Knock-On Effects of Housing Crisis to Strike Entire US Economy

Reddit

Financial bubbles are mortal organisms. Even though they might seem immortal for a time, they never live forever. The housing bubble will be no different. It will perish…eventually.

Are we ready for the after-life? Are we prepared to cross over into that netherworld where home prices tumble from the heavens like falling angels, and where property speculators weep and gnash their teeth and where the US economy itself abides in the outer darkness of excess debt and inadequate savings?

Based on America’s limited capacity to absorb a substantial bear market in housing, we fear that very few homeowners will find salvation in the afterlife of the bubble. A select few of us might achieve a partial salvation, provided we have not committed the mortal sins of borrowing too much or saving too little.
 
“US economic growth depends entirely on the continuation of the frenetic housing bubble,” warns Dr. Kurt Richebacher, editor of the Richebacher Letter.

Dr. Kurt may be wrong, of course. But what if he isn’t? Is America prepared for the end of the bubble? Are any of us prepared? Most macroeconomic indications do not inspire confidence.

Real Estate, both as an asset class and as an industry, has assumed such an outsized share of US economic activity that the entire economy would mourn the passing of the housing boom. Let’s consider a few surprising – if not alarming – facts.
Since the end of 2001, housing-related industries have produced a whopping 43% of the nation’s total net private sector employment growth. Obviously, therefore, any slackening of real estate activity would slow employment growth in the industry. Indeed, this massive job-creator could become a job-destroyer.

The nation’s banking operations have also become heavily reliant on the real estate sector. Mortgage-related assets at US banks have swelled to more than 60% of total assets. As the chart below illustrates, mortgage lending used to comprise a much smaller share of total bank lending.

Back in the days of Eisenhower, Kennedy and Johnson, US banks would lend to businesses for the purpose of investing in plant and equipment. Today, banks lend to homeowners for the purpose of buying garden plants and stereo equipment. Additionally, the American homeowners of 40 years ago were far more likely to pay off their mortgage debts than to increase them.

Net-net, the US economy has become increasingly reliant on real estate transactions. The proceeds of used home sales as a percentage of nominal GDP have soared to new all-time highs. “At 10.36% of nominal GDP, the dollar volume of trading in existing homes is nothing to sneeze at,” notes Northern Trust economist, Paul Kasriel.

“Of course, the principal direct contribution to GDP from existing home sales comes from commissions paid to real estate brokers, mortgage brokers and Wall Street securities houses which ‘securitise’ mortgages,” Kasriel notes. “[But] if this housing frenzy were to slow down, it likely would have a major ripple effect on the economy as a whole.”

Clearly, therefore, any prolonged slackening in the real estate market would directly imperil job growth and GDP. In addition, the adverse “knock-on” effects could be substantial.

“All bubbles essentially end painfully, housing bubbles in particular,” warns Richebacher. “They are an especially dangerous sort of asset bubble, because of their extraordinary debt intensity. The debt numbers speak for themselves: In 1996, US, private households borrowed US$332.2 billion…With the housing bubble in full force, it hit US$1 trillion in 2004.
“This debt intensity has its compelling reason in the particular way that accruing ‘wealth’ has to be converted into cash,” Richebacher continues. “In the case of an equity bubble, in general, the owner realises capital gains simply through selling a part of his stock holdings. No bank and no debt are involved…In this respect, a property bubble is a totally different animal. Since homeowners normally want to stay in their house, ‘wealth effects’ have to be extracted through additional borrowing against the inflating property value; that is, through mortgage refinancing. In essence, twofold borrowing is needed: FIRST, to boost housing prices; and SECOND, to withdraw equity.

“Yet,” Richebacher notes, “there is a second, even more dangerous, aspect to housing bubbles: they heavily entangle banks and the whole financial system as lenders. For this reason, as a matter of fact, property bubbles have historically been the regular main causes of major financial crises. During its bubble years in the late 1980s, Japan had rampant bubbles in both stocks and property. While the focus is always on the more spectacular equity bubble, hindsight leaves no doubt that the following economic disaster was mainly rooted in the property bubble. Both bubbles burst in the end, but the property deflation has continued for 13 years now, with calamitous effects on the banking system…”

Clearly, a post-bubble economy would be no friend to the debt-heavy, savings-lite US consumer. Throughout the 1960s, 70s and 80s, we Americans would save about 10% of our income each year. But today, the national savings rate has tumbled to zero – We don’t save nuthin’! “In 2004,” Richebacher observes, “household debt increased more than twice as fast as disposable income.” As we never tire of mentioning, therefore, American households have never before dared to face the future with so much debt and so little savings.

“For consumer spending to slump in the wake of a fading housing bubble,” Richebacher warns, “house prices do not need to fall at all. It is sufficient that they stop rising, thereby depriving households of new wealth effects…” The housing bubble has not crossed over the afterlife, but that day approaches.

Are you ready?

Eric Fry
The Daily Reckoning Australia

The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
Reddit

Comments

  1. Eric, Thank you for putting some metrics on this board. They confirm my fears.

    The vast majority of residential loans will continue to be paid one way or the other. Defaults in this market are not, in my view, a key global issue.

    Of key global importance is the impact of higher commercial interest rates, increasing defaults in the commercial debt market and (as your point out) reduced consumer demand. If the shift in consumer confidence becomes global then a global recession becomes a certainty.

    Riding against the crisis current is the existing momentum of a world economy in which the US is but one of many large players.

    In comparison to the US situation, productivity increases in Europe and Asia in the past few years have been real. The flow on effect of a significant US recession is hard to gauge, but I would expect a 12 month bear market to persist in these economies. Major Japanese exporters are already feeling the squeeze as the cost of selling their goods into the US increases.

    The other great unknown is the extent too which the Asian central banks will continue to prop up US consumer spending by investing their surpluses in US Treasury bonds. While they will probably continue to do it, they don’t have to! In the long run, the velocity of money in their own economies would improve if they didn’t!

    The flow over of this crisis into the “poor” developing world will of course be crippling. Expect higher political destabilisation to be a consequence.

    Another political issue is the continued affordability of that stupid and now hopeless war in Iraq .

    Coffee Addict
    August 17, 2007
    Reply
  2. As the chart below illustrates…..?

    Reply
  3. There is much talk of a housing bubble in the US and excessive household debt. Whilst it has no material effect on world markets I think that the Australian situation should be a cause of concern. If there ever was a country with artificially expensive property, and an economy that is completely dependent on housing it is Australia thanks to negative gearing. As a result we make nothing of value to export, we have no infrastructure, and our trade deficit makes the US one look like kids stuff.

    Clive Hutt
    August 18, 2007
    Reply
  4. The American dream is over,All the stones are set to fall.
    Old age pensions are unsustainable,
    military spending unsustainable,
    America is destined for third world status.The politicians have raped,gutted and looted the Americans blind .We now see middle class , who owned 300,000 $ houses, starting the move into tents and trailers.
    third world status is the outcome for America. certainly it can be adverted , for that Americans would have to give up on old age pensions and medicare. since the days when Ike warned them about the Industrial war complex ,or when JFK was in power since then Gangsters have run America into the dung heap

    Reply

Leave a Reply

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au