DAILY BANKRUPTCY REVIEW (DBR): The Great Housing Depression

Date: 04-May-2011

By Anders J. Maxwell

Traditional business cycle theory holds that housing leads the economy in and out of recession. This reflects the industry’s historic sensitivity to interest rates. While housing clearly led the recent downturn, having peaked by early 2007, this economic bellwether continues to plumb new depths.

Gauged by financial markets, however, the economy appears on a road to recovery. A Viewpoint article last spring (“Housing and the Economics of Sand Castles,” May 19, 2010) expressed the opinion that while financial markets were already enjoying a dramatic resurgence from the lows reached in 2008, this would prove transitory, based on a receding wave of liquidity earlier set in motion by the Federal Reserve, and further declines expected in housing.

A year later, that point of view has proven correct, at least related to housing. Home prices measured by Case- Shiller have continued downward; single-family starts were at an annual rate of 392,000 units in February and new sales reached a seasonally adjusted annual rate of 250,000, both record lows. Indicating this housing depression will continue, inventory for sale (including foreclosures) is estimated at 5.3 million units, propelled by foreclosure rates hovering over 12%. At current sales rates, this represents over two years’ inventory, a figure likely to increase, reflecting tightening lending standards and generally weak consumer confidence.

Further challenging capital market values have been a series of geopolitical shocks, including a destabilized Mideast and resulting triple-digit oil prices, a disrupted Asian supply chain following the Japanese earthquake, and growing tensions over record trade imbalances. Add to this volatile mix the contraction likely due to the looming fight over government deficit spending, and security valuations should have collapsed.

But that’s clearly not the case. In sharp contrast to the gloom in housing and construction, over the past year capital markets have continued to rise. Having gained nearly 80% from a trough in 2009 to last spring, equities measured by the S&P 500 are up an additional 10% the past year.

This sustained financial market rally reflects what traders refer to as “market technicals,” rather than a meaningful reflection of the economy. The renewed effort in the second half of 2010 by the Fed to maintain zero real interest rates and expand open market security purchases, which now exceed $1.5 trillion—dubbed “Quantitative Easing 2”—has markets awash in liquidity. The Fed’s interest-free lending and persistent intervention explain the dramatic recovery in equity markets, a resurgence in banking profits, and, recently, a small, but discernible, improvement in employment.

Reconciling these crosscurrents between rising financial asset values and declining housing holds the key to the economy’s future. Capital markets are indicating a significant improvement, while housing prices raise the specter of renewed contraction. Which of these two key barometers reasonably portends the future is clear.

The market in traded public securities continues to be inflated by the Fed’s ongoing quantitative easing. The magnitude of this unprecedented intervention is reflected in the Fed’s burgeoning balance sheet from purchases of government and mortgage securities. Underpinning bloated market indices, corporate profits are of dubious quality, due in large measure to nonrecurring cost-cutting and the extraordinary profits afforded the banking sector by the Fed’s interest-rate holiday. Given such tenuous supports, unemployment can be expected to remain elevated and growth in consumption lackluster.

Meantime, the primary cause of the “great recession”— systemic overleverage — has actually worsened and challenges our credibility with the international creditors on which the U.S. is completely dependent. While U.S. households have gotten the message and reduced borrowings 4% since year-end 2007, government debt has actually increased nearly 60%, resulting in a 13% expansion in the economy’s total debt.

Looking forward, the prospect of a continued depression in housing matters considerably more to the economy’s health than a Fed-induced market rally. Due to anemic real incomes, as well as depleting home equity, consumer spending, which comprises 70% of GDP, will continue to sap growth. Acknowledging the economy’s precarious state, “QE2” seems destined to be followed by a “QE3.” This is akin to pushing even harder on a string. Lacking demand, excessive liquidity leads to further distortion in prices and misallocation of capital. Evident from recent experience, this also encourages more debt financing, setting the stage for the next “subprime” train wreck.

In conclusion, inflated market indices are grossly misleading. Housing retains its position as the harbinger of things to come. Housing prices are down 30% from the peak in 2007 and starts are at 50-year lows. This grim leading economic indicator is flashing crimson, signaling another step down in a broadening bear market.

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