America faces risk of recession

The personal pain of losing one’s home through foreclosure cannot be understated, but as Warren Buffet remarked recently, the subprime mortgage problem is not likely by itself to trigger a recession.

Unfortunately, there are four other housing-related dominoes about to fall that will act to depress the economy over the next two years and raise a very significant risk of recession.

These four recession-risk dominoes include: 1) the rapid decline of mortgage equity withdrawals by home-owning consumers, 2) the increased monthly mortgage payments that will be due on adjustable mortgages about to reset, 3) the general reversing of the housing wealth-effect as housing values decline, and 4) the growing loss of jobs in the home
construction, home sales, and the mortgage finance industries.

The first domino: Mortgage equity withdrawal is the process of consumers obtaining cash through home equity lines and loans, mortgage refinancing, and home sales.

A recent study co-authored by Alan Greenspan indicates that consumers obtained approximately $1 trillion in cash through these techniques in 2005, which in turn boosted consumer spending by $325 billion that year.

Goldman Sachs has determined that the temporary boost to spending from the booming housing economy has already dropped from 7 percent of GDP in 2005 to 4 percent of GDP in 2006, and they project it will drop significantly again in 2007. Early indications for 2007, through the end of March, show that home equity lines of credit had actually decreased over the prior six months — the first such drop since 1999.

The second domino may well topple with the scheduled interest rate increases in adjustable rate mortgages.

The Mortgage Bankers Association estimates that up to $1.5 trillion of adjustable rate mortgages are scheduled to reset upward in 2007. And more of the same is in store for 2008. Because personal savings rates are already negative, higher monthly mortgage payments will necessarily decrease funds available to consumers for other spending.

The third domino — the wealth effect — refers to consumers spending a greater percentage of their income because they believe they have a higher net worth. Since a home is usually a person’s largest asset, its current value has a big impact on most consumers’ perceived wealth, and their spending habits.

The S&P/Case-Shiller home price index indicates national home prices have fallen about 1 percent since February 2006. The National Association of Realtors has predicted, for the first time since it has kept the statistic, that the median price for all U.S. homes will decline by 1 percent in 2007.

Others are more pessimistic. Economist Edward Leamer, of UCLA’s Anderson Forecast, predicts an annual national housing price decline of 2 percent to 3 percent in 2007. Given that 2.8 percent of all homes are now vacant — a record since the Census Bureau began compiling that statistic in 1956 — one can see why the pessimists might be right.

The fourth and final domino is just beginning to sway as the number of residential construction, real estate and mortgage finance jobs — which have increased greatly during the past six years — now are beginning to rapidly decline.

Membership of the National Association of Realtors has swelled by 500,000 since 2002, and more than 800,000 construction jobs were added from March 2004 to April 2006.

An analyst at Moody’s calculates that 200,000 housing-related jobs have already been lost since the peak of the housing market. An analyst at Citigroup estimates that 600,000 residential construction jobs, and an additional 300,000 manufacturing jobs tied to housing, will disappear in 2007. If the Citigroup analyst is correct, additional job losses in the mortgage finance sector could bring total housing-related job losses to over 1 million in 2007.

The culmination of these falling housing dominoes is the stagnation we are just beginning to see in consumer spending.
The Commerce Department’s report of weaker-than-expected consumer spending in March, the weakest since the fall of 2005 in the aftermath of Hurricane Katrina, appears to be the beginning of the consumer-led slowdown.

This is a warning sign that troubled times lie ahead for businesses that sell to consumers — especially in regions where once-robust appreciation in home prices has now reversed.

For example, automotive analysts found that 30 percent of automobiles sold in California in 2006 were financed with home equity loans. Now we see that retail auto sales declined 17 percent in California in just the first 10 weeks of 2007.

While corporate profits have soared in recent years, workers’ wages have not. From 2000 to 2005, real median family income actually declined in the U.S. Yet, consumers kept spending, temporarily boosted by cash from the housing boom.
While some commentators have castigated homeowners for being profligate, most homeowners were using their home equity to maintain their living standard, but that avenue is now largely closed.

So one must look at the overall recessionary risk to the economy from the gathering storm in the housing sector — a storm now being whipped into a potentially destructive whirlwind by higher interest rates, tighter credit standards, falling home prices, and corresponding contractions in consumer spending.

The weak employment report shows non-farm payrolls rose a mere 88,000 in April. The slowing economy is signaling a growing recession risk which could further accelerate the deflationary spiral now underway in the housing sector.
As these threatening events continue to consolidate, the Federal Reserve will need all the skill it can muster to make the monetary policy adjustments needed to avoid a full-blown recession.

Riegle is chairman of government relations for APCO Worldwide Inc., a global communications firm based in Washington, D.C. He is the former chairman of the Senate Banking, Housing and Urban Affairs Committee. Dzivi is a former counsel to that committee and currently heads his own law firm in Sausalito, Calif.