The U.S. Housing Market Economic Double Negative Feedback Loop
Economics / Recession 2008 - 2010 Oct 15, 2008 - 09:47 AM GMTBy: Andrew_Butter
Perhaps the time for self-delusion is passed. The grand new plan, just replaced the $700 billion plan, that replaced the $80 billion plan to bail out AIG, that replaced the Bear Stearns bailout which was just pocket change.
Forgive me for being skittish but it seems like every time you blink the number goes up by a factor of ten. The way it looks now is that combined USA , Europe and UK , the damage could easily be $7 trillion.
And there still isn't a plan to neutralize all those Credit Default Swaps. Not even, so far, a coherent estimate of how many there are at risk; some say $70 trillion, some say more.
Nouriel Roubini's speech on 10th October is worth watching. He was one of the few guys who foresaw all this in Technicolor in 2004 (no disrespect intended for the guys on Market Oracle, but Roubini was first by a long shot).
His idea right now is that a "V" shaped recession is "outta ze window " and the choice is between a "U" shaped one and an "L" shaped one. I for one believe him; he also spoke about the "Negative Feedback Loop", this is (I think) what he was talking about:
My point: It's a Double perhaps a triple Loop , not a single one
So they neutralized the RMBS risks (perhaps), they propped up the banks, they are making credit directly available to corporations (and states?), and Fannie and Freddie have a mandate to write $40 billion of new mortgages a month. And they are going to give AIG another $38 billion so they can honor the latest round of CDS calls, (is that going to be a regular thing in the future, when the "time of the month" comes around?)
To "switch" from Bust to Boom the current account deficit will have to fall, and that will require fixing the economy; which will be harder than just printing money.
The option was to let more banks fail, and let new ones grow up from the ashes (or the manure). That's the way of nature, but the bozos who created this mess could not contemplate such a thing; Roubini's idea was to sort the bad apples from the half-bad ones, but it was not to be. Wait until the CDS's kick in!!
What's happening now is that prudent people who only borrowed to finance an economically viable endeavor are being punished at the expense of people who borrowed to live the high-life. Sadly Free Market doesn't mean Free Bailout any more than Free Love means Free Sex.
Que sera sera, what's next?
It's STILL all about housing
To fix housing the economy has to grow, if housing isn't fixed then the exposure on RMBS will go up and so will the number of CDS that get called. So more money rather than less will be required to patch up the system, which means that there will be less money around to grow the economy - that's the secondary loop.
"The Value of Housing in USA and UK " , showed how for one hundred years of history the price of housing oscillates around an equilibrium that is determined only by GDP per house PLUS (and this is something new) trend-line long term interest rates.
Sure GDP correlates with disposable income but GDP is better because this measure is dimensionally correct (expenditure per house) and it gives a valuation rather than an economic theory which doesn't explain the effect of long-term interest rates.
The analysis showed that since the start of the great experiment in Free Sex, house prices oscillate around the equilibrium determined by GDP and long-term interest rates, with increasing amplitude and frequency. Right now housing is priced less than the equilibrium, but that doesn't mean it will recover until the forces driving the oscillation are eliminated.
The key marker an investor is nominal GDP growth; and leading indicators of this marker are the ones to watch.
Forget about inflation, Roubini pointed out this is set to fall in the short term (although the cost of printing the bail-out funds will presumably push it up later), and anyway since they changed the estimation system in 1987 it's not measured correctly in the first place, so watching that index is pointless - not that this deterred Greenspan or Bernake.
The importance of GDP can be illustrated by comparing current foreclosure rates compared to GDP growth by US States:
Sure this correlation may be spurious, it may be that foreclosures are causing GDP growth to slow, certainly the "bust" has affected the contribution of GDP made by home-builders and related industries, on top of that wiping out of big parts of the financial services industry (if you can call that a "service", this sector had started to represent 30% of GDP, up from about 15% in 1975).
It's a loop, but imagine what will happen if (when) GDP growth shifts a point to the left!
Key to a recovery of the housing market is fundamentally about a recovery of GDP (nominal or real, it doesn't really matter which, nominal easier in the short term because it's easier to inflate than to facilitate real growth).
If there is not to be another 15% drop in house prices (if GDP grows) or 25% (if it doesn't), more has to be done than bailing out the crony capitalists on Wall Street.
Four thoughts :-
Follow the money (i.e. GDP).
Last week I ran the numbers on my model of US house prices (Fixing the USA Housing Crisis) . I used 3% nominal GDP growth over the next two years as the worst-case, that gave a bottom for the S&P Case-Shiller Index 15% below June 08.
It didn't occurred to me that nominal GDP growth might be negative, but after listening to Roubini I'm starting to believe that negative nominal GDP is a possible scenario.
If the worst case is assumed to be 1% (nominal) that gives a 20% fall to the bottom from June 2008. Put in minus 1% and the model spits out 25% (i.e. the Index would fall from 168 in June 08 to less than 130 by June 2010). Roubini said 20% in June now he's revised that to 15% - perhaps he's tired of people calling him "Dr. Gloom".
A criticism of Roubini is that "a stopped clock is right twice a day", well I don't know how he came up with 15% to 20%, but my clock was right 98% of the time for a hundred years.
Every percentage point drop increases the incentive for homeowners to send the keys back. On top of that, falling GDP increases the proportion that simply can't keep up with payments (rather than the ones that just look at their options and decide that they won't).
Keynes
Here are some sign's to watch for before letting go of any cash that's left (these are Roubini's ideas not mine, I think I got them straight).
1): IF: The US Government starts working on "Nationalizing" housing and debt reduction.
2): IF they start weeding out the bad apples from the half-bad ones.
3): IF: They decide to re-read Keynes, monetarism didn't work - the evidence is everywhere.
Take a big part of the money that was going to be thrown in a panic at crooked and incompetent bankers, and invest it in bridges, levees, roads, cities that don't need cars to work (or so many).
Invest in nuclear energy (get the French to build the plants - theirs don't blow up or cause environmental hazards), and wind energy, and drill for oil (at least George got one thing right, do it in Central Park if you have to).
The quickest way to make sure that the USA is not in danger from raggedy bandits with long beards, is to reduce dependence on foreign oil.
Valuations of assets and liabilities
Currently assets and liabilities are not valued correctly (if at all), at least not according to International Valuation Standards (nor is CPI). Talk about driving blind!!
The lunatic way that accounting standards allow assets and liabilities to be valued is just another reason why bean counters should stick to counting beans and be prohibited by law from using long words they don't understand like "value" and "markets".
This is the logic of current accounting standards (IFRS and FASB).
"My audit client has borrowed $500 billion dollars and has gone down to the casino and placed a bet of the whole amount on Number 16".
But the wheel is still spinning so I can't "recognize" that on the balance sheet because I don't know if he will win or lose, and I'm too stupid to work out the probability, or even to imagine what will happen if he does lose.
In any case my client met a very nice man called Richard at the bar who told him that he could cover the bet in case it lost, if he bought him a drink. And Richard looked like an honorable person, so in my professional opinion that's OK. And in any case the ratings agencies who know all about "probability" are quite "comfortable".
So I'm going to make a small comment in the footnotes of page 56 of my 121 page audit report that there are some potential "off balance sheet liabilities" but these are covered and so there is nothing to worry about (just like I did when I was doing audits for Enron when I worked for Andersen)."
Read the small print. That's what is says in plain English on every single set of audited accounts of every single "shadow bank", signed-off by a Big Four accounting firm and submitted to, and approved by the banking regulators and the SEC.
Good idea before making an investment to find out how the assets and liabilities both current (on the balance sheet) and contingent (off the balance sheet) are valued. And if transparent information is not provided, steer clear. If there is one long term investment strategy that could work, it is looking for companies with really transparent accounts.
The point insofar as the economy is concerned is that having a system of valuation that values things too high when they are over-priced and too low when they are under-priced, i.e. a valuation methodology that consistently gives the wrong answer, is fundamentally de-stabilizing.
It's hard to explain this to a rocket-scientist banker (don't even try and explain it to an accountant), but the time to write 110% mortgages with teaser rates is when the assets are under-priced, not over-priced. Paradoxically, now is the right time to start relaxing LTV levels not tightening them.
Disband the Military Industrial Complex
No I'm not a hippy, a communist or an apologist for bandits.
Quite a large chunk of the "plans" could be paid for if the US Government realize that they can no longer afford their grand illusion of super-cop or that the might of the military will protect the American people from unseen dangers. And if it fails to do that, well logically all you have to do is spend more.
Sorry to spoil the fairy-tale, but the real terrorists all lived on Wall Street and they caused more damage to ordinary Americans than Osama bin Ladin could possibly have dreamed of, and that's just so far, wait until this all unfolds.
Perhaps the time has come for Rambo to stop acting out his Hollywood Joan of Arc fantasies. If Iraq and the Middle East oil states (and Israel and NATO) want to go on getting "protection" then they should pay for it. They can afford it.
The fantasy is like a script for a James Bond movie that some bad man might take over the oil supplies and then, out of spite cut off USA . The logic of why is mysterious; a more likely outcome is that the bad man would increase the price...umm, but "bad men" already did that didn't they?
The "evidence" for that happening in reality is about as solid as those blurred pictures that Colin Powell was touting. It is pointless spending trillions of dollars, just in case this happens. Let the "bad men" take over the oil, and in the unlikely event that they start acting silly, well, Nuke the bastards.
If the US Government cuts their budget for defense in half, and then cuts it in half again, and uses the trillions of dollars that are saved on repairing the economy, that will be a sign to ordinary Americans that their government is really interested in protecting them and putting their best interests above the interests of the lobbyists and crony capitalists that currently run the show.
And a sign to the world that what's in store is a "U" not an "L".
By Andrew Butter
Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
Copyright © 2008 Andrew Butter
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