Housing Cannot Recover If Employment Is Trending Down   (December 14, 2011)

Housing cannot "recover" until employment recovers.

The Federal Reserve is working on the theory that all housing needs is a boost in demand driven by cheap financing and near-zero down payments. The steady decline in housing valuations suggests that the Fed's theory is incorrect. Cheap money simply fuels reckless speculation by those protected from risk by Federal guarantees; in the real world, housing is correlated to employment, not cheap money.

If employment is in a downtrend, then housing will follow. In Another Reason for Stocks to Tank in 2012: Jobs (December 8, 2011), I posted some charts that showed--surprise--stock valuations were correlated to employment. (no job = no money to dump into 401Ks and equity accounts.)

It’s also no secret that housing and employment are correlated, and the causation is intuitive. If more people have jobs, then more people have incomes that support the purchase of a home. In the other direction, the more houses that are built to meet rising demand, the more jobs will be created in construction and real estate.

We can see the correlation in this chart from the St. Louis Federal Reserve displaying employment per capita for workers age 45-54 and the index of home prices.

As employment of those in their peak earning years rose, so did home prices. This is partly a function of basic supply and demand: Rising demand pushes prices higher.

As employment fell, demand declined, and so did home prices.

The Federal Reserve famously has a dual mandate: to maintain stable inflation and employment. The Fed attempts to pursue these goals with monetary tools such as setting interest rate targets, while the Federal government supports housing by subsidizing mortgage interest via tax policy and guaranteeing mortgages via the housing-lending agencies of Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA).

The Fed’s primary tool for stimulating demand for housing has been to lower mortgage interest rates, by buying the US Treasuries that set the baseline cost of long-term debt and also mortgage securities. Indeed, the Fed’s first quantitative easing (QE) program was to buy about $1 trillion in distressed mortgage debt outright. This removed the impaired debt from banks’ balance sheets and also served to lower mortgage rates.

The Fed’s assumption was that lower rates would stimulate demand for houses.  As this chart illustrates, lower rates have stimulated precious little demand. 


Part of this failure can be traced to the decline in employment. Fewer people have the wherewithal to support buying a house. But demand is only part of the picture, as millions of foreclosures and defaults have created a huge overhang of excess supply that is estimated to number some 2.5 million homes.

What is not expressed in charts of mortgage rates, employment, and housing inventory is the implosion of housing as a speculative market. Millions of households bought more than one home as a speculative play; according to a recent report from the New York Fed, one-third of all home mortgages issued in 2006 were to people who already owned another home.

Millions of others bought homes with low down payments, while millions more added second mortgages or home equity lines of credit (HELOCs) to their existing first mortgages to extract equity. 

As a result, “owner equity as percentage of household real estate,” as measured by the Federal Reserve, has fallen from 60% in 2005 to a mere 38.6% in the third quarter of 2011. When we consider that roughly 30% of all homes in the US are owned free and clear (i.e., have no mortgage), then we can estimate that equity in the remaining two-thirds with mortgages is marginal.

Interestingly, despite millions of foreclosures and write-downs, mortgage debt has actually risen from its 2006 level of $9.86 trillion to $9.93 trillion in the third quarter of 2011. (So much for deleveraging.) The “ForeclosureGate” MERS/robo-signing scandal is another systemic wild-card in the housing deck that is has created a legal logjam in the foreclosure pipeline. Since no one can predict the eventual resolution of this logjam, we will set it aside, noting it as an additional impediment to the clearing of the housing market.

With this dramatic contraction of equity in mind, it is understandable that 10.7 million (22%) of all homeowners with a mortgage are “underwater” -- that is, they owe more on their mortgage than their home is worth, while another 5% have negligible equity.

Another aspect of the Fed’s failure to boost demand by lowering rates results from the Fed’s misunderstanding of how risk is priced when interest rates are kept artificially low via official intervention and manipulation. If we place ourselves in the shoes of a mortgage issuer, we realize that artificially low rates deprive the lender of a means to price risk. In an open, transparent market, interest rates rise and fall according to the perceived risk that the borrower might default and/or the asset underlying the loan might decline substantially in value.

In the current housing market, falling prices make it clear that there is still downside risk of homes declining further in value going forward. Furthermore, the unstable employment environment means that a household could shift quickly from low-risk to high-risk if the principal breadwinner's job was lost and could not be replaced.

Since rates have been artificially suppressed to goose demand, lenders have no way to compensate for the risk of issuing a mortgage except to insist on very substantial down payments or to simply avoid lending to all but those with the very best credit scores.

Anecdotally, this is precisely what we see happening. Households that easily qualified for jumbo mortgages in the boom years are being turned down for refinancing mortgages. From the point of view of the mortgage issuer/lender, why take a chance of massive future losses for a paltry 4% interest rate?

The tragic irony of the Fed’s policies of buying impaired mortgage debt and suppressing mortgage rates is that this has impeded the market from properly pricing houses, mortgages, and risk. And when the price of assets, debt, and risk cannot be discovered by transparent market forces, then participants must remain wary of future price discovery.

In other words, manipulating and impeding the market only increases the risk, driving the risk-averse out of the market. That leaves only the reckless in the housing market — those plunking down 3% for an FHA-backed mortgage and those lenders who have transferred the risk of default to the Federal agencies: Fannie, Freddie, and FHA.

This “moral hazard” — the separation of risk from gain/loss — leaves the taxpayer on the hook for not only making good the staggering losses already recorded by Fannie Mae and Freddie Mac, but also for future losses in mortgages backed by FHA, which has seen its mortgage portfolio explode from 3.8 million to 5.7 million in just the past two years. As anyone could predict when down payments get as tiny as 3%, a slide in home values of a few percentage points can easily put the homeowner underwater, and consequently the default rate on FHA mortgages has been rising.

With a paper-thin supplemental cash reserve of $2.6 billion supposedly backing up its $1.1 trillion mortgage portfolio — a mere one-quarter percent of the portfolio -- FHA will soon need a taxpayer-funded bailout in the billions of dollars to keep afloat.

The Federal Reserve and the Federal government have attempted to boost the housing market’s demand and valuations by introducing moral hazard on a vast scale and by making it impossible for the open market to discover the price of housing, mortgages, and risk. Prudent lenders and buyers have been forced by this systemic risk to withdraw from the market, even as artificially low mortgage rates, near-zero down payments, and government-backed mortgages have created generous incentives for the most reckless buyers and lenders to take their chances. After all, if you can’t lose more than 3% by buying a spot on the real estate roulette wheel, and all mortgage losses will be made good by the taxpayers, then why not gamble? 

In this manipulated market, the reckless have nothing to lose, while the prudent cannot possibly assess the real risk or price of assets and debt. The grand irony is that in attempting to “save” the housing market by suppressing mortgage rates and the market’s discovery of the price of homes, debt, and risk, the Fed has systemically crippled the housing market.

There is a subtext to the Fed’s fervent intervention in the mortgage and housing markets: By propping up housing prices, it also props up the sagging balance sheets of its favored (and politically powerful) “too big to fail” banks. From this perspective, we can see that the Fed’s public concern for employment masks its real concern, which is keeping the “too big to fail” banks from a market recognition of their insolvency.

When will the housing market “recover”? Housing can only find solid footing if the market is freed to discover the prices of property, mortgages, and risk. Until then, the market will drift along in a haze of moral hazard and official support of the imprudent and reckless.

In Part II: How Low Will Housing Prices Go?, we explore the macro-economic trends likely to further depress housing prices in the coming years, as well as look at several time-tested models for determining how much downside is left for housing prices and how we'll be able to estimate when the housing market finally reaches a bottom.

Click here to access Part II of this report (free executive summary, enrollment required for full access).

This article was first published on Chris Martenson.com as "Headwinds for Housing."

If you're giving "store-bought" gifts this year:
And your gift-giving philosophy favors 1) everyday utility 2) durability/high quality 3) cost between $5 and $23, and 4) made in U.S.A. then this is the list for you: Favorite Practical Kitchen Tools (All Under $23, many under $10, most made in U.S.A.)

If this recession strikes you as different from previous downturns, you might be interested in my new book An Unconventional Guide to Investing in Troubled Times (print edition) or Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc. Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

My Big Island Girl (fun, free MP3 song)

Readers forum: DailyJava.net.

Order Survival+: Structuring Prosperity for Yourself and the Nation (free bits) (Kindle) or Survival+ The Primer (Kindle) or Weblogs & New Media: Marketing in Crisis (free bits) (Kindle) or from your local bookseller.

Of Two Minds Kindle edition: Of Two Minds blog-Kindle

"This guy is THE leading visionary on reality. He routinely discusses things which no one else has talked about, yet, turn out to be quite relevant months later."
--Walt Howard, commenting about CHS on another blog.

NOTE: contributions are acknowledged in the order received. Your name and email remain confidential and will not be given to any other individual, company or agency.

  Thank you, Robert H. ($5/mo), for your immensely generous subscription to this site-- I am greatly honored by your support and readership.  

Or send him coins, stamps or quatloos via mail--please request P.O. Box address.

Subscribers ($5/mo) and contributors of $50 or more this year will receive a weekly email of exclusive (though not necessarily coherent) musings and amusings, and an offer of a small token of my appreciation: a signed copy of a novel or Survival+ (either work admirably as doorstops).

At readers' request, there is also a $10/month option.

The "unsubscribe" link is for when you find the usual drivel here insufferable.

Your readership is greatly appreciated with or without a donation.
For more on this subject and a wide array of other topics, please visit my weblog.


All content, HTML coding, format design, design elements and images copyright © 2011 Charles Hugh Smith, All rights reserved in all media, unless otherwise credited or noted.

I would be honored if you linked this essay to your site, or printed a copy for your own use.



Making your Amazon purchases
through this Search Box helps
support oftwominds.com
at no cost to you:

Add oftwominds.com to your reader:


My Big Island Girl
Thrill the players to bits:
buy it via CD Baby or
amazon.com (99 cents)

Instrumentals by my friend
and mentor Coconut Charlie:

Crash Course
Secret Asian Man
Third Stone
Tonic Float

Survival+   blog  fiction/novels   articles  my hidden history   books/films   what's for dinner   home   email me