Why the Real Estate Slow Down Matters So Much

Last night on K&C, Larry asked me about the improvement — after 5 down months — in New Home Starts. My answer was a single data point does not make a trend. Besides, rates are still historically cheap compared to the 1990s, when mortgages were primarily above 8%. (I also failed to mention in the allotted time that this is a notoriously noisy data series, with very inconsistent reporting standards; see this for more on that subject).

Econo_20060620202342

The way Real Estate’s growth rate has cooled is very consistent with our expectation for a "slow motion slow down" in the economy. But I did not have time for the specifics as to why I believe a decelleration, and then outright reversal, in Real Estate will matter so much to the economy. Let’s flesh this out a bit more:

Its long been a tenet of our economic outlook that the prime driver of the 2002-05 recovery has been the Fed. They slashed interest rates to 46 year lows, bringing the Fed Funds rate down to 1%, while cranking up the printing presses. Then, they kept rates low for a long time. Cheap money sent all sorts of hard assets — oil, gold, real estate, other commodities — soaring. This stimulus — and not tax cuts, as Rich Lowry incorrectly claims — was the key driver of the economy. Hey, I like tax cuts as much as the next guy, and personally benefitted ALOT from the dividend tax rate of 15% (before the AMT got me). But I calls ’em as I sees ’em, and it was historically ULTRA-low interest rates, and not the marginal change in top rates, that have been the prime domestic engine. (China was a close second, with the weak dollar right behind it).

Where was I? Oh, yes, Real Estate. When we first started prosletyzing this perspective of RE as the key, the skepticism was thick and the pushback was fierce. Now, this viewpoint has become fairly well established. Even the mechanism of MEW — Mortgage Equity Withdrawal — has gotten recognition as it put trillions of dollars into the hands of consumers, where it has been transmogrified into SUVs, new Kitchens, and HDTV plasma screens.

The mechanism for how this plays out is less well understood by Wall Street and the general public,  and is slowly becoming accepted. It has begun to infiltrate the collective consciousness of investors. How the prime mechanism of the growth engine plays out, where its trending, and how it is likely to shift
over time will be the key to if we ultimately end up with an economic soft landing, a hard landing, or an outright crash.

To get a sense of how important MEW is, look at what GDP would be like without it. (Pretty scary, huh?). The usage patterns of consumers is the key to understanding where this can go.

Here’s where it gets tricky: Despite the rise in interest rates and the cooling of real estate, US Mortgage Equity withdrawal has remained robust. According to an article in Economy.com by Zoltan Pozsar, in Q1 2006, gross equity extraction slipped sequentially from $1.033 trillion to $996.8 billion (annual run rate). This is still "way up in the stratosphere" to quote Joanie. MEW represented 8.4% of personal income in Q1, and is a very meaningful source of spending cash with incomes flat and real incomes negative.

The Penebscott Princess puts it this way:

"How does John Q. get his hands on some MEW? 1. sale of home. 2. refis 3. HELOCs. (In that order, btw.) Okay, since the sale of a home is the largest factor, what is truly bad news then, is a deceleration in the pace of home sales and of course, any evidence that prices are softening as well.

And we know that both are in the works. So yesterday’s HMI release, a real dog, was unwelcome news, while acknowledging that it reflects new home sales only. Because face it. If they ain’t linin’ up to buy new ones, fat chance the used ones are flyin’ off the shelves either.

Bottomline, the increase in interest rates is depressing sales and prices in the housing industry. In turn, this should eventually become evident in John Q.’s spending habits as the well runs dry. But for the moment, we now have one mystery solved as to where he’s gettin’ his funding: he’s either sellin’ or hockin’ the ranch."

So how does all this fit in with our concept of a "slow motion slow down?"  Spending patterns following mortgage equity withdrawals. The extra MEW green in consumers pocket is typically spent over 2 to 3 quarters. That implies the $249B or so extracted in Q1 will be spent from then to Q3. If Q2 slows even more, that gets spent from then thru Q4, and so on.

Even as MEW slows, it will still be stimulative, albeit at a decreasing rate, for the foreseeable future.  This will continue until something stops the spending — most likely, a sentiment panic that freezes consumers from spending, with a religous epiphany involving saving money (hard to even imagine tho that may be). 

I suspect that will occur slowly — much later this year or early 2007. The market’s action in May could even be the beginning of discounting that consumer slow down.   

>
Mortgage Equity Extraction, components

Mew_gross

Source: Federal Reserve Staff working papers

>

Bottom line: Without something else to take the place of MEW, the consumer cannot drive the US economy at these levels for very much longer.   Unless business spending ramps up dramatically, there is nothing else on the horizon to take the spending baton.

That spells trouble for GDP.

>

UPDATE: June 21, 2006 9:54am

The request goes up for the MEW GDP chart, and courtesy of Calculated Risk, here it is:

click for larger chart

 

Gdpmew

>


UPDATE June 21, 2006 2pm

The WSJ picks this up in Market Beat: Mew Mix

>


Source:
Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences
Alan Greenspan and James Kennedy
Federal Reserve Board, Staff working papers in the Finance and Economics Discussion Series (FEDS)
September 2005
http://www.federalreserve.gov/pubs/feds/2005/200541/200541pap.pdf

US Mortgage Equity Withdrawal Remains Strong
Zoltan Pozsar in West Chester
Economy.com, June 16, 2006
http://www.economy.com/dismal/pro/blog.asp?cid=23826

Softer Housing Sector Is Seen,But Data Don’t Point to Collapse
CHRISTOPHER CONKEY and MICHAEL CORKERY
WSJ, June 21, 2006; Page A2
http://online.wsj.com/article/SB115080544699585067.html

Print Friendly, PDF & Email

What's been said:

Discussions found on the web:
  1. Trends I’m Watching commented on Jun 21

    Market Drivers

    Trend: Higher interest rates and decreasing mortgage equity withdrawal will gradually slow consumer spending in the near future. Barry Ritholtz writes about the forces that have been driving the economy at The Big Picture blog. Source: The Big Picture….

  2. vf commented on Jun 21

    i live in a small town in mid-south. a local biz mag yesterday reported that in the $400k-$2mm price point there are 113 unsold homes on the market in a certain new development. there were 62 this time last year. this is just the first phase of the bear market in housing. we haven’t even witnessed the liquidation phase yet and there is a lot of bank debt collateralized with 2nd mortgages at 125% LTV.. when the liquidation begins LTVs will collapse and notes will get called, only exacerbating the selling..

  3. Brian commented on Jun 21

    It’s going to get interesting when all of our debt becomes a much larger % of GDP with everything slowing down and a crashing housing market.

  4. trendwatcher commented on Jun 21

    The GDP chart with and without MEW is crystal clear and really scary. Definitely worth trotting this out again to remind us of what’s happening.

  5. alan commented on Jun 21

    How about a slowly declining dollar to partially offset the decline in housing and provide some stimulus to the economy? Since the median price of homes in many areas is now 10 to 15 times median family income, up from 3 to 4 times 15 years ago, is the new homeowner ever really going to own that house free and clear? An increase in house prices encouraged a decrease in national savings. For each dollar decrease in national savings and subsequent increase in the trade deficit, that’s a dollar lost to our manufacturing base at home, so isn’t it time to stop the bleeding?

  6. edhopper commented on Jun 21

    Barry, are you still saying we were not in a bubble, and therefore that bubble is not going to collapse?
    I read from this that without MEWs we have been in a recession, or very close, for 5 years. Without Home ATMs mainly fueled by low interest rates AND Subprime loans, I can’t see how housing doesn’t collapse.

  7. bjk09 commented on Jun 21

    For as long as I’ve been following the stock market, there has always been someone predicting the imminent demise of the consumer. And that person has been wrong, and then wrong again, and again, and again.

  8. Anonymous commented on Jun 21

    How long have you been following the stock market?

  9. James commented on Jun 21

    This is a flawed analysis. Higher rates will slow the economy. A lower level of mortgage withdrawals will not slow the economy. This is money coming from the credit markets that wasn’t extra. It was borrowed by consumers, therefor not lent to someone else and not spent by the lenders.

  10. Alaskan Pete commented on Jun 21

    BJK09, I won’t venture to guess your age. But I will wager that “as long as you’ve been following the stock market” the household balance sheet and savings rate were in much better shape than currently.

    With a negative savings rate, increasing cost of debt service, flat to negative real wages, and end of rapid price appreciation fueling MEW…where exactly do you reckon the consumer will acquire the loot to keep the spending orgie going?

    Add in the fact that an economy that turns on consumer spending and housing. As housing slows, it will enter a vicious self reinforcing feedback loop as the slowdown in housing (resulting in employment cuts) feed through to consumption bottom line. All those out of work mortgage brokers, appraisers (aka crooks), framers, roofers etc won’t exactly be lining up for iPods and mediocre food at the neighborhood Applebee’s.

  11. bj089k commented on Jun 21

    About ten years. Anyway, the point is that this is a perennial. It’s like the whole “Japanese are going to stop buying our debt” or “there is a derivatives time bomb about to explode” or “the government is inventing inflation statistics,” another BP staple.

  12. Barry H. commented on Jun 21

    I would like to know if BR’s information on mortgage equity withdrawal (MEW) is netted with mortgage equity acquisition (MEA).

    If John sells his home for 100k (BR’s largest source of MEW) that has a loan of 50k…..and then buys another home for 200k with a loan of 150k….what has changed?

    John did not waste his MEW on toys that depreciate with no residual value. His net worth has not changed. And although MEW was increased by 100k, MEA was increased by 200k. A net increase in equity was realized, not an equity withdrawal.

    In this situation, John’s house will have to go down substantially in value for a long time for him to be hurt. Either way, he stays put in his lovely home for another 15 – 30 years. Go John!!!!

    Yes, ARMS will hurt, but not everyone went the ARM route. When my wife and I did home improvement, we locked in at 4.5%…yeah baby!!

    BarryH

  13. Barry Ritholtz commented on Jun 21

    Hey bjk09,

    Is it your strategy to assume that the US consumer will never ever slow down? (Sold to you). Sounds like a money loser.

    BTW, I haven’t said the US consumer was dead yet; I did say last summer that signs of their tiring were present. As I wrote in the WSJ in August of last year: (Shopped Out?):

    For at least the past decade, anyone who has bet against the resiliency and unending spending capacity of the U.S. consumer has decidedly lost the wager. Even through the recession of 2000-01, they hardly slowed their profligate ways. Sept. 11 managed to create a pause in spending — at least for a short time — but it was more than made up for in the ensuing quarters. Indeed, the careers of economists who have declared the U.S. consumer to be tapped out litter the countryside like corpses after a war.

    Repeat after me: These things are cyclical

  14. JoshK commented on Jun 21

    A few people I know of are multiple property investors who have leveraged one investments gains into the next via “MEW”. A lot of this is financed with variable rate debt. This leaves them open to strings of default shock.

    Does anyone know where this can be quantified? The multiple-releveraging is a hard # to come by.

  15. cm commented on Jun 21

    James: With a fractional reserve banking regime (look up the term), a large part of loans is money created out of thin air. It’s not money that has previously been owned by the lender or by its investors.

  16. advsys commented on Jun 21

    Thanks for the data on MEW but even more importantly I was not aware of the 2 quarter phase in on spending of that MEW. Very helpful.

    Please keep us all apprised of more key data like that.

  17. advsys commented on Jun 21

    Another quick thought. Low interest rates have been an incredible stimulus. There has been money flowing into the system from many other sources too. Does that not also contribute to the housing boom? General economic stimulus?

    Agreed the tax cuts have been a tiny tiny tiny portion of the liquidity boom. On top of that this is money that essentially leaves us short the money needed to pay for government services. Which leads towards borrowing which is of course only a very short term boost to liquidity.

    I am talking about monies that came from the amnesty on foreign profits and from carry trades.

  18. eightnine2718281828mu5 commented on Jun 21


    For as long as I’ve been following the stock market, there has always been someone predicting the imminent demise of the consumer.

    So the Dow 36000 types win in the end?

    That’s good to hear.

  19. Ned commented on Jun 21

    what we are worrying about, it seems to me, is the wealth effect in reverse. Joe and Josephine consumer see their net worth shriveling with the price of their home and cancel the cruise to Cancun and the new wardrobe and put off buying the giant flatscreen to watch the World Cup and start riding bikes everywhere to save money on gas and make up for the cancelled healthclub memberships and what Pete said too, of course.

  20. Barry Ritholtz commented on Jun 21

    I predict Dow 100,000.

    Of course, it may be by 2050 — but still — its a great Glassman-like reason to buy!

  21. B commented on Jun 21

    Dow 100,000? Why wait? A few more days like today and we’ll punch right through that 80 year trend line on the Transports into a new and glorious world called Heaven.

  22. Mike commented on Jun 21

    Is it possible that the something that replaces MEW to drive the economy is the large amounts of cash that are on the corporate balance sheets. Is is also possible that those corporations use that cash (through spending and investment) to keep this thing going a little longer? Just wondering.

  23. Mark commented on Jun 21

    If LEI comes in sucky tomorrow, what does that do to this rally? How about to commodities in general and gold specifically? Does Beeks have the orange crop report again?

  24. Anonymous commented on Jun 21

    Corporations aren’t going to invest that money in production capacity unless there are consumers out there to buy the extra product. Just buying more production capacity doesn’t increase demand.

    The trend is in fact the reverse — share buybacks, which are the opposite of capital investments, are now at an all time high.

  25. S commented on Jun 21

    Mike:

    It seems to me the M&A bankers have been pretty effective at persuading CEOs to buy already productive assets. Why invest in new plant and equipment when you can buy your competitor?

  26. B commented on Jun 21

    It isn’t so much that the M&A guys and gals have convinced anyone of anything. It is that we had a blow off in capex in the late 1990s and companies are awash in excess capex spending whether it be IT, software, plants, new equipment, etc. That is why productivity continued to rise through the market collapse and into today. There is so much ability to grind more out of the capacity at hand without hiring. So, the productivity miracle is really just a farce.

    So, with companies trying to rationalize all of these misappropriated investment of the late 1990s, why are they going to spend on capex until the prior cycle’s investments are rationalized? They aren’t. Instead, what do you do with excess cash when you don’t need to invest in capex? You buy your competitors. This is as good as it gets for the M&A business.

  27. Blissex commented on Jun 21

    I have just discovered a terrifying little article about this:

    «in Q1 2006, gross equity extraction slipped sequentially from $1.033 trillion to $996.8 billion (annual run rate).»

    which says something about ARM related foreclosures:

    http://seattlepi.nwsource.com/business/274522_foreclosures20.html

    «ARMs are now starting to fall by the wayside as the difference in interest rates narrows. The average rate on a 30-year fixed rate loan in May was 6.60 percent, compared with 5.63 percent on a one-year ARM, according to Freddie Mac. In 2003, rates on a 30-year fixed were at 6.54 percent, while ARMs carried a 3.76 percent rate.
    This year, more than $300 billion worth of hybrid ARMs will readjust for the first time. That number will jump to about $1 trillion in 2007, according to the MBA. Monthly payments will leap too, many beyond what homeowners can afford.
    »

    ARMs have only made sense, with their extra low initial rate, as a speculation move: buy a house with a ARM, and resell it at a huge profit in a couple of years before the rate readjusts. If that works, very good. If it does not happen, well, not so good newsARMs are now starting to fall by the wayside as the difference in interest rates narrows. The average rate on a 30-year fixed rate loan in May was 6.60 percent, compared with 5.63 percent on a one-year ARM, according to Freddie Mac. In 2003, rates on a 30-year fixed were at 6.54 percent, while ARMs carried a 3.76 percent rate.
    This year, more than $300 billion worth of hybrid ARMs will readjust for the first time. That number will jump to about $1 trillion in 2007, according to the MBA. Monthly payments will leap too, many beyond what homeowners can afford..

    I hope Barry will find this little article supporting his sober assessment of the impact of any housing crunch.

    Then we have the usual issue: will the Federal Reserve mercilessly squelch inflation, killing the housing market and the economy, or will the pain for all those voters owned by an ARM such a potent political force that they will be saved by a restart on asset price inflation and damn the torpedoes?

  28. Blissex commented on Jun 21

    «Unless business spending ramps up dramatically, there is nothing else on the horizon to take the spending baton.»

    Well, the ultra loose monetary and fiscal policy in the USA for the past several years (monetary for 10 years, fiscal for 5) has resulted in a wildly inflationary investment and jobs boom, but in Bangalore and Shanghai rather than Columbus or Buffalo.

    However, there are signs that investment in those places has resulted in no spare capacity, and maybe, just maybe, there will be some spillover back into the USA, as USA companies are forced to invest back in the old country. That might help, even if not quite as dramatically as spending windfalls from asset price booms…

  29. whipsaw commented on Jun 21

    per Mark:

    “If LEI comes in sucky tomorrow, what does that do to this rally? How about to commodities in general and gold specifically? Does Beeks have the orange crop report again?”

    I believe that most of the LEI components have already been reported, so I’d be surprised if it made much difference either way in and of itself. I’d be inclined to think that there won’t be much important News! until the 29th when FOMC announcement is made after the release of GDP. Then pretty quiet until NFP on July 7 which is about when I expect the big slide to begin.

  30. Blissex commented on Jun 21

    «I predict Dow 100,000.
    Of course, it may be by 2050 — but still — its a great Glassman-like reason to buy!
    »

    Barry, don’t joke on this: it could be a great Buffett-like reason to buy! :-)

    Of course Buffett bought when P/Es for blue chips were less than half what they are now, and at the beginning of a few decades of constant USA and international expansion, and one in which there was the one time effect of the Cold War victory.

    The Dow could get to 100,000 in 2050, but it could be at the same time as a BigMac in 2050 gets to $50 :-).

    Uhm, I wish I could find the full time series of the Big Mac Index. The Economist site has a table from 1998 which had the Big Mac at $2.56 and now it is at $3.10 (21% higher).

    On about the same dates the Dow industrial was 8,891 and 10,930 (23% higher); the Dow composite was at ,2862 and 3,783 (32% higher).

    Now in the 44 years to 2050 it only takes an inflation rate of 6.5% compound to get a Big Mac price of $50, or just 5.2% compound to get the Dow industrial from 10,930 to 100,000.

    Hey, at a compound rate of 5.2% the Dow industrial will be at 36,000 by 2030.

    Well, I am easily amused :-).

  31. donna commented on Jun 21

    10 years. What a baby. ;^)

  32. theroxylandr commented on Jun 22

    I do not agree that MEW just added consumption to GDP. There is a split between just funneling MEW to plain consumption and reusing those money to upgrade real estate or buy second house.

    There are 6 million new homes build in the last 3 years. There are not somany new families. I.e. many people expanded their real estate ownership.

    But yes, sure, this bubble will be a huge drag, recession in 6 months, mark my words.

  33. Blissex commented on Jun 22

    «There are 6 million new homes build in the last 3 years. There are not somany new families. I.e. many people expanded their real estate ownership.»

    Sure, there has been an increase in asset owning. But there are three important points:

    Those 6 million new homes means a lot of money spent on paying builders, realtors and so on. Thus investment in new house equity means a lot extra consumption, even if that is not directly MEW.

    Refinancings on existing home, which are an immense stock of housing, have been running pretty high too. MEW has happened indeed.

    There is constant pressure on housing by new families, because of high immigration. There was an academic study a decade or so ago that looked at demographics and predicted, with extremely convincing numbers, a housing bust around 2000, as new buyers would shrink so much.

    Famously, this has not happened, and another paper looked at the story and found that the enormous wave of illegal immigrants had more than compensated for the baby bust.

    Hey, some research claims that rents per square foot in LA’s barrios are higher than in Beverly Hills; nothing new here: much the same was true of the immigrants slums in NY many decades ago.

  34. Eric A. commented on Jun 22

    … a sentiment panic that freezes consumers from spending, with a religous epiphany involving saving money (hard to even imagine tho that may be).

    I just saw a new (?) TV ad for ING Direct. The slogan? “SAVE your money.” Innovation at work!

  35. Software Nerd commented on Jun 23

    It’s true that the spurt in home-buying, spurred by easy finance has spurred GDP. However, “theroxylandr ” makes a good point about the way the Fed’s report presents the numbers.

    With the Fed numbers, a renter moving to a new or existing house does not extract equity, but an owner moving upscale typically does (if his new loan is larger than his old one).

    The “cash-outs” number (from the Fed’s chart) is a better starting point. I’m not sure how much of the “Net increase in Home Equity” should be added to that either. After all, some of that probably went toward “debt-consolidation”.

  36. Brad S commented on Jun 23

    BR has mentioned smart money in relation to short interest recently. I work for a commercial real estate firm and my personal view on the real estate market is also to view what the smart money is doing. From my vantage point, I consider REIT’s, homebuilders and large mortgage banking operations as the smart money. While my evidence is annecdotal, I think it’s worth considering:

    1. REITs – Rather than purchasing new projects or pursuing developments on their own, most large REITs are now soliciting joint venture partners (ie pension funds and large insurance companies) in order to move forward. While they certainly have the liquidity to take these projects on alone, they simply don’t want to take the risk.
    2. Home Builders – I have several clients that are large publicly traded home builders. While they are not shrinking in size, they are less focussed on acquiring new land and are more focussed on completing the projects they have in front of them. In other words, the strong desire to keep the pipeline full is now decreasing.
    3. Mortgage Brokers/Bankers – Most of the large mortgage operations are now laying off workers in droves. Generally speaking, these operations are still quite busy, but there is no question that mortgage originations are falling.

    In my opinion all three of these sectors are indicating a housing and general real estate slow down. Of what proportion that slow down will be is yet to be seen. In the real estate world, it’s a common theme that when the doctors and lawyers are heavily buying real estate, don’t hesitate and sell it to them. Personally, we’re selling A LOT of real estate to doctors and lawyers right now……If you’re not a real estate professional, proceed with extreme caution in this market.

  37. The Big Picture commented on Mar 6

    Federal Reserve: Household Equity at all time lows

    The Fed just released the Balance Sheet of Households for 2007 Q4. It shows home owners equity as a percentage of household real estate at 47.9%, the lowest on record. Going back 20 years, this number was as high as 68.2% in 1986. In other words, for …

Posted Under