Saturday, January 3, 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