turn around household incomes is both lower inflation, and better tax breaks for wage earners. To date it is only the top 1 percent of income-earners whose incomes have improved since 2000.

But population (and household formation) continues to grow. Harvard’s Joint Center for Housing Studies predicts 1.2 million households per year will be formed over the next 10 years that will require housing. This much pent-up demand will be the basis for a recovery, once housing values stabilize.

And interest rates should continue to remain low, both due to government efforts and the recession. So it is static household incomes and a 1 million plus excess of unsold housing—a result of the housing boom—that are weighing down housing values. The federal proposal for cheaper mortgage rates that would specifically target home purchases should help to lower housing inventories.

That is why the housing recovery will be so uneven. The old rust belt regions have seen the biggest loss in incomes, which is why cities like Columbus, Ohio and Indianapolis are 14 and 16 percent undervalued, respectively, according to the Business Week article. Values are even lower in cities like Dallas and Houston, Texas because of overbuilding; where housing is undervalued 31 and 34 percent, respectively.

But Chicago, New York, and Los Angeles—our largest metropolitan areas—are already at their “correct” price level, according to Business Week. In fact, only 4 of the 25 cities surveyed seem to be overpriced.

The incoming administration’s middle class tax cuts and proposal to create or retain at least 2.5 million jobs in the next 2 years can help to solve the drop in household incomes. Housing values nationally have returned to 2004 levels, which is why it is important to arrest any further decline in values.

© Harlan Green 2008

Are Lower Interest Rates the Recession Cure?

Now that we know this recession started in Dec. 2007, what are the various tools to help us climb out of it? We can look at the stimulus packages already in the works, but immediate help may come from several proposals to lower interest rates that would stimulate real estate sales.

The Federal Reserve has agreed to use $500B to buy up all manner of debt and Mortgage Backed Securities from the GSEs, including Fannie Mae, Freddie Mac, and FHA/VA. This will in effect bring down the cost of new mortgages by relieving them of any questionable assets on their books. Just the announcement of this plan has already driven down conforming fixed rates one half percent in a week.

And the new Jumbo-conforming product with higher loan limits that takes effect in 2009 should give real estate a boost if rates remain as low, or lower than they are now. The 2009 jumbo-conforming 30-year fixed rate is currently quoted at 5.25 percent, for loans that will be funded in 2009.

And lastly, the Treasury is talking about buying down fixed rates to around 4.5 percent for home purchases, in order to reduce the huge inventory of unsold new and existing homes. This will give a boost to housing values, which is what lower interest rates tend to do. In fact, rates are still too high for most homeowners. Some 10 million homebuyers have negative equity in their homes and that total will continue to climb if values don’t stabilize, thus causing more foreclosures.

The latest housing price indicators are still falling. The Case-Shiller index said all three aggregate indices and 13 of the 20 metro areas are reporting new record rates of decline. Looking at the returns of the U.S. National Index, prices are back to where they were in early 2004. As of September 2008, the 10-City Composite is down 23.4 percent from its peak, the 20-City Composite is down 21.8 percent and the National Composite is down 21.0 percent.

But pending purchase contracts for existing homes have begun to level out. The National Association of Realtors’ Pending Home Sales Index, a forward-looking indicator based on contracts signed in October, slipped 0.7 percent to 88.9 from an upwardly revised reading of 89.5 in September, and is 1.0 percent below October 2007 when it was 89.8.

Lawrence Yun, NAR chief economist, said a review of the past year is instructive. “Despite the turmoil in the economy, the overall level of pending home sales has been remarkably stable over the past year, holding in a generally narrow range,” he said. “We did see a spike in August when mortgage conditions temporarily improved, which underscores two things – there is a pent-up demand, and access to safe, affordable mortgages will bring more buyers into the market.”

There is no question that any further drop in interest rates will continue to help home sales and prices. The NAR’s Affordability Index has continued to climb and is up a whopping 34 percent from 2006, at the height of the housing boom. This is both due to the lower interest rates, and the fact that the national median existing-home price has fallen 18 percent since 2006.

© Harlan Green 2008