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