Eye on the Economy - 09/18/2009 (Plain Text Version)

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Market Distress Peaked in October 2008

One way of measuring the distress in financial market is to look at the spread or difference in interest rates between the 3-month LIBOR — a market rate determined by borrowing and lending between large banks in London that is used as an index for short-term commercial loans — and the 3-month Treasury Bill.

In normal times, that spread hovers somewhere in the neighborhood of a half-percent. During times of distress, the spread widens.

For example, during the 1990-1991 recession the monthly average spread peaked at 1.3% in November 1990. In the current recession, the monthly average spread peaked at 3.37% in October 2008.

On a daily basis, that spread peaked on Oct. 10, 2008 at an astounding 4.57%. Clearly, the problems in the subprime mortgage market had spread to virtually every nook and cranny of the financial markets. [return to top]

The Feds to the Rescue

Facing the prospect of a financial market collapse, the Federal Reserve and the Treasury Department worked feverishly to provide liquidity to the financial markets, to prop up those entities that needed rescuing and to reassure the public.

The Federal Reserve has been purchasing mortgages and mortgage-backed securities since January 2009. To date, Fed purchases have totaled $836 billion, and it may end up purchasing as $1.25 trillion in mortgages and securities. Although that volume of purchases may have replaced other purchasers, it has kept prime mortgage rates below 5.5% since November 2008.

While the Federal Reserve originally indicated that purchases would last through the end of 2009, that decision is open to change and we expect the Fed to stretch its purchases beyond the first of the year.

One concern that has been raised frequently is the large amount of liquidity that the Federal Reserve has pumped into the financial system — and is still in the system — greatly increases the risk of future inflation. However, this line of reasoning ignores the significant reduction in lending that occurred in the financial system during the past two years.

If the Fed had not partially offset this deleveraging by adding liquidity to the system, the economy would have fallen into an even deeper recession, almost certainly producing significant deflation.

However, the Fed’s liquidity injection did not lead to increased borrowing because most of it only partially replaced existing borrowing. Further, because there has been no new net borrowing, the Fed’s action did not spur an increase in spending.

In fact, spending fell, producing our current recession. The added liquidity kept spending from declining further than it did, preventing an even sharper drop in economic growth than we have experienced.

As long as there is significant slack in the economy, there is little danger from inflationary forces. As of August, inflation as measured by the Consumer Price Index (CPI) fell 1.5% on a year-over-year basis while core inflation (the CPI excluding volatile food and energy prices) rose a modest 1.4% — the smallest increase for that measure in more than five years.

Certainly as the financial markets continue to improve and lending eventually moves towards some form of normalcy, there will be a need to withdraw some of the liquidity the Fed injected into the market.

To some extent this is already happening naturally as the emergency loans that provided liquidity to the market are being re-paid. At this point, the danger is greater that the Fed, in reaction to this type of criticism, withdraws too much liquidity too fast, pushing the economy into another downward slide.

This is exactly what happened during the 1930s when the economy began to revive and fears of inflation — in the midst of massive deflation nonetheless — led the Fed into serious monetary error. This is not a mistake that Federal Reserve Chairman Ben Bernanke and members of the Federal Reserve Board are likely to make.

It may well take the financial markets several years to return to what many will consider normal. Along the way, there will be ample time for the Federal Reserve to reverse the actions it has taken to add liquidity to the financial markets.

Further, the Fed has numerous powerful tools — from buying and selling financial securities to determining the percentage of financial institutions’ deposits that have to be held as reserves — to reduce the amount of liquidity in the U.S. financial markets. [return to top]

Financing for Housing Faces Major Hurdles

For about three years now, builders have faced increasing difficulty in obtaining AD&C loans. Not only have builders found it increasingly difficult to obtain these loans, but in many cases they have faced significant adverse changes to existing loans — including reductions in lines of credit, demands for increased equity for outstanding loans and, in some cases, demands for full repayment of outstanding loans.

These types of increased requirements have transformed many performing loans into non-performing loans.

In the Federal Reserve’s third quarter survey of senior loan officers of large regional banks conducted in July, 46% of the 54 banks responding said that over the previous three months they had tightened credit standards for commercial real estate loans, which include residential AD&C loans. That marked more than three years of continually tightening lending standards for commercial real estate loans.

The one positive is that the net percentage of banks tightening these loan standards has fallen each of the last three quarters. These results were reflected in NAHB’s second quarter builders’ survey regarding AD&C lending, where 64% of builders said that credit conditions for acquisition debt were worsening, down from more than 80% reported in the last several surveys.

Similarly, 63% of builders said that the availability of loans for single-family construction was worse, but that was at least down from the more than 70% who reported in previous surveys that availability was worse. While the percentage saying availability is worse remains high, it is at least down from the peaks reported in late 2008 and early 2009.

Meanwhile, the mortgage market has not fared much better. In the Fed’s July senior loan officer survey, 22% of the 51 banks responding said that, over the previous three months, they had tightened credit standards for prime mortgage loans to consumers — while none indicated that they had loosened their requirements.

 For non-traditional mortgage loans (“Alt-A” loans or loans above subprime in quality, but below the standards to qualify as prime loans), nearly half of the 24 banks responding said they had tightened standards. Again, none said that they had loosened standards on those loans.

If there is any positive to be garnered from the survey, it is that most of these banks are no longer tightening their mortgage lending standards. Most of the tightening still occurring appears to be minor and around the edges.

Nonetheless, this survey now represents two-and-a-half years of tightening credit standards to approve mortgage loans. That is not an auspicious lending environment for potential home buyers. [return to top]

Is the Recession Over?

A number of commentators have been arguing recently that the current recession is over or that it is rapidly drawing to an end. Even Bernanke has joined the chorus.

There is definitely improvement in the economy — and even in housing. However, as we have pointed out previously, the improvement is surfacing in an extraordinarily low level of activity.

Although improvement is certainly better than the alternative, it still leaves us with a long struggle ahead — and the prospect of backsliding into trouble again still exists.

Some of this “improvement” is actually a slowing in the deterioration of some economic measures — a necessary step to recovery, but still painful nonetheless.

A prime example is the August employment report. Non-farm payroll employment fell by 216,000, the smallest decline in a year and less than a third of the January decline. Still, nearly 7 million jobs have disappeared from the economy since employment peaked in December 2007.

More than a million residential construction jobs have been lost since industry employment peaked in February 2006. Over the last 12 months, almost half of million of the nearly 6 million jobs lost overall were in residential construction. During the same 12 months, the overall unemployment rate rose from 6.1% to 9.7% and the unemployment rate in construction (both residential and non-residential) rose from 8.2% to 16.5%.

The economy and housing still face many challenges. Any backsliding in the financial markets presents a threat to a recovery and the housing market.

Although there has been improvement in the financial markets, obtaining a mortgage is still very difficult. Foreclosures continue to hang over several local markets, putting downward pressure on home prices. Improper use of foreclosure sales in appraisals have added to the difficulty in obtaining a mortgage and completing a home purchase.

The $8,000 first-time tax credit expiring at the end of November is another possible blow to housing. To date the tax credit has helped motivate many potential first-time home buyers to enter the housing market. However, that push is already abating as the time to purchase a home and qualify for the tax credit is rapidly drawing to a close. [return to top]

Housing Continues to Struggle

Most of the news from the housing sector of late has been good, but it must be kept in perspective.

While August total housing starts of 598,000 (at a seasonally adjusted, annual rate) — up 1.5% from July’s 589,000 — sound good, starts were down 30% from August 2008 and were just a third of the nation’s long-term trend needs of roughly 1.8 million starts a year.

 Further, the August increase was concentrated in the multifamily sector, which is notoriously volatile on a month-to-month basis. Multifamily housing starts, which were down to 95,000 in July — the second lowest multifamily starts number on record — have been bouncing around at roughly 110,000.

Single-family starts, which normally account for about 80% of overall starts, fell 3.0% in August, to 479,000 from 494,000 the month before. The decline undoubtedly reflects the winding down of the first-time home buyer tax credit and August represents the last month in which a home builder could hope to start construction on a house that could be completed in time for settlement by Nov. 30, the end date to qualify for the first-time home buyer tax credit. Even then, adhering to this timetable will be a stretch for most builders and buyers attempting to meet the deadline.

Many of the starts may well have represented builders moving to replace their inventory of lower priced houses that had been sold under the tax credit.

This view is reinforced by builders’ sentiment reflected in the September NAHB/Wells Fargo Housing Market Index (HMI), which inched up a point to 19 in August. This positive news is tempered by the fact that, although the measure has been trending up from its lows of 8 and 9 in the latter part of last year and early this year, it still remains at a very low level relative to its history. A reading of 50 is considered neutral.

Of even more concern is that the two underlying indexes that drove the HMI higher were current sales relative to past sales and current traffic relative to past traffic. The one forward-looking measure, builders’ expectations for the next six months, was down. The current sales and current traffic measures were undoubtedly driven by the first-time home buyer tax credit, while sales expectations were likely driven by concern over expiration of that tax credit. [return to top]

Eye on the Economy Will Not Be Published on Sept. 30

Eye on the Economy will not be published on Sept. 30. Publication will resume on Oct. 14. [return to top]

Plan to Attend Construction Forecast Conference on Oct. 21

Plan to attend the 2009 Fall NAHB Construction Forecast Conference & Webcast on Oct. 21 in Washington, D.C. — or watch in on the Web — to get the latest facts, insights and analysis of the housing industry.

Panels of nationally recognized experts at the day-long conference will discuss economic trends, government policies, developments in the housing industry and the results from NAHB's recent surveys.

For more information and to register, visit www.nahb.org/cfc. [return to top]

Want to Know the Housing Starts Through 2017?

Find out in HousingEconomics.com's Long-Term Forecast.

Subscribe and get downloadable Excel tables that feature the housing starts forecast, gross domestic product (GDP), demographics and more. 

To learn more, visit www.housingeconomics.com. [return to top]

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