Economic Review and Outlook
U.S. HOUSING MARKET: OUTLOOK AND ANALYSIS OF CURRENT TRENDS
April 11, 2011
Robert F. DeLucia, CFA Consulting Economist
Summary and Major Conclusions: The boom-bust cycle in the U.S. housing market was the most extreme in more than 75 years. The cycle has followed the broad pattern of previous cycles within major developed economies, implying an extended bottoming process during all of 2011, followed by a moderate recovery in 2012 and 2013. While the bulk of the housing depression has passed and the market is no longer in freefall, recovery remains elusive because of a lingering imbalance between supply and demand. The demand for housing remains depressed while the inventory of unsold homes remains excessive, implying further erosion in house prices in 2011. Home sales and new construction should begin to improve toward the end of this year, while house prices will lag. Along with state and local governments, housing will be the last sector to participate in the economic recovery. Despite all-time record affordability, the fundamental demand for housing remains depressed. Major headwinds to housing demand include low levels of job security, a moderate pace of job creation, depressed consumer confidence, stringent bank lending standards, and a decline in household formation.
0169232-00002-00
The critical issue for investors is the magnitude of future declines in nationwide house prices. Both the economy and banking system can absorb another 5-10% decline from current levels; however, a decline of 15% or more would have a severe impact on the banking and household sectors, increasing the risk of recession. The worst case scenario relates to the current foreclosure crisis. While the pace of new foreclosures has peaked, sales of distressed properties already in the pipeline are accelerating, exerting further downward pressure on prices. The risk of a vicious cycle of increased foreclosure sales, falling house prices, rising negative equity, and more foreclosures is of greatest concern. Investors should monitor the following trends as leading indicators of a sustained bottoming in house prices: Job creation, consumer and builder confidence, mortgage delinquency rates, bank lending standards, pending sales, mortgage applications, and the ratio of distressed sales to total monthly home sales. In the end, the single most important independent variable is employment.
Weekly Economic Perspective
Economic Perspective – April 11, 2011
"If all the noise that you are hearing about housing has you totally confused, join the crowd. One day you'll read that owning a house has never been more affordable. The next day you'll see news that housing starts have plunged to their lowest level in half a century, as headlines announced in March. After four years of falling prices and surging foreclosures, it's hard to know what to think.
U.S. HOUSING STARTS Annual Total 1960-2010 Thousands of Units Source: Bloomberg
Even Robert Shiller and Karl Case cannot agree. The two economists, who created the S&P/Case-Shiller Home Price indices, are right now offering sharply contrasting views of housing's future. Shiller recently warned that chances were high for a further double-digit drop in U.S. home prices. But in an interview with Fortune, Case took a far brighter view." Fortune Magazine April 11, 2011 "Nothing works well in the economy when house prices are falling: The house remains the most important asset for most households and a key source of collateral for many small businesses seeking credit. The fallout on the financial system and broader economy could be serious if house prices decline much further." Mark Zandi, Chief Economist Moody’s Analytics Testimony to Senate Budget Committee February 3, 2011
Traditional business cycle trends have strengthened in recent months, implying that the transition from a fragile recovery to self-sustaining economic expansion might be imminent. Improving trends are evident in most sectors, including consumer spending, business capital investment, exports, and even the broad manufacturing sector. However, two sectors remain conspicuously absent from the recovery: State and local governments and the residential real estate market.
Primary Laggard - The single most notable laggard is the U.S. residential real estate market. Indeed, following five full years of profound weakness, the fundamental condition of the housing market exhibits very few signs of recovery. This week's Economic Perspective provides an update and analysis of current and expected future trends in the housing market, along with an analysis of broad macroeconomic implications. Housing Depression - By way of background, the downturn in the housing market that began in 2006 is the most severe since the Great Depression. All measures of housing have suffered unprecedented declines from bubble peaks in 2005 and 2006, including housing starts (-80%), sales of new homes (-82%), sales of previously owned homes (-45%), and new residential construction (-60%) as measured in the GDP account. Employment in the construction industry has declined by 30%.
Economic Perspective – April 11, 2011
House Prices - The cumulative decline in nationwide house prices has exceeded 32% from the 2006 peak, as measured by the CaseShiller House Price Index (see chart). Nearly five million households have lost homes through foreclosures or short sales. With the exception of house prices and foreclosures, most housing-related measures are in a bottoming process, but a robust recovery is unlikely any time soon.
CASE-SHILLER HOUSE PRICE INDEX U.S. Home Price Index Quarterly 2000-2010 Source: Bloomberg
Historical Perspective - The current housing cycle bears close resemblance to previous boom-bust cycles in other developed economies during the past two decades. The most relevant precedents are Norway, Finland, Sweden, and the UK, each of which experienced a symmetrical pattern of 5-7 years of boom followed by a 5-7 year period of collapse. Japan Property Bubble - While the current domestic housing bust is the worst since the 1930s, the most prominent boom-bust real estate cycle in modern history occurred in Japan during the 1980s and 1990s. Following a massive rise in real estate values - both commercial and residential - prices collapsed by 75% over the following decade. Real estate prices in Japan still remain 50% below the all-time peaks of 1990. Current Conditions - The housing market is no longer in freefall and the worst of the housing depression has passed. However, the real estate market has not yet firmly stabilized and further moderate weakness lies ahead. New construction and sales continue to stagnate, while house prices remain in a moderate downtrend and are vulnerable to further declines. Supply-Demand Imbalance - The basic problem with the residential real estate market is straightforward: A persistent imbalance between supply and demand. The fundamental demand for housing remains depressed while the supply of unsold homes remains
excessive. The result is predictable: Home sales are stagnant, new construction remains extremely depressed, and nationwide house prices continue to weaken. Demand Factors - The demand for housing remains extremely depressed despite heightened affordability in most major markets. Persistently weak demand can be attributed to five factors: Labor markets are improving, but at a sluggish pace; both consumer confidence and job security remain extremely fragile; bank lending conditions remain weak; the negative outlook for house prices has served to restrain homebuyers because of widespread buyer anticipation of future price declines; and new household formation has declined by 50% as a result of very high unemployment in the traditional first-time buyer age group of the population. Job Creation - In the end, the single most important factor is employment: There is a very high statistical correlation between home sales and job creation. Rising
Economic Perspective – April 11, 2011
home sales, in turn, are supportive of both house prices and new construction. Consequently, a durable and sustained recovery of the housing market is ultimately predicated upon a significant revival in labor market conditions.
U.S. MORTGAGE APPLICATIONS Purchase Index 2002-2011 Mortgage Bankers Association Source: Bloomberg
Supply Factors - The massive overbuilding of single-family homes, apartments, and condominiums during the 2000-2007 period, along with a record increase in foreclosures, have produced an unprecedented glut in the inventory of unsold homes. The inventory of previously owned homes has declined from an alltime peak of 4.5 million units in 2008, but remains 50% (1.5 million units) above the average level of the decade ending in 2005. Vacant homes for sale are near an all-time high of 2.2 million units, more than 50% or 800,000 units above the 2000-2005 average. The key point is that the housing market suffers from a glut of unsold homes which could persist for another several years. Some Positive Factors - Despite the overwhelming dominance of negative factors, there are some preliminary positive indicators. Eventually, these positive factors will provide a solid foundation for a sustained housing market recovery, although an improving trend is unlikely until 2012 and beyond: Housing Affordability - The index of housing affordability - which takes into account median house prices, mortgage rates, and income - has risen to the highest level in the history of the series and is currently at a level 45% above the average of the past 25 years (see chart). Rental Versus Ownership - A comparison between homeownership versus rental costs currently indicates a significant economic advantage for homeownership; in many markets, such as Atlanta, monthly rental costs currently exceed the all-in cost of homeownership by more than 30%.
New Home Inventory - The inventory of unsold newly-built homes - which contrasts sharply with the inventory of previously owned homes - has fallen to an alltime low. Job Creation - Labor market conditions are in a distinct improving trend, but the pace of recovery remains moderate; continued strengthening of job creation will eventually trigger a sustained recovery in housing. Credit Conditions - Bank lending standards are gradually easing for residential mortgage lending but at a painfully slow pace, and credit conditions still remain relatively tight. Given the reluctance of banks and other private lenders to make new mortgage loans, Fannie Mae, Freddie Mac, and FHA have accounted for more than 90% of mortgage lending since the financial crisis.
Economic Perspective – April 11, 2011
HOUSING MARKET OUTLOOK The outlook for the housing market is one of caution. The key assumptions in my 2011-2012 forecast can be summarized as follows:
INVENTORY OF UNSOLD HOMES U.S. EXISTING HOMES FOR SALE Millions 2002-2010 Source: Bloomberg
Home sales will remain in a bottoming pattern at levels 40% below all-time peaks; a gradually rising trend should become apparent later this year and throughout 2012, as labor market trends improve. Residential construction is also in a bottoming pattern at levels nearly 60% below all-time peaks; housing starts should begin to trend higher later this year and during 2012, providing a modest boost to overall U.S. GDP. Mortgage delinquencies appear to be in a peaking process, especially for early-stage (60-day and 90-day) delinquencies, a leading indicator for future defaults and foreclosures, which should gradually decline over the next several years. For the banking industry, the gradually declining trend of net loan chargeoffs and provisions for loan losses during recent quarters should persist through the remainder of this year and during 2012. House prices will be in a declining trend for the remainder of this year, followed by stabilization during 2012. Further price declines appear inevitable in view of the extreme imbalance between market supply and demand and rising ratio of foreclosures to total monthly sales. My forecast for house prices assumes a further decline of 5-10%, which would imply a cumulative decline of roughly 40% from the all-time peak in 2006. Nationwide house prices may not return to 2006 peak bubble levels until 2020.
Regional Differences - Future housing trends will vary greatly among various geographic regions: Recovery in bubble markets – Florida, California, Nevada, and Arizona - will significantly lag that of non-bubble markets, simply because of greater speculative excesses in bubble markets and the longer period of time needed to burn off the excess inventory of homes for sale. Leading Indicators - Investors should monitor the following critical factors as leading indicators of a sustained recovery in housing. I expect these indicators to become increasingly positive over the next two years, although at a frustratingly slow pace: Labor market trends, in particular the monthly pace of job creation, the pace of wage increases, and gradual decline of the unemployment rate;
Economic Perspective – April 11, 2011
Bank lending standards and a greater willingness of banks to make residential mortgage loans;
U.S. HOUSING AFFORDABILITY Index of Home Affordability Source: Bloomberg
Surveys of consumer confidence and home buying plans; Trends in sixty-day and ninety-day mortgage delinquency rates, which tend to lead trends in mortgage defaults and foreclosures; Trends in pending sales (contracts signed) which tend to lead house sales (closings) by 1-2 months; The index of mortgage applications for home purchase (see chart), also a leading indicator of sales; Trends in vacancy rates and in the unsold inventory of homes; The ratio of distressed sales to total monthly home sales, a critical determinant of house price trends; An increase in all-cash buyers - an indication of increasing participation of opportunistic value-driven investors seeking to take advantage of the overshoot in house values and bargains in many local markets. HOUSING AND THE ECONOMY Despite shrinkage of residential construction to only 2.5% as a share of total U.S. GDP - down from the all-time peak of 6% in 2005 - the housing market plays a significant role in the overall outlook in view of its large multiplier effect. Housing Market Impact - Continued weakness in the housing market will act as a headwind to economic growth. The primary transmission mechanism between housing and the economy is twofold: (1) The impact on the financial health of the banking system, and by extension, the availability of credit; and (2) The impact on household finances, and therefore, the outlook for consumer spending.
Credit Availability - Because finances have improved significantly over the past two years, the banking system can absorb a further 5-10% decline in house prices. However, a decline of 10-15% or more could trigger an escalation of loan losses, increasing the need for banks to raise additional capital, with an adverse knock-on effect for bank lending. With respect to the household sector, falling house values trigger a negative wealth effect, which acts to undermine growth in consumer spending. Worst Case Scenario - The major risk to the outlook relates to the current foreclosure crisis. While the number of new foreclosure filings appear to have peaked, the ratio of distressed sales (foreclosures and short sales) to total monthly sales is in a rising trend. Because market prices are predicated upon the composition of monthly sales, a high and rising percentage of distressed sales could exert downward pressure on prices over the next 6-9 months. From a level of only 5%
Economic Perspective – April 11, 2011
in 2007, the ratio of distressed sales has increased to 30%; a further rise in this ratio to a range of 40-50% is possible in future months, as the bulge in foreclosures works its way through the pipeline. A high share of distressed sales - at an average discount of 30% - could drag down the entire market.
RESIDENTIAL MORTGAGE FORECLOSURES PER CENT OF TOTAL BANK LOANS MBA Quarterly 2005-2010 Source: Bloomberg
Vicious Cycle - Since declining house prices push more homeowners into a negative equity position, there is an increased incentive for homeowners to default, creating a wave of new foreclosures. The result would be a vicious cycle, whereby rising foreclosures trigger a decline in house prices, which in turn results in more foreclosures and additional house price declines. At a certain level, this sequence of events has the potential to trigger another financial and banking crisis that could push the overall economy back into recession. The period of maximum risk of this potential vicious cycle appears likely to fall within the upcoming 69 months, which in turn implies a period of maximum risk for house prices.
Robert F. DeLucia, CFA, was formerly Senior Economist and Portfolio Manager for Prudential Retirement. Prior to that he spent 25 years at CIGNA Investment Management, most recently serving as Chief Economist and Senior Portfolio Manager. He currently serves as the Consulting Economist for Prudential Retirement. Bob has 37 years of investment experience. The information provided is not intended to provide investment advice and should not be construed as an investment recommendation by Prudential Financial or any of its subsidiaries. Prudential, the Prudential logo, and the Rock symbol are service marks of The Prudential Insurance Company of America, Newark, NJ, and its related entities, registered in many jurisdictions worldwide.
April 11, 2011
Robert F. DeLucia, CFA Consulting Economist
Summary and Major Conclusions: The boom-bust cycle in the U.S. housing market was the most extreme in more than 75 years. The cycle has followed the broad pattern of previous cycles within major developed economies, implying an extended bottoming process during all of 2011, followed by a moderate recovery in 2012 and 2013. While the bulk of the housing depression has passed and the market is no longer in freefall, recovery remains elusive because of a lingering imbalance between supply and demand. The demand for housing remains depressed while the inventory of unsold homes remains excessive, implying further erosion in house prices in 2011. Home sales and new construction should begin to improve toward the end of this year, while house prices will lag. Along with state and local governments, housing will be the last sector to participate in the economic recovery. Despite all-time record affordability, the fundamental demand for housing remains depressed. Major headwinds to housing demand include low levels of job security, a moderate pace of job creation, depressed consumer confidence, stringent bank lending standards, and a decline in household formation.
0169232-00002-00
The critical issue for investors is the magnitude of future declines in nationwide house prices. Both the economy and banking system can absorb another 5-10% decline from current levels; however, a decline of 15% or more would have a severe impact on the banking and household sectors, increasing the risk of recession. The worst case scenario relates to the current foreclosure crisis. While the pace of new foreclosures has peaked, sales of distressed properties already in the pipeline are accelerating, exerting further downward pressure on prices. The risk of a vicious cycle of increased foreclosure sales, falling house prices, rising negative equity, and more foreclosures is of greatest concern. Investors should monitor the following trends as leading indicators of a sustained bottoming in house prices: Job creation, consumer and builder confidence, mortgage delinquency rates, bank lending standards, pending sales, mortgage applications, and the ratio of distressed sales to total monthly home sales. In the end, the single most important independent variable is employment.
Weekly Economic Perspective
Economic Perspective – April 11, 2011
"If all the noise that you are hearing about housing has you totally confused, join the crowd. One day you'll read that owning a house has never been more affordable. The next day you'll see news that housing starts have plunged to their lowest level in half a century, as headlines announced in March. After four years of falling prices and surging foreclosures, it's hard to know what to think.
U.S. HOUSING STARTS Annual Total 1960-2010 Thousands of Units Source: Bloomberg
Even Robert Shiller and Karl Case cannot agree. The two economists, who created the S&P/Case-Shiller Home Price indices, are right now offering sharply contrasting views of housing's future. Shiller recently warned that chances were high for a further double-digit drop in U.S. home prices. But in an interview with Fortune, Case took a far brighter view." Fortune Magazine April 11, 2011 "Nothing works well in the economy when house prices are falling: The house remains the most important asset for most households and a key source of collateral for many small businesses seeking credit. The fallout on the financial system and broader economy could be serious if house prices decline much further." Mark Zandi, Chief Economist Moody’s Analytics Testimony to Senate Budget Committee February 3, 2011
Traditional business cycle trends have strengthened in recent months, implying that the transition from a fragile recovery to self-sustaining economic expansion might be imminent. Improving trends are evident in most sectors, including consumer spending, business capital investment, exports, and even the broad manufacturing sector. However, two sectors remain conspicuously absent from the recovery: State and local governments and the residential real estate market.
Primary Laggard - The single most notable laggard is the U.S. residential real estate market. Indeed, following five full years of profound weakness, the fundamental condition of the housing market exhibits very few signs of recovery. This week's Economic Perspective provides an update and analysis of current and expected future trends in the housing market, along with an analysis of broad macroeconomic implications. Housing Depression - By way of background, the downturn in the housing market that began in 2006 is the most severe since the Great Depression. All measures of housing have suffered unprecedented declines from bubble peaks in 2005 and 2006, including housing starts (-80%), sales of new homes (-82%), sales of previously owned homes (-45%), and new residential construction (-60%) as measured in the GDP account. Employment in the construction industry has declined by 30%.
Economic Perspective – April 11, 2011
House Prices - The cumulative decline in nationwide house prices has exceeded 32% from the 2006 peak, as measured by the CaseShiller House Price Index (see chart). Nearly five million households have lost homes through foreclosures or short sales. With the exception of house prices and foreclosures, most housing-related measures are in a bottoming process, but a robust recovery is unlikely any time soon.
CASE-SHILLER HOUSE PRICE INDEX U.S. Home Price Index Quarterly 2000-2010 Source: Bloomberg
Historical Perspective - The current housing cycle bears close resemblance to previous boom-bust cycles in other developed economies during the past two decades. The most relevant precedents are Norway, Finland, Sweden, and the UK, each of which experienced a symmetrical pattern of 5-7 years of boom followed by a 5-7 year period of collapse. Japan Property Bubble - While the current domestic housing bust is the worst since the 1930s, the most prominent boom-bust real estate cycle in modern history occurred in Japan during the 1980s and 1990s. Following a massive rise in real estate values - both commercial and residential - prices collapsed by 75% over the following decade. Real estate prices in Japan still remain 50% below the all-time peaks of 1990. Current Conditions - The housing market is no longer in freefall and the worst of the housing depression has passed. However, the real estate market has not yet firmly stabilized and further moderate weakness lies ahead. New construction and sales continue to stagnate, while house prices remain in a moderate downtrend and are vulnerable to further declines. Supply-Demand Imbalance - The basic problem with the residential real estate market is straightforward: A persistent imbalance between supply and demand. The fundamental demand for housing remains depressed while the supply of unsold homes remains
excessive. The result is predictable: Home sales are stagnant, new construction remains extremely depressed, and nationwide house prices continue to weaken. Demand Factors - The demand for housing remains extremely depressed despite heightened affordability in most major markets. Persistently weak demand can be attributed to five factors: Labor markets are improving, but at a sluggish pace; both consumer confidence and job security remain extremely fragile; bank lending conditions remain weak; the negative outlook for house prices has served to restrain homebuyers because of widespread buyer anticipation of future price declines; and new household formation has declined by 50% as a result of very high unemployment in the traditional first-time buyer age group of the population. Job Creation - In the end, the single most important factor is employment: There is a very high statistical correlation between home sales and job creation. Rising
Economic Perspective – April 11, 2011
home sales, in turn, are supportive of both house prices and new construction. Consequently, a durable and sustained recovery of the housing market is ultimately predicated upon a significant revival in labor market conditions.
U.S. MORTGAGE APPLICATIONS Purchase Index 2002-2011 Mortgage Bankers Association Source: Bloomberg
Supply Factors - The massive overbuilding of single-family homes, apartments, and condominiums during the 2000-2007 period, along with a record increase in foreclosures, have produced an unprecedented glut in the inventory of unsold homes. The inventory of previously owned homes has declined from an alltime peak of 4.5 million units in 2008, but remains 50% (1.5 million units) above the average level of the decade ending in 2005. Vacant homes for sale are near an all-time high of 2.2 million units, more than 50% or 800,000 units above the 2000-2005 average. The key point is that the housing market suffers from a glut of unsold homes which could persist for another several years. Some Positive Factors - Despite the overwhelming dominance of negative factors, there are some preliminary positive indicators. Eventually, these positive factors will provide a solid foundation for a sustained housing market recovery, although an improving trend is unlikely until 2012 and beyond: Housing Affordability - The index of housing affordability - which takes into account median house prices, mortgage rates, and income - has risen to the highest level in the history of the series and is currently at a level 45% above the average of the past 25 years (see chart). Rental Versus Ownership - A comparison between homeownership versus rental costs currently indicates a significant economic advantage for homeownership; in many markets, such as Atlanta, monthly rental costs currently exceed the all-in cost of homeownership by more than 30%.
New Home Inventory - The inventory of unsold newly-built homes - which contrasts sharply with the inventory of previously owned homes - has fallen to an alltime low. Job Creation - Labor market conditions are in a distinct improving trend, but the pace of recovery remains moderate; continued strengthening of job creation will eventually trigger a sustained recovery in housing. Credit Conditions - Bank lending standards are gradually easing for residential mortgage lending but at a painfully slow pace, and credit conditions still remain relatively tight. Given the reluctance of banks and other private lenders to make new mortgage loans, Fannie Mae, Freddie Mac, and FHA have accounted for more than 90% of mortgage lending since the financial crisis.
Economic Perspective – April 11, 2011
HOUSING MARKET OUTLOOK The outlook for the housing market is one of caution. The key assumptions in my 2011-2012 forecast can be summarized as follows:
INVENTORY OF UNSOLD HOMES U.S. EXISTING HOMES FOR SALE Millions 2002-2010 Source: Bloomberg
Home sales will remain in a bottoming pattern at levels 40% below all-time peaks; a gradually rising trend should become apparent later this year and throughout 2012, as labor market trends improve. Residential construction is also in a bottoming pattern at levels nearly 60% below all-time peaks; housing starts should begin to trend higher later this year and during 2012, providing a modest boost to overall U.S. GDP. Mortgage delinquencies appear to be in a peaking process, especially for early-stage (60-day and 90-day) delinquencies, a leading indicator for future defaults and foreclosures, which should gradually decline over the next several years. For the banking industry, the gradually declining trend of net loan chargeoffs and provisions for loan losses during recent quarters should persist through the remainder of this year and during 2012. House prices will be in a declining trend for the remainder of this year, followed by stabilization during 2012. Further price declines appear inevitable in view of the extreme imbalance between market supply and demand and rising ratio of foreclosures to total monthly sales. My forecast for house prices assumes a further decline of 5-10%, which would imply a cumulative decline of roughly 40% from the all-time peak in 2006. Nationwide house prices may not return to 2006 peak bubble levels until 2020.
Regional Differences - Future housing trends will vary greatly among various geographic regions: Recovery in bubble markets – Florida, California, Nevada, and Arizona - will significantly lag that of non-bubble markets, simply because of greater speculative excesses in bubble markets and the longer period of time needed to burn off the excess inventory of homes for sale. Leading Indicators - Investors should monitor the following critical factors as leading indicators of a sustained recovery in housing. I expect these indicators to become increasingly positive over the next two years, although at a frustratingly slow pace: Labor market trends, in particular the monthly pace of job creation, the pace of wage increases, and gradual decline of the unemployment rate;
Economic Perspective – April 11, 2011
Bank lending standards and a greater willingness of banks to make residential mortgage loans;
U.S. HOUSING AFFORDABILITY Index of Home Affordability Source: Bloomberg
Surveys of consumer confidence and home buying plans; Trends in sixty-day and ninety-day mortgage delinquency rates, which tend to lead trends in mortgage defaults and foreclosures; Trends in pending sales (contracts signed) which tend to lead house sales (closings) by 1-2 months; The index of mortgage applications for home purchase (see chart), also a leading indicator of sales; Trends in vacancy rates and in the unsold inventory of homes; The ratio of distressed sales to total monthly home sales, a critical determinant of house price trends; An increase in all-cash buyers - an indication of increasing participation of opportunistic value-driven investors seeking to take advantage of the overshoot in house values and bargains in many local markets. HOUSING AND THE ECONOMY Despite shrinkage of residential construction to only 2.5% as a share of total U.S. GDP - down from the all-time peak of 6% in 2005 - the housing market plays a significant role in the overall outlook in view of its large multiplier effect. Housing Market Impact - Continued weakness in the housing market will act as a headwind to economic growth. The primary transmission mechanism between housing and the economy is twofold: (1) The impact on the financial health of the banking system, and by extension, the availability of credit; and (2) The impact on household finances, and therefore, the outlook for consumer spending.
Credit Availability - Because finances have improved significantly over the past two years, the banking system can absorb a further 5-10% decline in house prices. However, a decline of 10-15% or more could trigger an escalation of loan losses, increasing the need for banks to raise additional capital, with an adverse knock-on effect for bank lending. With respect to the household sector, falling house values trigger a negative wealth effect, which acts to undermine growth in consumer spending. Worst Case Scenario - The major risk to the outlook relates to the current foreclosure crisis. While the number of new foreclosure filings appear to have peaked, the ratio of distressed sales (foreclosures and short sales) to total monthly sales is in a rising trend. Because market prices are predicated upon the composition of monthly sales, a high and rising percentage of distressed sales could exert downward pressure on prices over the next 6-9 months. From a level of only 5%
Economic Perspective – April 11, 2011
in 2007, the ratio of distressed sales has increased to 30%; a further rise in this ratio to a range of 40-50% is possible in future months, as the bulge in foreclosures works its way through the pipeline. A high share of distressed sales - at an average discount of 30% - could drag down the entire market.
RESIDENTIAL MORTGAGE FORECLOSURES PER CENT OF TOTAL BANK LOANS MBA Quarterly 2005-2010 Source: Bloomberg
Vicious Cycle - Since declining house prices push more homeowners into a negative equity position, there is an increased incentive for homeowners to default, creating a wave of new foreclosures. The result would be a vicious cycle, whereby rising foreclosures trigger a decline in house prices, which in turn results in more foreclosures and additional house price declines. At a certain level, this sequence of events has the potential to trigger another financial and banking crisis that could push the overall economy back into recession. The period of maximum risk of this potential vicious cycle appears likely to fall within the upcoming 69 months, which in turn implies a period of maximum risk for house prices.
Robert F. DeLucia, CFA, was formerly Senior Economist and Portfolio Manager for Prudential Retirement. Prior to that he spent 25 years at CIGNA Investment Management, most recently serving as Chief Economist and Senior Portfolio Manager. He currently serves as the Consulting Economist for Prudential Retirement. Bob has 37 years of investment experience. The information provided is not intended to provide investment advice and should not be construed as an investment recommendation by Prudential Financial or any of its subsidiaries. Prudential, the Prudential logo, and the Rock symbol are service marks of The Prudential Insurance Company of America, Newark, NJ, and its related entities, registered in many jurisdictions worldwide.
