Will the US housing bubble mean a recession?

Chris Mayer - Fri 24 Nov, 2006

...As US housing investment retraces, a recession of some sort looks like a lock...

 
 
- "Wise men in their bad hours have envied/The little people making merry like grasshoppers/In spots of sunlight hardly thinking..."
 
- Robinson Jeffers, American poet

- The US housing bubble is in the midst of deflating. There is no doubt now that the halcyon days of this housing boom are over.

- New home construction in the US tumbled in October - hitting six-year lows. Sales are slowing. Inventory continues to build. Based on September's rates of sales, it would take more than six months to sell off the existing new homes on the market. That's just new homes. Never mind the existing stock of older homes. Existing home inventories are up 70% from the beginning of 2005, with nearly 4 million unsold units.

- So predictably, prices are falling. The median price of a new home in the US fell nearly 10% in September from a year ago. That's the steepest drop on record, which goes back about 40 years. It was also the second consecutive month of price declines. Anecdotal evidence suggests things are much worse in certain pockets of the country. At this point, most Americans have heard horror stories from neighbours and friends trying to sell in this market.

- Buyers are getting cold feet. They are starting to walk away from contracts. DR Horton, one of the largest homebuilders in the country, reported its cancellation rate increased to 40% in its latest quarter. Toll Brothers, the luxury homebuilder, reported the highest cancellation rate in company history.

- Former KB Homes chief, Bruce Karatz (now disgraced in an options-dating scandal), called the current downturn in the US the worst one he's ever seen - including the early 1990s, when many builders went belly up.

- As an aside, it's fascinating to me that this was a topic of fierce debate not long ago. It seems only months ago there were defenders who believed there was no housing bubble. All sorts of reasons floated to the surface, like dead goldfish, to deny the obvious.

- Now, it's just a matter of debate as to how bad things will get. This is a nice illustration of Hyman Minsky's view on financial stability. The late Minsky coined his thesis the Financial Instability Hypothesis, which, despite its grand name, offered up a relatively simple insight. "Over periods of prolonged prosperity," Minsky wrote, "the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."

- In simpler terms, long stretches of good times lead people to take more chances. In Minsky's terms, we find more "speculative units" and "Ponzi units" - entities financed increasingly with debt in a manner less than prudent. In the US housing arena, we certainly saw a vast increase in creative financing.

- A wise individual once observed that innovation in finance usually amounts to buying more and more with less and less. Again, we saw that in US housing, with a surge in unconventional house payments: more adjustable-rate loans, more interest-only loans, "low docs," "no docs" and much more. In this new era of creative financing, the old 30-year house loan with 20% down became a quaint vestige of a bygone era - like a vinyl record or a fully-funded pension plan.

- So now the pendulum has begun to swing the other way. What does this mean? It means a rollback of the speculative and Ponzi finance units, as Minsky would say. It means a withdrawal of EZ credit to the US housing market. Which means a consumer-spending retrenchment...and a very likely recession.

- In fact, as US housing investment retraces, a recession of some sort looks like a lock. "Since World War II," Fred Hickey, eminent editor the Hi-Tech Strategist writes, "whenever residential investment exceeded 5.5%, it has always lead to recession." Last year, investment in US housing topped 6%.

- US consumers have less money to spend. In aggregate, cash squeezed from home equity no longer flows so freely. The latest numbers show cash-outs slowed to half of what they were a year ago. In other words, the cash flowing to consumers from cash-out refinancings could drop by more than $300 billion.

- For perspective, the drop in US gasoline prices probably adds only $80 billion or so to consumers' pockets. The loss from housing, as you can see, makes the gasoline matter look like the proverbial fly on the chariot wheel.

- Some slowdown in US consumer spending seems inevitable. Where else will consumers get the money? They are tapped out.

- Jeffers wrote about the wise men in their bad hours envying the carefree people, who made merry like grasshoppers. For some time, the wise men that warned of ill tidings in the housing market were scoffed at, while the grasshoppers played on. But playtime is almost over. Before long, we would guess, the grasshoppers will be envying the wise men.


Regards,

Chris Mayer
for The Daily Reckoning