Thursday, August 20, 2009

SMACKDOWN WEEK: Slimy? Mudhole? My home this is!




I'd like to start by describing my generic view of consumer decision making. People make decisions based on their own circumstances. So whether the Solos decide to buy Jaina and Jacen a new summer wardrobe or to keep the ragged stuff from last year is all about how the Solos are doing. The fact that unemployment is rising galaxy wide isn't an important factor in their decision making. Obviously if Han is worried about his job in particular, that would make a difference, but if he expects the smuggling market to remain strong, 5% overall unemployment or 7% or 10% isn't going to impact their decisions. Not by a large degree anyway.

I'll put this another way to illustrate the point. What if unemployment were especially low? Han could still lose income for one reason or another. People still lose their jobs in good times. So I argue that the Solo family's spending habits are a function of their specific income level and perceived stability. A poor macro picture in and of itself isn't relevant.

What's the conclusion for overall spending? Its that statistics like consumer confidence is over-rated. I've looked at the correlations, and consumer confidence is, at best, a coincident indicator. In other words, consumers don't lose confidence and then the economy weakens. The economy weakens and then consumers feel less confident. That tells you the confidence in and of itself has no bearing on economic activity. One doesn't cause the other.

I think Cash for Clunkers is an illustration of this point. Consumer confidence is still quite low, but give them a good enough deal on a car and they're ready to buy. Ready to take on a major financial commitment despite this purportedly weak sentiment. (Don't through me comments suggesting that I liked this program, I didn't. I'm just making a point.)

I have a similar view of the wealth effect, be it from financial assets or one's home. It all depends on an individual's situation. Let's zoom our targeting computer onto home values. There is a certain segment of the population that was using home equity to fund spending. Clearly that group will have to pare back spending. But there is a large segment of people for whom that peak value in homes is a meaningless number. I bought my house in 2001. It probably rose in value through 2006, then has fallen a solid 15 or 20% since. But none of that matters since I've never taken any equity out. I've just been sending my checks in every month.

I'll go even further and say that for most people, the biggest influence on how much money they choose to spend is how much money is currently in their checking account. The candy bar was called "Pay Day" because people celebrated Pay Day by buying stuff like candy bars! That is to say most people make decisions based on very short-term considerations. Not high-minded thoughts like "I've lost money in my 401(k) and I therefore need to save more if I'm going to retire in 29 years." For most regular Joe Americans, they can't (or choose not to) think that far ahead.

Point here is that if you take a consumer with a fairly stable job and good home equity, they aren't doing anything differently today than they did two years ago.

If I stopped here you might think I'm pretty bullish on consumer spending. In the short-run, I'm probably more bullish than a lot of people. But in the intermediate term, a number of factors are going to retard growth in consumption in a profound way.

Let's take my presumption above as truth, that most people make consumption decisions based primarily on how much cash they currently have access to. In the short-run, maybe that hasn't changed much. Like I said, if you didn't spend your home equity, it doesn't matter that your home value has declined a bit. That is, until you want to move. Then you need to come up with more cash to make your next down payment. I said that people might not change their current buying habits just because their 401(k)s declined, but eventually when they do to retire, they are going to have less money. For people closer to retirement, they are either going to have to save more aggressively or keep working, which is de facto savings.

Then there is the reality that consumer credit is going to be harder to come by. We know home equity loans are going to be more difficult just because of the lack of equity. But we also know that generally retail credit is not going to reach the same levels seen during the securitization boom. There just won't be enough capital to fund it at that same level. The reality is that these "0% financing for 12 months" deals were quasi-price reductions, but typically banks were involved in supplying the credit. I think those kinds of deals will be less prevalent. Not non-existent, but less common.

Taxes are another issue. I expect both federal and local tax rates to increase in the coming years. The feds might only target the rich, but locals will probably target more insidious increases, like sales tax or governmental fees. Clearly if we increase the price of everything by 1%, that's going to impact consumer spending.

Finally, I think we're going to enter a phase where unemployment is going to remain fairly high for an extended period. I don't think we'll stay at 10% for too long, but I think we'll still be above 7% at the end of 2010. Maybe even well into 2011. So even under my thought that consumers react to their own circumstances, more consumers are being impacted by "circumstances" than in past recessions. In fact, if more workers stay in the work force past normal retirement age, that increases the size of the work force and thus keeps unemployment high.

Bruce Kasman of J.P. Morgan back in April said he thought the economy was going to bounce into malaise. I think consumer spending will be similar. Consumers have some degree of pent-up demand for goods which will create a deceptive bounce in the next few months, but then we level out into a mediocre growth rate.


Somewhat paradoxically, my view of housing is pretty bullish, at least when contrasted with mainstream opinions.

First, you have to think about what caused the housing bubble/crash in the first place. I'm not talking about the deeper underlying causes, which we can debate, but the more proximate causes.

  • Lending conditions become too easy, causing demand to increase
  • Supply increases in response, both from new starts and rehabs
  • Losses from sub-prime cause banks to pull back lending, demand falls
  • Foreclosures rise, largely because of loans made to borrowers who could not afford regular payments and/or reset levels.
  • Builders/rehabs still have a substantial supply over-hang. They can't destroy supply as demand falls, so prices fall.
The housing problem is therefore no more complicated than a simple supply/demand imbalance. In fact, one could argue that the supply/demand imbalance wasn't even that large, but that the contagion was great because of the impact on the financial system.

So predicting an end to generalized home price declines is as simple as determining when supply is meeting demand.

Ask yourself, how did we know supply was not matching demand before? Because even as prices fell, demand didn't seem to pick up. We can see this in housing transactions. From March 2007 through January, existing home sales declined from 5.75 million units to 4.05 million units. Perhaps more telling is the fact that the figure only showed an increase in 5 out of 21 months. New home sales show a similar pattern although more severe. Units fell from a peak of 1.4 million units to a paltry 329,000.

Since that time we've shown pretty strong increases in both series. New home sales are up 17% off the bottom, existing up 6.7%. Both series have increased 4 out of the last 5 months.
Demand is meeting supply.

It doesn't really matter that total demand is much lower than in the past. Not in terms of home prices. If you are talking in terms of contribution to GDP or some such, then yes, overall activity isn't adding to GDP like it once did. But in terms of home prices continuing to decline, as long as supply meets demand, there isn't any reason to expect more declines.

I also consider the Case Shiller Index, which looks like its bottomed. I have long argued that that index is fraught with lags and other data problems. But if its lagging, then you'd say that housing might actually be better than indicated. Absent some catalyst to the negative, I don't see homes continuing to decline.

This isn't to say that home prices will start rising in spectacular fashion. I think demand is just now meeting supply because buyers think homes are cheap. If they were to rise above "cheap" then buyers would pull away. Plus all the problems consumers have that I mentioned above apply to housing. But inflation-level home price increases are perfectly reasonable.

The best argument for another leg down in home prices is accelerating prime foreclosures. I can't deny that prime foreclosures are high and rising. But I also think there is a substantial difference between a classic foreclosure and a bad loan foreclosure.

This downturn started when a set of loans, most of which never should have been underwriten (i.e. no doc loans), started going bad. A good percentage of these loans were de facto investment loans, even if they were supposedly underwritten with a residence pretense. For this and other reasons, these loans were not only bound to go bad, but they were bound to produce above-average losses for the lending bank. Think about a half-completed rehab gone bad. What can a bank do buy sell it as aggressively as they could?

Furthermore, these loans were concentrated in particular areas. If you wanted to do a flip, you did it in a "hot" neighborhood. So when they started going bad, all the banks were trying to sell houses in the same general areas within a given city. This is a factor that I think hasn't gotten enough attention. You have 10 houses on the same block for sale, each chasing the rest of them lower and lower trying to get the one buyer who wants to live there. Obviously this is a recipe for some ugly price changes.

I'm not here to say that all of the bad loans went to sub-prime borrowers. Look at any option-arm securitization and you'll see "prime" borrowers. The reality is that if someone took out a truly bad loan, one that the borrower never really could have afforded, then the loan must be at least two years old by now. By August 2007, the mortgage securitization market was already in shambles and the joke of the NINJA loan was already well known. I'd guess that July 2007 was about the last time you could get a classic no-doc mortgage. So in order to claim there is a wave of mortgage defaults coming, you have to explain to me why these people would default now instead of a year ago.

Now of course, we have unemployment rising and that certainly has an impact on foreclosure rates. But this is totally different than the bad loan foreclosures, in my mind. Unemployment-type delinquencies are more likely to be resolved through a modification. The borrower eventually finds a job and can resume payment. In addition, those foreclosures would be more spread out. Again, I think people underestimate the impact of concentrated foreclosures. If there is one foreclosure in your neighborhood, it doesn't destroy the value of all the other homes. Six or seven is a different story.

Next time on SMACKDOWN! Uh... I'll decide tomorrow!


Aaron said...

Just one beef with your foreclosure assumptions. If I recall right, we still have a pretty strong wave of option-ARM recasts coming through. I'd guess these could cause more of your "bad loan" foreclosures in the future.

Tom Lindmark said...

A couple of beefs with the foreclosure analysis.

Agreed that unemployment foreclosures can normally be cured with modidifation but we have an abnormal situation right now. Specically the defaulter may well be underwater and prefer a fresh start as opposed to rescuing the home.

A large portion of current demand is being provided by investors. So long as they stay in the game the supply/demand arguments you propose are valid. If not, that changes the equation markedly. They also represent an overhang as they try and take gains on any future moves up in prices.

roosh said...

Completely unrelated, but thought you would enjoy this, given the star wars theme of the blog :)

The Oriole Way said...

Can't say that I disagree with any of the consumer spending analysis, but I think a few points are missing from the housing analysis:

1) CaseShiller is not seasonally adjusted. Let's wait an see how the index performs in the fall especially because...
2) The first time home buyer's tax credit expires in November. I think this $8,000 (which can be applied as a down payment) is really helping sales on the low end.
3) And at the upper levels, who is going to buy most of these places? There are very few move-up buyers (because they've either been foreclosed on or had their equity wiped out), and the baby boomers are largely done trading up.

I can definitely see an argument that low-end prices are done declining, but we may very well have another leg down in sales at those levels when the tax credit goes away. I think prices on the mid- to high-end still have a ways to go.