How Housing Has Affected the Economic “Ecology” May 2008 Paul L. Kasriel Director of Economic Research

This past cycle was accompanied by one of the biggest housing booms in the post-WWII era.

The housing boom played a major role in increasing employment The housing boom played a major role in increasing employment. The housing bust is now responsible for contracting employment.

The recent housing boom created an enormous amount of “paper” household wealth …

…which, in this cycle, households could more easily and cheaply borrow against.

This increased home-equity borrowing activity, along with corporate stock buybacks …

… enabled households to increase their consumption to a record high in relation to their after-tax income.

But now with home equity falling …

… with mortgage lending terms tightening …

… and with the unemployment rate rising …

… price-adjusted retail sales are contracting.

With the housing sector still contracting and the consumer sector beginning to, economic activity in other sectors also will slow.

Large and small business sentiment has soured, which will likely rein in “animal spirits” with regard to capital spending.

With unemployment increasing and retail spending slowing, commercial real estate vacancy rates are beginning to rise.

This augurs poorly for private nonresidential construction activity going forward.

Consumer price inflation has resurged in recent months, primarily because of sharp advances in energy and food prices.

The rate of increase in energy prices is likely to abate as the demand for energy moderates because of the global economic slowdown.

Food price increases are less likely to moderate much because of … increased demand from developing economies such as China and India the boondoggle for Midwestern corn farmers called corn ethanol low inventories of grains, in part due to droughts

With the unemployment rising and employee compensation already slowing relative to productivity, labor costs will not add to inflationary pressures.

In addition to food price increases, the biggest threat to higher inflation would be a continued weakening in the dollar.

It is important to recall, however, that inflation is a lagging economic process.

Not surprisingly, the housing boom resulted in a mortgage debt boom, with home mortgage debt rising to a record high percentage of total U.S. nonfinancial debt.

Home mortgage debt is now twice as large as U. S Home mortgage debt is now twice as large as U.S. Treasury debt held by the public.

Home mortgage borrowing rose to a record high percentage of GDP in this past cycle.

Despite outsized increases in property values, residential real estate reached record high leverage ratios in this past housing boom.

Contrary to conventional wisdom, commercial banks have a record amount of mortgage-related debt on their balance sheets.

Herein lies the problem – the collateral of the single largest debt class in the U.S. is experiencing perhaps its most severe decline in value in the post-WWII era.

And with still large excess inventories of homes, there is no relief in sight for home prices.

Although the largest credit problems are in the home mortgage market, distress is beginning to be signaled in the consumer loan and commercial real estate markets, too.

With nonfinancial corporate profits contracting and interest rates on high-yield corporate bonds rising, increased corporate bond defaults are likely.

Conclusions and implications: The current recession is likely to be more severe than the last because it will be concentrated in the household sector, which accounts for about 75% of real GDP. Because financial institutions will experience large losses across a wide spectrum of debt classes and because there is the likelihood of increased regulation, the financial system will be capital “impaired” at least through 2009. Even though the Federal Reserve is offering “cheap” credit to the financial system, financial institutions will have diminished demand for the Fed’s offer because they will not have the capital to support lending to the private sector. Thus, the economic recovery, which could emerge early in 2009, will be muted due to the relative lack of credit creation from financial institutions.

In the words of Mel Brooks: Hope for the best, expect the worst!