by Calculated Risk on 2/21/2007 08:25:00 PM

"If there is one development to worry about the potential of recession it will be housing."
San Francisco Fed President Janet Yellen, 2/21/2007

San Francisco Fed President Janet Yellen spoke today in California: The U.S. Economy in 2007. Here are some excerpts on housing:

[T]he housing sector has been at the leading edge of the overall economic slowdown, and I’d like to turn my attention to that important sector now.
...
Despite the continued weakness in housing construction, which ... enters directly into the calculation of real GDP, there are some signs of stabilization in other aspects of housing markets, suggesting that construction activity may level out before too long. For example, home sales have steadied somewhat after falling sharply for a year or so. Considering this in combination with the continued drop in housing starts that I mentioned earlier, it is not surprising to find that inventories of unsold homes have begun to shrink. This development suggests that the process of resolving the imbalances between demand and supply in the housing market may be underway, and, as a result, we could very well see the drag on real GDP from housing construction wane later this year.

It's probably important to understand how "housing construction enters directly into the calculation of real GDP". Every month, the Census Bureau calculates construction spending, value put in place. The BEA uses this number to calculate Residential Investment (RI). This is essentially the amount of money homebuilders spend on construction each month. It doesn't matter if the home is sold, what matters for GDP is that a home is being built.

Since housing completions are still near record levels (even though starts have fallen off a cliff), construction spending hasn't fallen very much yet. And because starts have fallen significantly, we know that the RI component of GDP will continue to decline over the next few quarters. The question is if there will be another downturn in housing or, as Dr. Yellen suggests, the drag from housing will "wane".

However, since home completions are still near record levels, there has been very little impact yet on jobs and consumer spending - at least so far. Those impacts are in the future.

Of course, such a turn of events is by no means a given, because the improvements we’ve seen may just be temporary. ...

In addition to concerns about weakness in housing construction, there has been worry that difficulties related to housing markets could spread to consumer spending more generally. Since consumption expenditures represent two-thirds of real GDP, even a relatively modest impact from housing markets on this big sector could put a noticeable dent in overall economic activity.

Up to this point, we haven’t seen signs of such spillovers. Consumption spending has been well maintained, showing a robust growth rate for all of 2006. However, going forward, there are at least a couple of ways that spillovers from weakness in housing could depress consumer spending, and these channels bear watching. First, housing makes up a significant fraction of many people’s wealth, so a significant change in house values can affect consumer wealth and therefore consumer spending. As you know, there have been fears about plummeting house prices. But so far, at least, house prices at the national level either have continued to appreciate, though at a much more moderate rate, or have fallen moderately, depending on the price index you look at. Looking ahead, futures markets are expecting small declines in a number of metropolitan areas this year. While these modest movements are undoubtedly imparting less impetus to consumer spending now than during the years of rapid run-ups, their effects are not likely to be dramatic.

... housing market developments also could spread to consumer spending if enough homeowners experienced financial distress. For example, rising variable mortgage rates could strain some consumers’ cash flow. What we find, however, is that, because of the rapid appreciation of home prices in prior years, most homeowners are sitting on a substantial amount of equity, a financial resource that they can fall back on. In particular, adjustable-rate borrowers with equity can avoid a rate reset by refinancing. Moreover, only a small fraction of outstanding variable rate mortgages are scheduled to be reset in each of the next few years.

Although Dr. Yellen mentions the housing wealth effect, I'm surprised she doesn't mention the possible impact of less Mortgage Equity Withdrawal (MEW). The wealth effect and MEW are related, but MEW probably shows up more directly in consumer spending. The wealth effect just means someone feels wealthier and therefore they are a little more willing to spend. However MEW is actual money burning a hole in the consumer's pocket.

Of course, financial distress could be a bigger problem for some borrowers who used so-called exotic financing—like interest-only loans, piggy-back loans, and loans with the possibility of negative amortization. These instruments are often designed to allow subprime borrowers into the market. In fact, there are signs of trouble for some households. Delinquencies on variable-rate mortgages to subprime borrowers have risen sharply since the middle of last year and now exceed 10 percent. But fortunately, delinquency rates for other types of mortgages—including all prime borrowers and even subprime borrowers with fixed-rate loans—have edged up only very modestly. I know that it’s common to see newspaper stories about homeowners who have run into trouble, and those situations are, indeed, regrettable. From a national perspective, however, the group with rising delinquencies still represents only a small fraction of the total market, with little impact on the behavior of overall consumption.

A forward-looking view of the credit risks associated with subprime mortgages can be obtained from a new financial instrument related to these mortgages. These instruments suggest a big increase in the risk associated with loans made to the lowest-rated borrowers, but little change in risk for other higher-rated borrowers. Based on these results, it appears that investors in these instruments expect the losses to be fairly well contained. Of course, a shift in market sentiment about the risk of some of these securities is always possible. Such a shift would have ramifications for mortgage financing and housing, likely through tighter credit standards and higher mortgage rates for certain borrowers. In fact, we already have seen some tightening among commercial banks in recent months.

The bottom line for housing is that the concerns we used to hear about the possibility of a devastating collapse—one that might be big enough to cause a recession in the U.S. economy—while not fully allayed have diminished. Moreover, while the future for housing activity remains uncertain, I think there is a reasonable chance that housing is in the process of stabilizing, which would mean that it would put a considerably smaller drag on the economy going forward.

I've never felt housing would experience (edit) "plummeting prices" or a "devastating collapse" (note: ac points out that Yellen defines a devastating collapse as one that takes the economy into recession, so I agree that is possible), and I think that is a bit of a strawman from Dr. Yellen. But what happens when credit standards are tightened as Yellen suggests is happening? Some potential buyers are removed from the market, and demand decreases. So we currently have record levels of supply and we will probably see less demand. Does that sounds like a market that is coming into balance?

I discussed the possible impact of tighter credit standards on the 2007 housing market before: Subprime: The impact on Existing Home Sales in 2007 Needless to say, I'm not as sanguine as Dr. Yellen.