Every day, another economist claims that
the impact of the slowdown in housing on the US
economy has been overstated; a few months ago,
many still disputed that there even was a housing
bubble. There has been a housing bubble, the
bubble has only started to deflate, and it may
have very negative long-term implications for the
US economy as well as the US dollar.
Almost every day, a high-profile company
directly or indirectly targeting the US consumer
warns that its outlook is bleak. Let it
be
Yahoo warning about advertising revenues; let it
be Dell's warning that its eternal rebate programs
cannot push sales any more; or let it be the
automakers that sell many of their brands at
prices below last year's level, yet are still
unable to boost volume. All these incidents are
linked to the US consumer; and US consumer
spending, in turn, is very closely linked to the
health of the housing market. It also comes as no
surprise that so far this year, the US dollar has
fallen significantly versus a basket of
currencies.
Home-building activity has
collapsed, with some builders reporting as many as
half their orders canceled. The volume of homes
sold has declined and inventories are up. Home
prices have - so far - held up reasonably well,
mostly because the cost of long-term mortgages has
been reasonable; while short-term interest rates
have risen, interest rates on longer-term loans
have in some instances even come down.
As a
result, the squeeze on consumer spending has been
relatively mild and limited to a squeeze on
homeowners who have been dependent on adjustable
rate mortgages who have seen their rates rise;
beyond that, the squeeze has been on home owners
who have employed their homes as automated
teller machines - these owners are
dependent on eternally rising home values to
finance their spending.
By
keeping inflation expectations low and the threat
of an economic slowdown high, the Federal Reserve
(Fed) has engineered an environment where
homeowners have the opportunity to move out of
adjustable-rate mortgages into longer-term,
fixed-rate mortgages.
The Fed publishes a
"Financial Obligations Ratio" (FOR) that tries to
capture all forms of debt service payments from
lease payments on cars and other debt service
payments such as mortgage payments as a percentage
of disposable income. Please have a look at the
chart, which divides this ratio into debt service
payments due to mortgage payments and those due to
other consumer spending (the total FOR would be
the sum of the two, not shown); the chart also
shows the Fed Funds Target Rate, which the target
interest rate the Fed charges other institutions
for overnight lending. At the time of this
writing, data have only been published through the
end of the first quarter of 2006:
As
interest rates were declining from 2001 until
2003, a gradually increasing portion of disposable
income was spent on servicing debt. This may sound
counter-intuitive, but was the result of a
coordinated effort by the Fed and the
administration to keep consumer spending through
low interest rates and low taxes. Despite the
corporate recession caused by the bursting of the
tech bubble and the tragedy of September 11, 2001,
consumer spending remained robust. What was
happening is that ever more purchases took place
on credit, the total debt burden (not shown on the
graph) steadily increased.
Now look on the
right hand side of the graph, and you see that as
interest rates creep up, the percentage of income
spent to service mortgages has been going up.
Aside from higher interest rates, home values
continued to rise during this period.
Many say American consumers are hopelessly addicted
to spending. We disagree - Americans during the Great
Depression and the generation that grew up during
these years were great savers. American consumers
are far more rational than they are given credit
for: it is the policies in place that have
fostered consumption ad absurdum. If you look at
the right hand side of the chart, you will see
that as debt service payments for mortgages
continue to climb, the allocation made for
consumer goods is beginning to come down.
Because housing has held up reasonably
well, we so far experience the "soft landing"
scenario so many have been praying for. We often
emphasize how dependent the US economy is on
consumer spending. Economist Kurt Richebacher put
this in perspective: "In 2005, real disposable
incomes of private households in the United States
increased $93.8 billion, or 1.2%, while their
debts grew $1,208.6 billion, or 11.7%. Total
consumer spending on goods, services and new
housing accounted for 92% of real GDP growth."
Unlike the stock market,
the housing market is far less liquid; as a
result, the unwinding of the housing bubble takes
years. The "wealth effect" - the impact paper profits have
on household spending - is far more significant in
the housing market than it is in the stock market.
The conclusion to draw is that we are in for a
long and grinding road ahead.
Let us tie
in the dollar to the discussion. The boosting of
household spending through low interest rates and
low taxes has left its marks; the trade and
current account deficits have soared, the dollar
has not fared well:
These days,
foreigners need to acquire more than $2 billion
worth of US dollar-denominated assets every single
day, just to keep the dollar stable; we do not
need foreigners to sell US dollars for the dollar
to be under pressure, we just need them to buy
less. With the US economy slowing down, there is a
chance that the trade deficit is topping out as we
have to slow down consumption of imported goods.
But there is also a major risk that
foreigners will reduce their investments in the
US: it is that risk that policy makers are so
concerned about. Already corporate America is
investing its cash abroad as it sees better
opportunities overseas. As a further deterioration
in the housing market signals the way into
recession, where will foreigners invest their
money?
We believe that we have only seen
the beginning of the fallout of a slowing housing
market. As inventories of unsold homes increase,
home prices are likely to come down significantly
in many parts of the country. Because consumers
have so much more debt outstanding than in past
economic cycles, the drag on economic activity
will be amplified.
In the meantime, we
see the financial services sector engaging in
more speculative activity. Blue chip firms
are acquiring sub-prime mortgage lenders, such
as Merrill Lynch paying $1.3 billion this
month to get $7 billion worth of risky loans onto
their balance sheet. Merrill would refuse managing
the savings of the mortgage holders, but is gladly
taking on their debt; in an environment where just
about everyone could get a mortgage, you must be
in rather bad financial shape to resort to apply
for a mortgage with a sub-prime lender.
This particular lender Merrill
acquired, the nation's 10th-largest, issued almost $30
billion in mortgages last year. The attraction in
the business is the securitization of the
mortgages into collateralized mortgage obligations
(CMOs) and the resulting segmentation into various
securities. It is an open secret, however, that
this is a very obscure market dealing in at times,
very risky products that may not be well
understood, sometimes not even by the issuer.
In our view, just as investment banks are
eager to load up their balance sheet with hot
potatoes, a scandal waiting to happen is building
in the mortgage industry. To make home ownership
more accessible, many sub-prime lenders have
offered mortgages where only a fraction of the
interest is paid each month, and the remaining
interest is rolled into the principal. In other
words, each month, your mortgage is growing; the
hope is that higher home values will bail the
homeowner and the bank out.
Needless to
say, the holders of such mortgages typically make
little or no deposit. Why do lenders get engaged
in this sort of activity? Partially because the
promised yield is attractive and these hot
potatoes can be passed on. But, and here is the
scandal, the bank can also record the full
interest income each month, even if the homeowner
only pays a fraction; because it is part of the
terms of the mortgage that the homeowner only pays
a fraction of the full interest, the mortgage is
considered to be in good standing and the full
interest is recorded as income. Of course, the
balance sheet of the bank deteriorates, but as
long as Wall Street is more focused on earnings
than balance sheets, this is a very attractive
business.
Some lenders are getting leery
that the market may not play along forever.
Washington Mutual, one of the largest financial
institutions in the US and a major player in the
adjustable rate mortgage market, recently opted to
issue 20 billion euros (about $25.4 billion) of
debt in Europe; Europe has a long tradition of
large "secured debt" offerings, where mortgages
are packaged for resale; continental Europe has
not seen the distortions that have been created in
the US housing market. We would not be surprised
if there was one day a rude awakening that risks
in these products may be higher than anticipated.
Even if long-term interest rates remain
low, it may well spell trouble for a growing
number of homeowners. For homeowners to refinance,
their homes need to be re-appraised. With a lot of
arm-twisting, appraisers gave their nod of
approval, so that homeowners could get access to a
mortgage. But there comes a point when home values
decline that appraisers simply cannot endorse
unreasonable home valuations anymore.
At
that point, homeowners are stuck with their
current mortgage, possibly an adjustable-rate
mortgage. Homeowners may also not be able to
afford to move away as selling their homes would
not cover the mortgage. In an era where too many
homeowners have opted to pay no money down, have
closing costs rolled into the mortgage and likely
even taken out an equity line of credit to finance
the remodeling, this affects many homeowners.
There are those who say there is nothing
to worry about because there is a large group of
homeowners with fixed-rate mortgages with stable
incomes. Prices are not set by those who do not
sell; prices are set by supply and demand. And
supply has been increasing, providing pressure on
home values.
When Treasury Secretary Henry
Paulson says that the US must help the Chinese
master their growth as it would be to its peril
not to do so, what he means is that we cannot
afford a slowdown. If we were suddenly to turn the
US into a nation of savers (rather than consumers
of imported goods), we could expect the dollar to
recover. But because the housing market will have
a worse impact on the economy than many
anticipate, we expect the Fed to try to "rescue"
the economy.
With commodity prices coming
down and long-term interest rates falling, the
fear of deflation is back on the table. Fed
chairman Ben Bernanke is known to see grave
dangers in deflation; before becoming chairman, he
commended Japan on its ultra-loose monetary
policy; he has also written in-depth about the
Great Depression and identified the gold standard
and too strong a dollar as an impediment to
economic recovery.
In conclusion, we see
the housing market slowdown signal an upcoming
recession. We see the dollar at risk should
investments in the US decrease faster than
consumption slows. And we see substantial risks to
the dollar once it becomes apparent that the Fed
will come to the perceived rescue of the economy.
Even with gold under pressure in the short
term, investors in gold firmly believe that the
Fed will have to opt for growth rather than price
stability. As numerous asset classes may be at
risk in the environment ahead, shifting money out
of the dollar into a basket of hard currencies may
provide valuable long-term diversification.
Axel Merk is the
portfolio manager of the Merk Hard Currency Fund, a no-load mutual fund that
invests in a basket of hard currencies from
countries with strong monetary policies assembled
to protect against the depreciation of the US
dollar relative to other currencies.
(Copyright 2006 Merk Hard
Currency Fund. Used
by permission.)
