Thoughts on the housing slowdown

The commentary below is from the estimable Scott Grannis, Chief Economist at Western Asset Management. It qualifies as essential weekend reading. (Alas, once again eBlogger does not support the uploading of image files, so the charts are MIA.)
-- David M Gordon / The Deipnosophist
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(Begin Scott Grannis...)
All of the attached charts, coupled with just everything you see from Wall Street and in the press, suggest that the housing market is softening. Indeed, the peak in housing most likely occurred about 9 months ago. The prices of major home builder stocks are down 40% from last summer's peak. Inventories of unsold homes have skyrocketed 50% in the past year. A survey of major home builders reflects deteriorating conditions for only the third time in 20 years. 30-year fixed mortgage rates are up 140 bps from last summer's lows, and adjustable rates are up over 200 bps. Applications for new mortgages have fallen 25% in the past year, housing starts are down 10%, and an index of mortgage refinancing activity has plunged 80%. Housing price futures are now trading on the CME, and every one of the 9 contracts tied to major metropolitan housing markets shows prices declining.

Residential construction accounts for some 6% of GDP, mortgage equity withdrawal (MEW) has been estimated to be of similar magnitude, some $600-800 billion per year, and the value of private residences accounts for over one-third of households' $53.8 trillion net worth. Surely a downturn in construction activity, lower home prices, and a big drop in MEW has the potential to take a big bite out of the economy. Some estimates I have seen and that look reasonable suggest that a housing slowdown could subtract 1.5% from GDP growth, potentially resulting in an economy that grows only 2% instead of 3.5%. That would be enough to put the Fed on hold for an extended period, barring a further deterioration in the inflation outlook.

Not surprisingly, given the plethora of data already available, the majority of analysts, and even the Fed, expect that housing is already contributing to slow the growth of the economy. However, since it's no secret that housing is soft, the real surprise would be if the economy didn't slow down. Is that possible? I thought I would make the following observations, which don't receive nearly as much attention as the housing slowdown, if only to ensure that we aren't blindsided should the economy fail to weaken as expected.

• Mortgage equity withdrawal does not create new demand. If I refinance my mortgage and take some equity out, and then spend some of that equity, my spending comes about at the expense of someone else's spending (i.e., the person who lent me the money for my new higher mortgage balance). I didn't work harder or produce anything new, I just spent some money that otherwise would have been spent by someone else. Also, it's important to note that mortgage equity withdrawal is not being financed by new money creation. Indeed, the M2 money supply is growing at only a very modest 4% pace these days, much less than the 7% growth in nominal demand. To be sure, MEW most likely results in more business for the Home Depots and furniture manufacturers of the world, but again that comes at the expense of spending in other areas. My friend David Gitlitz reminds me that less MEW might even be good for the economy, to the extent that money not spent by homeowners might end up being spent on things that are ultimately more productive than marble countertops and slate floors. In the end, however, since MEW doesn't represent productive activity, a reduction in MEW doesn't necessarily subtract from growth.
• Nonresidential construction activity could offset a good portion of the slowdown in residential activity. Nonresidential construction accounts for about 11% of GDP, and its contribution to overall growth in the first quarter was 50% higher than it was last year, even as the contribution from residential construction fell by 50%. Corporate profits after tax are at an all-time high relative to GDP, so there is no shortage of funds available to finance the construction of new business-related structures. Indeed, businesses on average have not been investing or distributing their profits as fast as they have been collecting them, which is why the corporate sector has been deleveraging.
• State and federal tax receipts are booming. Federal revenues alone are up at a 13% annual pace for the past two years. That is the fastest growth in real terms in recorded history. Booming revenues are coming from all sources: business profits, personal incomes, dividends, and capital gains, and the data through May don't show any signs of a slowdown. Where's there's smoke, there's fire: strong tax receipts imply lots of productive activity. It could be that other areas of the economy have already turned up by enough to offset the slowdown in housing.
• Households are net beneficiaries of higher interest rates. According to my estimates, based off of the Federal Reserve's household balance sheet data, U.S. households as of March 2006 had over $8 trillion in floating rate assets (e.g., CDs and money market funds) and about $5 trillion of floating rate debt (e.g., ARMs and credit card balances). Higher interest rates thus increase households' net cash flow. It should also be noted that ARMs don't adjust immediately, and annual interest rate hikes are typically capped, so the pain that ARMs are going to cause will be spread out over the next several years and will only affect a minority of borrowers, since about two-thirds of all mortgages are fixed-rate. Of course, the logic of my first observation would suggest that if households are positively impacted by higher interest rates, then other sectors of the economy are negatively impacted, so the net result for the economy is something of a wash. But at least this highlights the difficulty and complexity of any attempt to extrapolate the impact of housing on the overall economy.
• Households have not materially increased their leverage. For all the talk of MEW and the profligate ways of the U.S. consumer (as reflected in a record-breaking trade deficit), you would think that households had leveraged themselves to the hilt and that the economy was like a house of cards. Yet according to the Fed, the ratio of U.S. households' total financial obligations (debt service, auto lease payments, rents, homeowner's insurance, and property taxes) to disposable personal income increased from 17.7% in 1997 (when the current housing boom started) to 18.6% as of last December.