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Credit: A Starring Role in the Downturn
Òscar Jordà
FRBSF Economic Letter
April 16, 2012

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Credit is a perennial understudy in models of the economy. But it became the protagonist in the Great Recession, reviving a role it had not played since the Great Depression. In fact, the central part played by credit in the downturn and weak recovery of recent years is not unusual. A study of 14 advanced economies over the past 140 years shows that financial crises have frequently led to severe and prolonged recessions. Shining the spotlight on credit turns out to be crucial in understanding recent economic events and the outlook.

From the Great Depression until the fall of Lehman Brothers, the United States did not experience any large-scale systemic banking crises. Modern macroeconomic models generally omitted banks and finance. But that did not seem to be a problem as long as the financial sector remained reasonably stable. In the waning years of the 20th century, there was ample support for such models. In the United States, output grew 4% annually, inflation ran about 2%, and unemployment was around 4%.

The Great Recession upended this paradigm. Attention has focused once again on leverage and excess credit—the “Achilles’ heel of capitalism,” in the words of James Tobin’s (1989) review of Hyman Minsky’s book Stabilizing the Unstable Economy. Of course, this was not the first such rude awakening. Economic history is replete with financial crises that force economists to relearn the role that credit plays in their genesis and aftermath. This Economic Letter reaches back 140 years, examining the experiences of 14 advanced countries, to document the enduring influence of credit in the economic fortunes of nations. Credit is critical to correctly understanding current economic events. The Great Recession broke the mold cast in the typical post-World War II downturn. The recovery appears to be following a different model as well.

The march of economic history is punctuated by a few landmark events. One worth highlighting is the dramatic explosion of credit that followed World War II. Schularick and Taylor (2012) show that, up until then, real private lending had grown apace with economic activity. After World War II, and especially when the Bretton Woods international monetary system broke down in the early 1970s, credit grew at about twice the rate of output. The outsized role played by the financial sector in the past few decades has become a focus of controversy in studies of the recent crisis and the post-crisis period.

A cursory review of the 2008 global financial crisis lends support to the notion that excess credit was the culprit. Countries that experienced the largest credit booms, such as the United Kingdom, Spain, the Baltic States, Ireland, and the United States, are experiencing the slowest recoveries. Economies that entered the recession with comparatively low leverage, such as Germany, Switzerland, and emerging market countries, have emerged from the downturn quickly. This raises a question: Is excess credit always a bad thing?

Credit and the boom

It is easy to cast excess credit formation as the villain while memories of near financial catastrophe are still so fresh. However, there is an important counterargument that must be considered. To the extent that a sophisticated financial sector improves apportionment of resources and pricing of risk, credit can result in better economic outcomes. Research by Jordà, Schularick, and Taylor (2011) supports this view. This work uses the excess growth rate of real private lending relative to real GDP growth per capita as a proxy for leverage. It finds that periods with higher-than-average leverage tend to be periods of higher-than-average economic performance.

For all 14 countries over 140 years, when leverage is above average, economic expansions last about one-and-a-half years longer and the cumulative increase in output is 4% higher. Focusing just on the post-World War II period, the differences are even more pronounced. High-leverage expansions result in 38% accumulated gains in output, compared with 28% for low-leverage expansions. They last 9.7 years and produce average annual rates of growth of 3.4%, compared with 8.9 years duration and 2.4% growth rates for low-leverage expansions.

It is difficult to separate cause and effect. Does faster credit formation lead to faster growth or is it the other way around? Even assuming credit facilitates growth, are these gains enough to compensate for deeper recessions and the occasional financial crisis? Let’s first consider the type of recession that follows a credit binge.

Credit and the bust

Is the intensity of credit creation in the expansion phase systematically related to the severity of the subsequent recession? And is there a difference between how credit behaves in an ordinary recession versus how it performs in a recession associated with a financial crisis? The answers to both questions appear to be yes, and therein lie the lessons that can inform the economic outlook.

Broadly speaking, in a financial crisis, a large fraction of banking system capital becomes depleted. However, directly measuring such an effect can be difficult. An alternative is to look at the responses to capital depletion. Laeven and Valencia (2010) argue that, in a financial crisis, the banking system experiences significant financial distress that compels banking authorities to intervene. Examples of such intervention include liquidity support, guarantees on bank liabilities, asset purchases, nationalizations, restructuring, deposit freezes, and bank holidays. All these occurred after Lehman Brothers failed. Some were implemented even earlier, with the sale of Bear Stearns.

Jordà, Schularick, and Taylor (2011) find that, regardless of the genesis of the recession, more leverage results in deeper recessions and slower recoveries. Moreover, in financial crises, leverage is associated with a steeper and more persistent decline in consumption as households try to repair their balance sheets. Since consumption constitutes more than two-thirds of GDP, it is not surprising that losses in output follow a similar pattern.

Weakness in incomes and the process of deleveraging put downward pressure on prices, even in an environment of lower-than-normal interest rates that lasts several years. Looser monetary conditions take a long time to gain traction. During the first year of the recession, private real lending declines by a similar amount regardless of whether the genesis of recession is financial or nonfinancial. However, it takes on average about five years before lending approaches its pre-recession levels in recessions associated with financial crises, while lending usually recovers more quickly in nonfinancial recessions.

Simultaneous declines in the price and the quantity of credit are considered standard features of shrinking demand for credit. Such declines would be consistent with the behavior of consumption and prices noted earlier. However, Jordà, Schularick, and Taylor (2011) only collects data on interest rates for government securities, not for interest rates charged to private borrowers. Typical “flight to quality” responses of panicked investors into government securities and rationing of credit instead of market-clearing interest rates are examples of developments common in financial crises that can complicate credit trends.

In the current environment of lower-than-normal interest rates, it is perhaps investment, measured as a percentage of GDP, that has suffered the steepest and most persistent declines. Investment is the variable that fluctuates most over the course of the business cycle. Normally, investment recovers within two years of the start of the recession. However, it takes substantially longer, often several more years, for investment to recover in a financial recession. That has serious consequences. A slower pace of capital accumulation usually is detrimental to the long-run productive capacity of economies.

Lessons for the outlook

We are unlikely to learn how the United States will recover from the Great Recession by examining other post-World War II downturns. In the United States, the past six decades have completely lacked another financial event like the one experienced from 2007 to 2009. Two examples of how the economy has fared since the start of the 2007 recession illustrate this.

Figure 1 shows employment and Figure 2 investment in the 17 quarters following the start of the average post-World War II recession and the 17 quarters since the onset of the recent recession. These figures display how much more severe and prolonged the falls in employment and investment have been in the most recent recession and recovery, eclipsing anything else observed in the United States during the post-World War II period.

Importantly, a year into the recent recession, conditions did not seem substantially different than the average post-World War II downturn. But the financial crisis that followed the fall of Lehman Brothers appears to have extended the recession by an extra year and sunk the economy to extraordinary depths. Today employment is about 10% and investment 30% below where they were on average at similar points after other postwar recessions. Much of the slow recovery in investment is in structures and residential housing, as might be expected. However, investment in equipment has also rebounded somewhat more slowly than in previous recoveries.

What do the diverse histories of 14 advanced economies tell us? Quantifying the leverage built up in the 2001–07 U.S. expansion, we can compute how much the financial crisis is weighing on the recovery relative to the norm. Data on leverage leading up to the Great Recession and the Jordà, Schularick, and Taylor (2011) analysis suggest that, even years after the recession ended, economic performance should be subdued, as we are now experiencing.

Consequently, economic forecasts should take into account the effects of the recent financial crisis. Compared with the average U.S. post-World War II recession, the forecast for real GDP should be lowered 0.6–0.8 percentage point in 2012, 0.5–0.7 percentage point in 2013, finally returning almost to normal by 2014. Similarly, inflation forecasts should be revised down between two-thirds and a full percentage point over the next three years. Professional forecasters appear to be making these types of adjustments.

Conclusion

Any forecast that assumes the recovery from the Great Recession will resemble previous post-World War II recoveries runs the risk of overstating future economic growth, lending activity, interest rates, investment, and inflation. The data suggest that, this time around, credit cannot be considered a secondary effect. The interaction between the financial system and the real economy remains a weak spot of modern macroeconomic modeling. A careful analysis of 14 advanced economies over 140 years—data that extend far beyond the narrow post-World War II experience of the United States—reveals that the role of credit is sometimes central to understanding the business cycle.

Òscar Jordà is a research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco.

References

Jordà, Òscar, Moritz Schularick, and Alan M. Taylor. 2011. “When Credit Bites Back: Leverage, Business Cycles, and Crises.” FRBSF Working Paper 2011-27.

Laeven, Luc, and Fabian Valencia. 2010. “Resolution of Banking Crises: The Good, the Bad and the Ugly.” IMF Working Paper 10/146.

Schularick, Moritz, and Alan M. Taylor. 2012. “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870-2008.” American Economic Review. forthcoming.

Tobin, James. 1989. “Review of Stabilizing an Unstable Economy by Hyman P. Minsky.” Journal of Economic Literature 27(1), pp. 105–108.

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Source: Daily Infographic

Spring brings signs of hope and renewal — except in the housing market
Barry Ritholtz
Washington Post
April 7, 10:02 AM

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Ahhh, winter is finally over. Each year about this time, flowers push up through the soil, trees begin to bud — and the stories about a real estate recovery appear.

Am I skeptic? But of course. To understand why, let’s consider a few questions:

What is shadow inventory?

This is important, as lowering the total inventory of houses for sale is how prices stabilize and sales volume moves higher.

Most buyers are familiar with ordinary inventory — houses listed for sale with real estate agents or by owners. Unfortunately, shadow inventory adds to the backlog. It includes bank-owned real estate, distressed houses not yet for sale, short sales and delinquencies that have not yet defaulted. Foreclosure properties are also in the shadow inventory.

These houses will eventually become part of the total supply for sale. Although there is no official count, estimates of potential shadow inventory run as high as 10 million.

That’s not all. There’s also a huge overhang of underwater homeowners — whose houses are worth as much as 25 percent less than what is owed. The owners don’t qualify for a mortgage modification. They may be delinquent but aren’t in default.

Two-thirds of all U.S. houses have mortgages. Of those, an estimated 21 to 29 percent of the mortgages are underwater, or up to 16 million houses. When prices finally do rise, we can expect many of these no-longer-underwater owners to put their houses up for sale. If only one in three do, that is another 5 million homes in inventory.

Are houses affordable?

Here’s where every discussion of affordability seems to start: the National Association of Realtors Home Affordability Index. In my view, it’s worthless.

Why did I come to such a harsh conclusion? The index offers little insight into how affordable housing actually is. In the biggest run up in housing prices in American history, the index never dipped into the level of unaffordable. Imagine that.

As ridiculous as that sounds, it’s even more absurd when we look at the NAR methodology, which ignores factors such as family savings rates, cash assets, consumer credit, indebtedness, credit servicing obligations, inflation and income gains.

The affordability index looks at the wrong things and ignores the important ones. The correct question is not whether the houses are affordable in theory. Rather, it’s whether potential buyers can afford to buy them.

Why does this matter?

In the real world, buyers have to be able to meet two key financial factors: down payments and mortgages.

Today, most families are cash poor and debt rich. They are deleveraging, not building up savings. Most simply do not have the $40,000 to put 20 percent down on a median priced house.

If you happen to have a down payment, there’s another hurdle: Qualifying for a mortgage. You must have a good credit score, not too much debt, a steady income, good employment history, etc.

The simple truth: House prices are down 35 percent from their peaks and mortgage rates are at record lows, but for those lacking the down payment and /or ability to access mortgage credit, houses are only theoretically affordable — but not for them.

Are the prices cheap?

Few had forecast the steep drop in median house prices.

Some regions that were excessively frothy during the boom — California, Las Vegas, South Florida and Arizona — have seen much greater price drops. Other areas had laws (Texas) or financial conventions (New York City) that mandated significant down payments and other prudent requirements and avoided much of the bloodshed.

The conventional wisdom seems to be that prices have stabilized and are overdue to start rising. The data, however, suggest something else. The most recent Standard & Poor’s / Case-Shiller index of national prices (January) shows prices are still falling, about 4 percent year-over-year.

There are some favorable factors:

• Prices are falling more slowly than they had been earlier.

• Nationally, house prices are back to where they were in 2003.

• The median prices of renting vs. buying now favor buying.

It’s not terrific progress, but it’s a marked improvement over three years ago.

What is the psychology of renting?

As the chart shows, costs of owning vs. renting are back to where they were in 1997, 1988 and 1976. The context is obviously different today. However, this is a favorite metric to show that houses are not all that expensive.

While rentals look less appealing as they go up in price, the other side of the equation is simple mean reversion. By most other metrics, house prices have nearly reverted to the mean.

The relationship between median income and median purchase price is yet another crucial factor, as any buyer who has a down payment and qualifies for a mortgage must earn enough to pay the mortgage.

And therein lies the rub: Real incomes have been mostly flat for a decade. Without real income growth, buying power simply remains flat. As you might imagine, that does not help price recovery in residential real estate.

House prices relative to income have come back down nearly to the mean. The uptick in 2009-10 was based on the first-time buyer tax credit. Once that expired, the prices dropped again.

So prices remain slightly elevated relative to where they have been historically. The variable, of course, is mortgage rates. The Fed’s zero interest rate policy is keeping mortgage rates at unprecedented low levels.

How do asset prices behave following a bubble?

Regardless of the asset class — stocks, bonds, commodities, houses, etc. — assets do not merely stabilize. We have never seen a stock market run up into bubble territory and then revert to fair value. Instead, we careen wildly past that level, to deeply undersold and exceedingly cheap.

That is the marvelous mechanism of markets. It is how assets are repriced, distressed holdings liquidated, capital markets stabilized, fools revealed, speculators punished — and money returned to its rightful owner, the prudent investor.

For a lasting recovery, we need to see houses cheap enough that they fall into “good hands” — long-term owners who can afford their mortgage payments.

Until that happens, houses will stumble along the bottom of the price range. The nation could easily see another 10 percent to the downside — assuming nothing else goes wrong.

This would actually be good news. The government interventions (first-time buyer tax credit, mortgage modifications and foreclosure abatements) have prevented prices from finding their own levels. If they did, houses would be much more affordable, and buyers would come out in droves.

That is how a true housing recovery begins.

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Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. @Ritholtz

Why should just banks have all the fun? Former FDIC Chair Sheila Bair proposes EVERYONE get access to the Fed window for free loans and 0% money.

Her gleeful take:

“Under my plan, each American household could borrow $10 million from the Fed at zero interest. The more conservative among us can take that money and buy 10-year Treasury bonds. At the current 2 percent annual interest rate, we can pocket a nice $200,000 a year to live on. The more adventuresome can buy 10-year Greek debt at 21 percent, for an annual income of $2.1 million. Or if Greece is a little too risky for you, go with Portugal, at about 12 percent, or $1.2 million dollars a year. (No sense in getting greedy.)

Think of what we can do with all that money. We can pay off our underwater mortgages and replenish our retirement accounts without spending one day schlepping into the office. With a few quick keystrokes, we’ll be golden for the next 10 years.”

I had no idea Shelia Bair had such a wonderfully wicked sense of humor!

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Source:
Fix income inequality with $10 million loans for everyone!
Sheila Bair
Washington Post April 13, 2012  
http://www.washingtonpost.com/opinions/fix-income-inequality-with-10-million-loans-for-everyone/2012/04/13/gIQATUQAFT_story.html

It is important to distinguish between leveraged and unleveraged non-bank lenders, both investors and both implicitly “shadow banks”.

Leveraged non-bank lenders are ultimately part of the regular banking system, not the shadow banking system. When a leveraged investor, such as a hedge fund, buys a loan directly or buys a bond (i.e. makes a loan), it funds the purchase of that loan in the banking system. Any recognized or unrecognized loss on that loan first hits the equity of investors in that fund. The bank lender to the fund continually ensures that the fund maintains adequate equity against the fund’s aggregate loan book, which means that investors in the fund take first loss. If interest rates rise and bond prices decline or if the fund loses money and investors redeem their capital, then the aggregate value of the fund’s portfolio should reflect the market value of the loans in the bank funding its positions (which in turn would hit the value of the bank’s assets). So, from a theoretical and practical perspective, non-bank lenders borrowing to make loans are simply conduit lenders of the banking system.

Alternatively, when an insurance company or mutual fund buys a bond it is a loan that is fully reserved. The unleveraged fund does not borrow to purchase the bond, as does a bank or leveraged investor. Any recognized or unrecognized loss on that loan must be immediately valued as a loss to, say, Pimco’s fully-funded fund and, in turn, to the investors in Pimco’s fund that wired cash to fund their investment. Thus, the loan Pimco made is fully-reserved and there is no risk to the banking system (albeit there is risk to investors and, if widespread enough, risk to the aggregate economy). This means that fully-funded investors disintermediate the banking system at their own risk, not at the risk of depositors or taxpayers (as is the case with “too big to fail” banks).

Last we looked, there was approximately $19.5 trillion in US bank assets (and almost $10 trillion in deposits) reserved by about $1.6 trillion. Globally, the ratio was about the same; approximately $95 trillion of bank assets reserved by about $7.5 trillion. Thus, banks are fractionally reserved at about 8%-9% of their loan books. Obviously, any losses in their loan books requires offsetting hits to their reserves. In the current environment it wouldn’t take much of a shift in bond values for system-wide bank insolvency. (Where is the risk again, in the shadow banking system?)

Finally, leveraged entities, either bank or non-bank, may borrow $1,000 from the Fed (directly or indirectly) at near 0% and purchase $10,000, $20,000, $50,000 US Treasury notes at 2%. Since the Fed has declared it has my back by targeting short rates near zero for at least through 2014, I have incentive to clip coupons and make 10%, 20%, 50% (almost an infinite return on capital). By the way, doing so funds Treasury…and Congress. It’s a win/win right? Banks and levered bond funds fund the government and their end-of-year bonuses are a lock.  (Pay no attention to the grossly false economic signal benchmark “risk-free” interest rates are sending to economists and tertiary bond and stock markets.) There’s no conspiracy here; only blatant incentives.

Lee Quaintance & Paul Brodsky
QB Asset Management Company, LLC
pbrodsky@qbamco.com

See also: 60 Minutes, An Imperfect Union: Europe’s debt crisis

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My Sunday Washington Post Business Section column is out. This morning, we look at the annual premature housing recovery.

The print version had the full headline The eternal optimism of spring — except in housing; the online version had the longer Spring brings signs of hope and renewal — except in the housing market).

Here’s an excerpt from the column:

“Ahhh, winter is finally over. Each year about this time, flowers push up through the soil, trees begin to bud — and the stories about a real estate recovery appear.

Am I skeptic? But of course. To understand why, let’s consider a few questions . . .

Which of course, we do, looking at shadow inventory, affordability, and valuation.

I like the way the Post put heavy emphasis on the Ned Davis Charts in the print edition:
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Source:
Spring brings signs of hope and renewal — except in the housing market
Barry Ritholtz
Washington Post, April 8 2012
http://www.washingtonpost.com/barry-ritholtz-on-investing-house-prices-are-down-mortgage-rates-are-low-but-is-the-real-estate-market-ready-to-rebound/2012/04/05/gIQAnveZzS_story.html

Washington Post Sunday, April 8 2012 page G6 (PDF)

Over at this month’s Esquire, they have a long diatribe titled The War Against Youth.

Spread throughout the piece are these various graphics which I imagined would look better if we could assemble them into one long infographic.

So we did — the full graphic after the jump.
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Read the rest of this entry »

All this week, we will be looking at the Housing Recovery meme, challenging the assumptions and data that make up that argument. Yesterday, we began with Debunking the Housing Recovery Story (Part 1 of 5). Today we look at exactly how affordable homes are today, as well as the home buying public’s ability to afford them (Home Affordability/Employment & Wages).

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Today, we are going to take a closer look at Home Affordability — and we learn that homes are not in fact very affordable at all.

We begin where nearly every other conversation about home affordability seems to start — with the National Association of Realtors (NAR) Home Affordability Index.

We first looked at this index back in August 2008, in a post appropriately titled NAR Housing Affordability Index is Worthless. Why did I come to such a harsh conclusion?

“The index as presently constructed is utterly worthless. It provides little or no insight into how affordable US Housing actually is . . .  As hard as this might be to imagine, it shows that over the course of the biggest run up in housing prices in American history, the Index remained perfectly affordable. Except for one monthly reading of 99.55 in late 2005 — a smidge below 100 — housing never dipped into the level of unaffordable over the entire giant housing boom.”

So the entire run up preceding a 35% drop in prices, the NAR HAI had but one month where homes where not deemed affordable. As ridiculous as that sounds, its even more absurd when we take a look at the NAR methodology:

“The index ignores factors like family savings rates, available cash assets, consumer credit, indebtedness, credit servicing obligations, inflation, income gains, and mortgage availability.”

The kindest thing I can say about the Affordability Index is that it lacks context. Hence, it looks at the wrong things and ignores the important ones. The question is not whether, in the abstract  homes are theoretically affordable; Rather, the correct question is whether potential buyers can afford homes. Ignoring this as it does means this is a meaningless metric for assessing the most important question of all when it comes to a US housing recovery: Whether or not people living in America can afford to purchase homes located in the same nation.

Sure, houses in the US are affordable to cash-rich Martians visiting Earth looking for a place closer to the Sun. But, not surprisingly, little green men with lots of cash are not what will be driving any US housing recovery. We can say the same about cash-rich Asians and South Americans (and any Europeans assuming the Euro is still around).

Why does this matter?

In the real world, the home buying process begins with two key financial factors: The potential buyers down payment, and their ability to qualify for a mortgage.

In today’s world, most American families are cash poor and debt rich. They are deleveraging, not saving. They simply do not have the $40,000 that is the standard 20% down payment on the median priced US home.

Those that do have the extra cash must then meet the next hurdle: Qualifying for a mortgage. This means they must have a good credit score, not be carrying too much debt, have a steady income, etc. (Even those that qualify must then make sure that their house appraises at the sale price, but that’s a latter discussion).

Regardless of the fact that homes are off 35% from their peaks, and mortgage interest rates at record lows, buyers have an insurmountable hurdle. For most potential home buyers, the NAR Home Affordability Index is a meaningless data point. Lacking any down payment and having restricted access to available mortgage credit, homes may be theoretically affordable — just not to them . . .

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Tomorrow: The problem with Mortgage Rates

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Previously:
NAR Housing Affordability Index is Worthless (August 13th, 2008)

See also:
NAR: Methodology for the Housing Affordability Index