Let's just say home prices drop in such a way that is appropriate to describe it as a national decline of 10% which I think would be a big number. I'm not sure that this impacts the wealth effect in a broad-based manner. Here is what I mean, I do not know exactly how much my house is worth. What I do know if that a cabin close to here with a much smaller lot than us in a house that is very similar to ours sold for $310,000 in September. A week later another cabin, that would need a lot of work but had a nicer lot sold for $349,000. Shortly thereafter a third property with a slightly lesser cabin (needs a new roof) than ours and a comparable lot sold for $309,000.
Let's say that back in September we could have sold our cabin for $335,000 (the reality of this does not matter, let's just say we could have). Now let's say that today we could only get $301,000, about a 10% decline. The numbers in this scenario would not change our consumption habits at all. We never pursued selling our house so we don't know what it was worth before and we don't know now. How many other homeowners in the country have no plans to sell, did not know what their house was exactly worth three months ago and won't know exactly three months from now?
Obviously a 10% decline would impact some folks but the question I am asking is whether the perceived impact is overstated.
One reader asked what type of things to own if a recession comes. I have written about this quite a few times. While the following is not comprehensive it covers a lot of ground; foreign stocks from countries that don't rely on exporting to the US, gold, currency exposure, foreign bonds, domestic stocks whose products have inelastic demand, AA and higher preferred stocks to name a a few.
Another reader left a few questions including what I meant in past posts when I talk about things that act like bonds most of the time but are not bonds. One example would be the call writing funds. I used to write about these more often, I think the concept is great but I only expose 3-4% of client accounts to them-they have their potential flaws too. Many clients (and me too) own Macquarie Infrastructure Trust (MIC). The Alpine Funds (open and closed end), although I don't use them in a meaningful way, might work in this context. I wonder if some of the Rydex currency ETFs fit the bill. More often than not they don't move a lot, the last two weeks notwithstanding, and a couple of them have a nice yield.
The same reader also asks whether you need to own ordinary shares, as opposed to ADRs, to capture the effect of that country. I write about this all the time, as recently as a few days ago in fact, and the answer is no. ADRs absolutely capture the effect.
Here is an example similar to what I used last week in the post about OMX group. The stock is National Australia Bank. The red line is the ADR, the blue line is the ordinary share traded in Oz, the green line is the benchmark ASX 200 index and the black line is the Australian dollar/US dollar exchange rate.Do you think it captures the effect? I would say yes. The ADR has outperformed the ordinary share because the Aussie is up against the green back. Notice in June when the Aussie was flat for a few weeks the ADR and ordinary traded in exact lockstep and in late March when the Aussie was down against the green back it was the ordinary that outperformed.
14 comments:
Roger.
What do you think about investing now in a falling dollar fund such as FDPIX?
Is there a similar play available in an ETF?
as a trade? after a huge move, by currency standard, in that direction?
I'm inclined to say no.
As a diversification tool in a diversified portfolio yes but you may not be happy with the first couple of percent-again the context is as a counter strategy though.
One ETF provider is working on this in ETF form, no news yet. I don't know if the firm working on it is public info so I have not named them here.
The numbers in this scenario would not change our consumption habits at all. We never pursued selling our house so we don't know what it was worth before and we don't know now.
Economists would note that they're talking about marginal changes of aggregate consumption: If just about everyone finds out that their house is worth less, it can either a) Increase consumption, b) Have no effect, or c) Reduce consumption. It's pretty clear that a) is unlikely, and since people fund at least some consumption from home equity loans and mortgages, b) isn't a given, either. Which leaves falling consumption as the only reasonable possibility.
It's likely that the effect will be most pronounced when people save more and spend less entirely because they don't see their homes as stable investments any more. It won't be dramatic, and it won't be universal, but if you tease out enough of the extraneous variables, it'll be there.
I heard a significant %(something like 40%) of houses were bought as investment in recent years. It is like having bought a long-dated call option on the house. For a practical purpose this is a pretty good analogy.
By putting up only 10% of the price of a house, you are hoping the market will give you 100%return on your down payment if the house goes up by 10% next year.
However, if the price of the house drops 10% instead, your equity after selling the house and paying the loan becomes zero. If I bought an extra house just for investment, I would probably want to sell this losing proposition quickly.
I believe the above analysis(quick and dirty to say the least)suggests the imapct of housing price drop could be more significant than most people ever imagined! Once the price of houses begins to drop, more selling will ensue!
40% of all houses sold, if correct, is not 40% of all houses that exist.
Of all the houses in the country what percent of them have been sold in the last fill in whatever time period you think is relevant.
I don't know the number of how many houses have sold nationally in, say the last three years.
Calculated Risk at http://calculatedrisk.blogspot.com/ has a number of posts on this Roger, the latest two of which address your question; e.g., "inventories of existing homes are at about 5% as a percent of total owner occupied units. This is an all time record, and is well above the median inventory levels of 3% of owner occupied units." There is also a neat little slap at Motley Fool's analysis of the real estate market in the latest post that may amuse you.
I agree with those commentators who think there will be a 'spillover' of housing deflation/inventory overhang and investment loss into the rest of the economy. However I'm not aware of any analysis that successfully makes a case for the degree of spillover and/or impact on consumption one way or another. In the absence of a convincing analysis one is probably just as warranted in assuming the effects will remain local and small as they are in assuming the effects will become nationally noticeable with concomitant impact on confidence leading to amplification of a downturn into a recession. I do not think the equity markets have priced in the latter possibility regardless.
The answer lies in how one prefers to balance risk and reward rather than in a single 'right' answer I think (the 'right' answer will be revealed in time of course). My own take is that risk is elevated and the probability of reward much reduced; i.e., current risk premiums are entirely insufficient to compensate for the probability of significant capital loss. That requires a more defensive posture in my case. The mileage of others will vary, as they probably should.
10% reduction in home price does not matter to you or me, BUT many people who borrow against their home to finance spending will be affected.
So a 1 or 3% reduction in spending could occurr. This is big.
thanks RW for the data. an extra 2%? can that really be the deathblow some fear?
to the 9:55 anon,
so if someone takes out a MEW instead of $50,000 maybe now they can only get $45,000?
$5000 times how many future MEW borrowers? Isn't home ownership something like 60% of the population? Is the population excluding childern maybe 225 million? So 135 million people own? So figure 2/3 of that number is couples makes for what I think might be 89 million households to potentially borrow against equity.
Despite all the attention do even 10% of home owners have actually have MEW balances? How many of those folks will actually be damaged by a decline?
The bank does not want anyone's house. A person that can make their payments makes for a good loan.
For folks who are over leveraged, they could get hurt any anytime.
Still I have to wonder if a worst case scenario is a general dislocation not a distaster/calamity/crumbling of the American way.
The primary threat of a home price turndown is psychological. It can transform a spendthrift society into a frugal one.
I have read studies about the underlying causes of such transformation in Japanese society since the early 1990s. Home price reduction is a primary cause because home equity could no longer be used as the main source of savings to support future expenses such as future tuition payments, retirement needs, and unforeseen contingency needs. Japanese society felt impelled to save discretionary income rather than spend it.
As time went on, and Tokio homes that sold at $800,000 sold for $600,000, then $400,000 and less, more and more people realized that home price depeciation was a continuing trend.
As far as I can estimate Roger, that 2% represents approximately 1.5 million existing homes. Not a huge number in national terms and the fact that they aren't selling quickly only tells us what we already know: many residential real estate markets are cooling. Still, inventory of existing homes is growing fairly quickly though: about 2.3 million in 2003 vs. about 3.9 million in 2006 (estimated to end of year).
Personally I think this is a situation where the tails of the curve aren't very 'fat': The probability of a Japanese style deflationary meltdown is low on the one hand and the probability that other factors such as capex will compensate for the real estate slowdown and/or that the most affected real estate markets have already bottomed and will rebound quickly is also relatively low on the other hand (could be a bit fatter than the other end of the curve though).
None of which really addresses the key spillover into the broader economy question.
IOW, your thesis is not unreasonable IMO, but absent the (relatively) improbable tails there is still a fair amount of area under the curve.
Regarding the wealth effect...I would agree that if my home value were to drop 10%, then I would be oblivious. But I've been in the same home for 21 years. I don't think I could afford my home if I were buying it now.
What I would like to know is the contractual structure of these recent loans and what provision, if any, was stipulated for LTV ratios.
Let's remember that increasing increasing interest rates are affecting all of those with home equity loans with a variable %--so that hits a broader swath of folks than just those who have bought a home, but rather large amount of re-fi's. The interest rate on my own unused equity line has increase 40% in the last 12 mos. Moreover, insurance rates and property taxes have increased greatly with increases in underlying assessed values (such a way to enhance local coffers where there is a real estate tax).
So where the decline in value may not have a psychological value (except for those on the edge who bought an investment property looking to flip it s-t and to the extent that it does not create a loan default), the increased home carrying costs (debt, insurance, taxes) certainly has to have an ouch factor.
I think that the holiday season will be telling. It will be the final confirmation of all of us who've been trying to divine to what extent the consumer has been/will be hit.
I think that most people have some general idea of the value of their homes at any given time. However, more than that, a lot of people know that the value has risen by 20%, per year, over the past three years "... it's crazy" they'll say when the neighbors talk.
But, in my view, this is what creates excess spending and what reins it in later: a perception that the value of the mortgage becomes a much greater/lesser percentage of the home's value. The actual numbers are less important than the perceived strength of the trend, and it's duration and the amount of money owed, relative to the asset value.
Jay Walker
The Confused Capitalist
There have been a number of studies on the wealth effect of assets. There is probably no one real good number, but 4% seems to pop up a lot.
In an advanced country like the US, real estate would be about 300% of GDP.
So a 10% drop in real estate pricing might be expected to have a .1*.04*3= 1.2%
In addition construction makes up about 11% of the overall GDP on average. About 70% is residential.
Since Construction is one of those inelastic supply versus elastic demand a 10% drop in pricing could easily lead to a 20% drop in construction. So call that another 2% drop to GDP.
So you are looking at a very conservative 3% drop in GDP relative to the current trend.
Jay Walker makes a good point, let me add a brief scenario based on the kinds of things that are happening now.
Your neighbor across the street has just sold her home for 300K, a 20% increase from last years comparables and you are pleased (even though you know what it's going to do to your land taxes next year). Then you discover she had to offer an incentive of a remodeled kitchen and bath ($60K value) and a carry back loan at lower interest to close the deal: Sale price does not include this, comparables and price growth in your neighborhood will still look great but you now suspect your property is worth less than you realized and that equity line you took out to help maintain your standard of living in the face of unexpected health expenses may be closer to the bone in consequence. What is your inclination when the wife says, "isn't it time we got a new car?"
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