US house prices and economic recovery

Recent commentators have suggested that house prices have a ways yet to fall, and that these further declines will lead to a further collapse in US output, potentially lengthening and deepening an already severe global downturn.  But while this US recession was kicked off by the sub-prime crisis, even the large declines in housing wealth that we have seen are not enough by themselves to explain the severity of the current downturn.  Let me explain why.

First, my comments are prompted by the following somewhat alarming figure (via Chad Jones):

Note: By nearly any measure, the appreciation of home prices between 2000 and 2006 was quite unusual. Source: Robert Shiller, Historical housing market data (Click on graph to get the Excel file)

This figure suggests that house prices may have a ways yet to fall.  (Of course, they may not; new home sales are up three months in a row, and we may have been correct in at least some of our past arguments for the appropriateness of high house prices.)  But while further declines would not be good news, they would be more a symptom of recession than a cause.  That is, while initially a small decline in house prices caused the current major recession, continued moderate declines would probably not have similar recessionary effects. In short, this is because the systemic weaknesses that amplified a housing price decline into a major recession have been significantly reduced.

Looking back to mid-1997, when the sub-prime crisis began, estimates of the total losses on sub-prime and alt-A mortgages were around 500 billion (this includes assuming all subprime debt outstanding lost half its value). At the time, this was about 3% of the value of the stock market, so most people thought the effects of this crisis would be small.

And initially it was.  But only until the fall of 2008, when the ramifications of the decline in house prices hit the financial sector with a fury.  Then it became clear that the decline in house prices was being amplified into a major recession by the global financial infrastructure.  When asset-backed securities lost money, so did banks and many financial institutions, and, especially after the fall of Lehman, investors saw the increased risk in funding financial institutions and, lacking sufficient expertise, largely stopped funding them.  During the 2000’s, banks, hedge funds, and corporations had become much more reliant on overnight funding provided largely by money market mutual funds. When Lehman fell, interest rates in these commercial paper markets increased and lending volume fell precipitously.  Unable to continue to borrow to invest, investors —banks, SIV’s,  and hedge funds—had to sell assets.  This massive desire to sell lowered the prices of these assets and thus the value of the collateral that many investors were using to borrow, leading to still more withdrawal of lending and in turn more selling.  As consumer demand fell, as firms cut back, and as the recession deepened, loans were not repaid and banks had little capital and many faced bankruptcy.  The U.S. stock market lost half its value in 2008.

Now, however, the exposure of the financial system to declines in house prices is much lower.  First, throughout the financial system, leverage is much lower.  There are no more structured investment vehicles hidden off the balance sheets of banks and holding mortgage-backed securities.  Second, we have large policy responses in place.  The Federal Reserve and Treasury are providing liquidity to keep the commercial paper markets lending, and the major banks have been largely recapitalized and have been stress-tested (although I think these tests were rather soft).

And markets reflect these factors.  Interest rate spreads are down to near pre-crisis levels.  Banks are trying to wean themselves from TARP.  And we see new funding channels opening rapidly as investors develop and draw on expertise at valuing investment projects that before they simply invested in without valuation.  All this while house prices continue to decline. Thus, further declines in house prices are thus unlikely to have similarly bad effects.