Recession Scenarios

On March 23, the Federal Deposit Insurance Corporation, which insures bank accounts in the United States, issued a report: "Scenarios for the Next U.S. Recession." On the whole, this was more forthright than most published reports by quasi-government agencies.

Before deciding how relevant this FDIC report is, check the latest shape of the interest yield curve. When the 90-day T-bill rate is higher than the 30-year T-note rate for 30 days, this is a very good indicator of a looming recession. Check here.

The FDIC panelists warned about the situation in the housing markets.

A large, long-term increase in consumer indebtedness has raised concerns that the next U.S. recession could originate in the household sector. The housing boom of recent years has resulted in a surge in new consumer debt, most of it in the form of mortgages.

In the first six years of this decade, the net increase of household wealth has been $5 trillion. This increase is enormous. American households, feeling wealthy, have cut back on their rate of savings . . . to zero, then negative. They are living inside their own savings accounts. Home owners see on paper that they are worth more money, and they assume "this real estate market is normal." But it isn’t normal. The condition of the housing market is unusual, to say the least.

Moreover, the increase in net housing wealth during the first half of this decade alone was two to three times as large as the gains posted during each of the prior two decades.

Despite the abnormality of this market, home owners are complacent. They see their homes as ATMs.

Although some new buyers have put very little down on their home and thus have accumulated little equity, many longtime homeowners have accumulated significant additional equity that remains untapped.

This increase in the market-imputed value of housing has persuaded residents that they are rich, that they need not save for retirement or anything else.

During recessions, households tighten their fiscal belts. They cut spending and begin saving more. This makes money available for capital construction and hiring. Thus, in the two years after most recessions end, economic growth is rapid and sustained. But the 2001 recession broke with this pattern.

Because Greenspan’s Federal Reserve poured money into the economy, cutting the federal funds rate from 6% to 1%, this capital accumulation phase of the recession was retarded. The recovery has therefore been the most anemic on record.

Furthermore, the housing market soared in response to the FED’s low interest rates. This makes the present situation unique, the panel concluded.

Historically, recessions have provided an opportunity for households and businesses to retrench and rebuild balance sheets that might have become strained late in the previous expansion. The response of businesses during the 2001 recession provides a classic example in this regard as investment, spending, and hiring activities were curtailed sharply from their heady, late-1990s pace.

The consumers felt wealthy because of the increase in the price of housing. They refused to cut spending.

In part because of the wealth-offset provided by housing, however, the long jobless recovery following the 2001 recession did not weigh heavily on the consumer sector. Consumers did slow their pace of spending growth in 2001 and 2002, but spending growth never fell below a 1 percent annual pace in any quarter, and in no quarter did it actually decline. By contrast, during the early 1990s recession, consumer spending declined for two straight quarters. At this point in time, however, the consumer sector has not experienced a real recession in 15 years.

The final sentence is worth considering. Consumers have not experienced a real job-threatening, gut-wrenching, savings-promoting recession in 15 years. They are totally confident today.

This has changed the mentality of consumers. They are not afraid of a turndown in the economy. They are convinced the government can and will protect them from adversity.

In some sense, this long recession hiatus itself raises concerns. Consumers have gradually become more indebted over time – so much so that they are now spending more in aggregate than they earn, resulting in the much-lamented negative personal savings rate.

In the classic child’s fable of the grasshopper and the ant, the grasshopper has a great summer but a bad winter. Greenspan decided to become the star of a re-make of Bruce Brown’s 1966 surf movie classic, The Endless Summer.

The personal savings rate may turn out to be a bit of a statistical anachronism in an economy where so much spending is driven by the accumulation of wealth rather than current income. Even so, home prices will not boom forever. Even a moderation in home-price growth would reduce the amount of new home equity added to the economy each year. This slower accumulation of wealth, coupled with rising interest rates that increase the cost of tapping that wealth, could soon begin to curtail the pace of U.S. consumer spending growth. Just as there has been a positive wealth effect from soaring home prices in recent years, the concern is that an end to the housing boom could result in a slowdown in consumer spending growth. However, it is important to keep in mind that such an outcome would likely play out over several years, as happened during the boom.

So, the panel is concerned about a long, slow decline in consumer spending. This in turn would slow the overall economy. This is another way of saying that the next recession could be far longer than the typical post-World War II recession that lasted a year.

DEBT, NOT PRODUCTIVITY

The report noted this amazing fact: The public’s increase in debt in 2005 was greater by far than its increase in after-tax income.

It is very likely that housing wealth has been a significant factor behind growth in consumer spending. Through the use of cash-out refinancing, increased mortgage balances, and greater use of home equity lines of credit, as well as through owners selling homes outright and cashing in on their accumulated equity, it is estimated that anywhere from $444 billion to $600 billion was liquidated from housing wealth during 2005. Whichever estimate one uses, the total almost surely eclipses the $375 billion gain in after-tax income for the year.

Now the sword of Damocles is beginning to swing. The FED has adopted policies that have raised short-term interest rates. This has led to rising rates for annual renewable mortgages (ARMs). The new buyers with bad credit who were extended these loans are now trapped. Rising rates mean rising monthly mortgage payments.

Meredith Whitney noted at the roundtable that the recent use of revolving home equity lines of credit in lieu of down payments has enabled an increasing number of first-time buyers to qualify for homes that they otherwise could not afford.

Overall, Ms. Whitney’s research suggests that a group that includes approximately 10 percent of U.S. households may be at heightened risk of credit problems in the current environment. This group mainly includes households that gained access to mortgage credit for the first time during the recent expansion of subprime and innovative mortgage loan programs. Not only do many borrowers in this group have pre-existing credit problems, they may also be more vulnerable than other groups to rising interest rates because of their reliance on interest-only and payment-option mortgages.

Think about this. Ten percent of mortgage payers may soon be in trouble. The threat of default by these people is growing.

The new bankruptcy law does not allow most of them to escape if they wind up owing more than the house can obtain in a foreclosure sale. But creditors will find that the cost of hiring lawyers to pursue these people will exceed the assets owned by these people. Nevertheless, the debtors’ credit ratings will be ruined for years.

Having said all this, the report says banks are in fine shape to weather the next recession. The problem is, the economy may not be.

CONCLUSION

The economy has been dependent on savings from foreign investors, including Asian central banks, for its growth. Consumer spending has increased, not by increasing productivity, but by debt. The American consumer is convinced that the bills will not come due, that he can tap into his home’s equity at low rates at any time. Save? Why?

This is transferring ownership of American capital and claims on future payments (bonds) to foreigners. Americans are de-capitalizing themselves. The central bankers of the world have spotted their marks, even as drug pushers in public high schools spot their marks. Americans are their marks. The "buy now, pay later" philosophy is gone. Today, it’s "buy now, pay never."

But, as the grasshopper learned, winter eventually comes. He can sing "the world owes me a living" all summer long, just as he sang in Disney’s 1934 version of the famous fable. But the world doesn’t owe him a living. Neither does the world owe us a living.

Summer isn’t endless. Also, killer waves eventually wipe out those surfers who refuse to paddle back to shore when the paddling is good.