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Monday January 19, 2009

US home prices the most vital indicator for turnaround

CONSENSUS is emerging that the current global recession will be one of the worst since the Great Depression (1929-1933) but when will the turnaround happen?

Before we can determine a useful economic indicator signalling a turnaround, we have to understand the causes of the current crisis. In a nutshell, the current crisis was caused by excessive debt used to create an asset bubble.The US savings rate has been falling since the early 1990s but the debt bubble surged when Fed funds rate was cut to only 1% in 2002 in an attempt to pull the economy out of recession caused by the bursting of the Nasdaq bubble and 9-11.The authorities even encouraged higher gearing by investment banks when the 15 times gearing limit for investment banks was removed in 2004. Mortgage debt surged by almost 300% from the beginning of 1997 till the end of 2007.

The debt bubble created a corresponding asset bubble, the largest being the housing bubble which saw the real prices of houses rising by 83% between 1997 and 2006.

It was a giant debt ponzi scheme abetted by financial institutions keen on earning fees from loans and repackaging the mortgage debt into high yielding asset-backed securities, some of which were backed by subprime loans.The debt ponzi scheme could go on as long as house prices were rising. In fact, rising house prices allowed US consumers to borrow more on their homes and sustain their spending even as savings as a percentage of disposable income averaged below 1% in 2005-2007.By the end of 2007, the debt to gross domestic product (GDP) in the United States had reached 350% and consumer debt had exceeded 100% of GDP, a level that is highest in US history, surpassing even the Great Depression levels. Mortgage debt amounting to US$10.5 trillion represents the largest single component of total US debt totaling a massive US$51 trillion.

Unfortunately, the law of diminishing returns also applies to debt. The higher the debt, the lower the benefit derived from additional debt as the new debt will be used to service existing debt and presumably to buy overpriced assets.

The beginning of the end started in July 2006 when home prices peaked. The subsequent fall in prices started to hurt subprime borrowers in 2007 and financial institutions holding securities backed by declining mortgage assets. The margin for error for highly geared financial institutions is slim due their high gearing.When Lehman failed, it had a gearing of 33 times. That means that if the assets it holds decline by just 3.3%, its capital will be wiped out. As long as home and other asset prices continue to decline, banks will continue to require new capital and will be reluctant to lend. This has triggered a vicious cycle of deleveraging which has further pushed down home prices.The bottom will come when US home prices stabilise. This will only happen when prices have declined enough for homes to be considered cheap. To-date, banks have suffered losses amounting to US$1 trillion and close to 7.6 million home mortgages, or around 25% of total US mortgages, have negative equity (home values less than mortgage debt).

A good indicator to monitor the bottoming of home prices would be the Case Shiller index which measures the home prices of 20 metropolitan areas in the United States. The index peaked at 206.5 in July 2006 which means that home prices have doubled since the index was started in January 2000 which coincided with the beginning of unsustainably sharp home price appreciation.

It has since fallen 22% to 161.6 in September 2008. As can be seen from chart 1, home prices in real terms have not risen much since 1890 which means that home prices track inflation over the longer term.Adjusting for inflation, home prices should have risen 30% from the beginning of 2000, indicating a Case Shiller index of 130. This means that home prices in the US could fall by a further 20% before fair values are reached.Of course, it could undershoot before recovering. A 20% decline in prices could wipe out close to US$4 trillion from US home values estimated at US$20 trillion at the end of 2007 and could put a further dent in the balance sheets of global banks. With the bursting of the debt and accompanying asset bubble of mega proportions, it can only mean an atypical global recession which is likely to be the worst since the Great Depression.However, we at least have a measure of when the carnage will end and this is when the Case Shiller index gets closer to 130, possibly at the end of 2009 or early 2010 if US home prices declines by around 1.5%-2% a month. (Source: The Star Online, 2009) 
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