The U.S. Housing Crisis and the Risk of Recession. 1. Recent Developments in the U.S. Housing Market Falling Housing Prices

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1 Economic Spotlight ALBERTA FINANCE Budget and Fiscal Planning March 4, 2008 The U.S. Housing Crisis and the Risk of Recession Summary The worsening U.S. housing slump is spreading to the broader economy and lending markets. Declining housing prices and tighter credit conditions could further adversely affect consumer spending and economic growth. The magnitude of the impact of housing slump on consumption, combined with lower construction activity and multiplier effects on investment and income could be enough to drag the U.S. economy into recession. 1. Recent Developments in the U.S. Housing Market Falling Housing Prices The average U.S. house price gained 62% from January to its peak in March From the March 2007 peak to December 2007, the average price declined almost 1. The growth in housing prices before 2006 was very strong, and the contraction since 2007 has been sharper than during the recession. As a result, the current decline in home prices could have a more severe impact on the economy than the recession. Chart 2 suggests that the price appreciation in housing markets was more concentrated among lowpriced homes than highpriced homes. This suggests 15% 12% 6% 3% 0% -3% -6% Chart 1. Growth Rate of U.S. Home Price Index Source: Standard and Poor's Chart 2. U.S. Home Price Index for Low-, Middle-, and Highpriced Homes Low priced Middle priced High priced Source: Standard and Poor's

2 that the growth of subprime loans was an important driver of home prices before Rising Mortgage Burdens U.S. household mortgage payments have risen significantly since as a result of higher housing prices. As shown in Chart 3, mortgage payments in the U.S. as a percentage of household income rose from 9.1% in the first quarter of to 11.8% in the fourth quarter of 2006, although the conventional mortgage rates decreased during the same period. The last time we saw this type of development in mortgage lending was before and during the recession. As shown in 12% Chart 3, the household 11% mortgage burden peaked in 10% the third quarter of 1991 and then sharply decreased followed by a significant 8% housing-market contraction. As the mortgage burden increased and the growth in 7% 6% 5% home prices slowed, homeowners lost the ability or incentive to pay off their mortgage, thus setting off a mortgage crisis. 86Q1 Chart 3. Mortgage Rate and the Ratio of Mortgage Payments to Household Income in the U.S. Share of mortagage payments 87Q2 88Q3 89Q4 91Q1 92Q2 93Q3 94Q4 96Q1 97Q2 98Q3 99Q4 Source: U.S. Federal Reserve Conventional mortgage rates 01Q1 02Q2 03Q3 04Q4 06Q1 07Q2 2. Direct Impact of the Contraction in Residential Construction on Economic Growth Since 2006, the housing slump has directly dampened U.S. economic growth. According to the U.S. Bureau of Economic Analysis, the contraction in residential construction reduced U.S. GDP growth by 0.2 in 2006 and 0.97% in 2007, even though the residential construction sector represented only around 5% of the economy. Chart 4. Contributions from Residential Construction Sector to U.S. GDP Growth 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% -0.8% -1.0% -1.2% Source: U.S. Bureau of Economic Analysis This drag on economic growth contrasts sharply with trends between and, when residential construction significantly boosted economic growth. Declining housing prices and tighter credit conditions could further adversely affect the residential construction sector and economic growth. 2

3 3. Impact of U.S. Housing Slump on Consumption and Growth Falling home prices and rising foreclosure rates are also expected to cut back consumer spending. The overall impact of the housing slump on consumption is the combination of two effects the traditional wealth effect and the relatively new and growing phenomenon of mortgage equity withdrawal (MEW). Wealth Effect of Housing Prices on Consumption Most economists believe that a decrease in home values reduces consumer spending both now and in the future - the so-called wealth effect. An increase in housing wealth reduces the need for homeowners to save for the future, allowing them to spend more than they otherwise would have spent. A decline in housing wealth is expected to have the opposite effect Q1 Chart 5. U.S. Housing Prices and Consumption Housing Price Index 97Q2 98Q3 99Q4 01Q1 Personal Consumption / Disposable Income 02Q2 03Q3 04Q4 06Q1 07Q2 Source: U.S. Bureau of Economic Analysis and Standard and Poor's 98% 96% 94% 92% 90% There are indications that U.S. housing prices and consumer spending are closely linked. As housing prices surged between late 1990s and early 2006, consumers boosted their spending faster than their income rose. Personal consumption as a share of total disposable income rose from 92.3% in the first quarter of to 96.2% in the third quarter of Since the housing slump began, the consumption share has decreased to 95.8%. Lower Housing Values Tighten MEW In recent years, U.S. households have been extracting more housing wealth through home-equity loans and cash-out mortgage refinancings. Because home-equity loans and mortgages are collateralized, homeowners can borrow more cheaply and housing wealth becomes more accessible. This suggests another channel, in which housing wealth could affect aggregate consumption. Studies have found that increases in housing prices can promote consumption because of the increased collateral value of housing, and its associated relaxation of borrowing constraints. As housing prices rise, homeowners then take more money out of their housing wealth for consumption. This credit channel impact of 7% 5% 3% 1% -1% 1994 Chart 6. Mortgage Equity Withdrawal and Saving Net equity extraction / disposable income U.S. Bureau of Economic Analysis and U.S. Fedearl Reserve 3 Saving rate 88%

4 home prices on consumption can be measured by looking at net mortgage equity withdrawal (MEW), which is defined by the U.S. Federal Reserve as the discretionary initiatives of homeowners to convert equity in their homes into cash by borrowing in the home mortgage market. Rising housing values result in higher MEW. If higher housing wealth really relaxes consumer borrowing constraints, households facing the constraints would spend a larger fraction of the increase now and a smaller amount in the future. As shown in chart 6, since the early 1990s there has been a strong negative correlation between the U.S. personal saving rate the net mortgage equity withdrawal. U.S. personal saving rates have been falling since the early 1990s as higher home values and financial innovations enabled homeowners to more easily tap housing wealth. However, this high consumption may not be sustainable if homeowners wealth declines or increases less rapidly, and a decline in home prices might significantly reduce consumption and GDP growth, at least in the short run. Estimated Impacts of Housing Prices Declines on Consumption and GDP Growth According to the U.S. Congressional Budget Office (2007), most empirical estimates of the wealth effect of housing price are within a range of around 2 to 7 cents of spending per extra dollar of housing value. 1 That is, a $1000 decrease in housing prices could reduce $20 to $70 of spending this year and in each future year. The study also finds that if nationwide home prices fall by 10%, the decrease in housing wealth would raise the saving rate by 0.2% to 0.7% and reduce consumption by $55 to $191 billion (Table 1). In this scenario, U.S. GDP growth could decrease by 0.4% to 1.4%. In addition to the wealth effect, some economists also find that mortgage equity withdrawal could significantly affect consumer spending. An IMF study (2006) suggests that each dollar of MEW promotes consumer spending by about 18 cents within a year. 2 Another study by Goldman Sachs (2006) finds that consumers spend between 29 and 39 cents of each dollar of MEW in the year they withdraw the equity. 3 However, other economists (e.g. Belsky and Prakken, ) find that mortgage equity withdrawal has little or even no impact on consumption after accounting for the wealth effect. 4 A Congressional Budget Office study finds that after adding in a small effect of MEW (assume that each dollar of MEW only promotes consumer spending by about 2 cents), a 10% decrease in nationwide housing prices could directly reduce consumption by $103 to $316 billion and decrease GDP growth by 0.7% to 2.2%. The magnitude of these impacts, combined with lower construction activity and multiplier effects on investment, income, and spending, could be enough to drag the U.S. economy into recession. 1 See Housing Wealth and Consumer Spending, U.S. Congressional Budget Office Background Paper, January See Vladimir Klyuev and Paul Mills, Is Housing Wealth an ATM? The Relationship Between Household Wealth, Home Equity Withdrawal, and Saving Rates, IMF Working Paper No. 06/ See Jan Hatzius, Housing Holds the Key to Fed Policy, Global Economics Paper No. 137, Goldman Sachs, February See Eric Belsky and Joel Prakken, Housing Wealth Effects: Housing s Impact on Wealth Accumulation, Wealth Distribution and Consumer Spending, prepared for the National Association of Realtor s National Center for Real Estate Research, 4

5 Table 1. Estimated Impacts of Housing Price Declines on Saving, Consumption, and GDP Growth Scenario The Range of Effect on Personal Saving Rate The Range of Direct Effect on Consumption The Range of Direct Effect on GDP Growth 2% Price Decline +0.2% to +0.7% -$21 to -$72 billion -0.1% to -0.5% without MEW Effect 10% Price Decline +0.5% to +1. -$55 to -$191 billion -0.4% to -1.4% without MEW Effect 10% Price Decline with +1.0% to +3.1% -$103 to -$316 billion -0.7% to -2.2% Moderate MEW Effect* Source: U.S. Congressional Budget Office (2007) * Assume that each dollar of MEW results in less than 2 cents of consumer spending. Conclusion: The prolonged U.S. housing slump has been a drag on the overall economy since In addition to its direct impact on the construction sector, the weakness in housing has been spreading to consumption and other parts of the economy. The housing and credit woes have significantly raised the risk of a U.S. recession. 5

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