Nouriel Roubini is a bit self-congratulatory in his latest post, and one can’t begrudge him. He took a lot of heat for his early prediction that the housing market would deteriorate badly and pull down the broader economy.
So far, since growth has slowed only somewhat, some economists still hold out hope that the impact of housing on GDP will be limited. Roubini, in “The Recessionary Macro Effect of the Worst U.S. Housing Bust Ever,” argues that the data coming in continues to support his earlier, grim forecasts.
He also notes that mortgage rates would have to fall 200bp to make current housing prices viable, and argues that the Fed was hoping that its September rate cut would be a step in that direction. But as most readers are well aware, long bond rates, which are the basis for pricing fixed rate mortgages, rose rather than fell based on higher inflation expectations.
A friend of mine who is a senior professional in one of the largest financial institutions in the world has sent me privately – and confidentially – the following email messages. Like me, he predicted a year ago that this would be the worst housing recession in US history and described a bust process that would go through 4 phases. Here is the way he is putting it:
It appears that we are now entering phase 2 on the timeline for the housing bust:
Phase 1: rising mortgage defaults, homes prices start falling, sale volumes falls, housing starts and permits decline.
Phase 2: home-builders’ bankruptcies, housing starts and permits crash, substantial layoffs in construction and real estate-related fields (mortgage brokers, mortgage lenders, etc.).
Phase 3: substantial price declines in major metro areas, large rise in defaults of prime but low-equity mortgages.
Phase 4: large-scale government intervention to help households going bankrupt. This is a political phenomenon, so the timing and nature of this cannot be reliably forecast.
Evidence of financial distress and default among homebuilders in phase 2:
Public builders in trouble….
I fully agree with him with one caveat: we are not just at the beginning of phase 2 but most likely already at phase 3 as most of the aspects of phase 2 have already occurred by now and some elements of 3 are already on their way (home prices are falling sharply in some major metro areas, we are seeing the rise in defaults in near prime and prime mortgages and some near prime and prime lenders are in trouble). And we are getting close to phase 4 as over a dozen proposals to rescue 2 million plus households on the way to default and foreclosure are now being debated in Washington.
Next, this senior colleague sent me the following additional message – after my latest blog revisiting my predictions – on the macro impact of the worst housing bust in US history:
Follow-up to your blognote today…
Even more interesting is that the current view has not substantially changed from that of a year ago. The evidence is now overwhelming and consensus admits what they denied last year: that we will experience at least a severe housing downturn — in price action unlike anything since the 1930’s, probably also in rates of foreclosure.
But consensus opinion remains unshaken that there will be only minor macro effects. This seems extraordinary to me. A 70 year record decline in what is perhaps the largest private asset class, the collateral for the majority of household debt, whose leverage is at an all-time record high. A downturn – perhaps crash – in the construction and real estate industries (18% of 2005 total metropolitan area GDP).
Perhaps the most astonishing aspect of this event is the refusal to recognize the possible dimensions, the impact, of what is coming.
Indeed, the soft landing consensus is increasingly delusional in believing that the biggest housing recession in US history will not have severe macro effect. Most of the consensus now recognizes that, after the spurt in growth in Q3 (probably a little above 3%) the economy is now rapidly decelerating and Q4 will be weak: for example one of the most bullish houses – JP Morgan – is now forecasting a Q4 growth of only 1%, fully in the growth recession territory (Bloomberg consensus for Q4 is an optimistic 1.8%). But this consensus next goes to assume and predict that Q4 will be the bottom of the US growth slowdown and that economic growth will recovery in soft landing territory (2.5%).
What is the basis for this alleged 2008 growth recovery? Mostly wishful thinking as the economic and financial shocks leading to falling demand (a worsening housing bust; anemic capex spending; slowdown in commercial real estate demand; sharp private consumption slowdown) and weak supply (weakening ISM; slowing down employment; glut of supply of new and existing homes, auto/motorvehicles, consumer durables; a capacity overhang; an excess inventory buildup) will fully persist into 2008. Indeed, as David Rosenberg, the chief US economist for Merrill Lynch put it in his most recent report:
We think a miracle is needed to avoid recession. With domestic demand growth struggling to stay above a 1% run-rate, if we manage to avoid a recession with another huge down-leg in homebuilding activity and home prices, we think it will be a miracle.
A miracle to avoid a recession! Indeed it seems that many of the soft landing optimists are now in wishful thinking mode, if not hoping for a miracle. As Ed Leamer showed in his Jackson Hole paper, six of the last eight housing recessions have ended up in a economy-wide recession; and this housing recession will end up being more severe than all of the former eight ones. The only two exceptions of a housing recession not leading to economy-wide ones were those during the Korean War and the Vietnam war when a massive fiscal stimulus rescued the economy. What we spent – or waste – on Iraq is not sufficient to get that fiscal stimulus; we would need another equivalent of $200 billion fiscal stimulus to do the job. A war with Iran is such an option: but a war in Iran would lead to an overnight doubling of oil prices to $200 per barrel plus and would lead to a certain U.S. and global recession.
Home prices will have to fall by 20% to bring back home affordability to semi-normal levels; or mortgage rates would have to fall by 200bps to get the same result. Chances of the latter happening are zippo as long rates went up after the Fed eased on September 18th. So the adjustment will occur via a painful and deflationary 20% fall in home prices that will trigger an economy wide recession as any mainstream macro-econometric model shocked with a 20% fall in home prices shows.
No wonder that Mishkin – in his Jackson Hole paper – went through a benchmark scenario where home prices fall by 20%; do you think that Bernanke had not read Mishkin’s paper before the Jackson Hole meeting? And the implication of the Mishkin paper was that the Fed needed to start with a 200bps Fed Funds cut to try to attempt to counter this home price shock alone; even that would not be enough as long rates and mortgage rates are likely to fall less than otherwise hoped by the Fed.
So no surprise that Marty Feldstein urged at Jackson Hole the Fed to cut rates right away – to start with – by 100bps. But, at best, the FOMC will give us another 25bps as a Halloween Treat on Wednesday, not the 200bps implied by the Mishkin analysis. So, what the Fed does is – again – too little too late. The consensus among the independent academic luminaries at Jackson Hole (Feldstein, Leamer, Shiller, and even implicitly, Mishkin) was that this was the worst housing bust ever and that the macro effects would be severe with a high risk of a recession. So why is the Wall Street consensus and the Fed not getting it?
What does the macro econometric model used by the Fed imply if you shock it with the worst US housing recession, 20% fall in home prices, collapsing HEW, a severe liquidity and credit crunch, a rise in investors’ risk aversion and uncertainty, and oil at $90? Would someone at the Fed let us know? And – based on that model – which cut in the Fed Funds rate it will take to avoid a recession? Hopefully someone at the Fed may have that answer and provide it to the public.