Sunday, October 27, 2013

The Most Important Information on the Stock Market, Credit Market, Macroeconomy, and Federal Reserve (September/October 2013)

Articles on the Federal Reserve, macroeconomy, overall market, and strategies:

4 Out Of 5 Valuation Methodologies Agree: The "Market" Is Overvalued (Goldman Sachs' charts) (Zero Hedge, 10/26/2013)

When Hyman Minsky Runs For The Hills: Japan Central Bank To "Own" 100% Of GDP In 5 Years (Zero Hedge, 10/19/2013)

Almost No Risk Is Priced Into Financial Markets, And There's Virtually Nothing On Investors' Radar (BAML charts) (Business Insider, 10/22/2013)

Bubble watching, with SocGen's Albert Edwards (FT Alphaville, 10/23/2013)

JPMorgan's Tom Lee on housing's growth rate, jobs, the economy, interest rates, QE etc... (Bloomberg TV, 10/14/2013)

Dan Loeb's Third Point Returns 10% Of Capital Amid "Concerns About The Global Economy" (Zero Hedge, 10/22/2013)

Richard Koo: I Can't Find Anyone To Refute My Argument That America Is In A 'QE Trap' (Business Insider, 10/23/2013)

Richard Koo: Forget Hyperinflation — The Fed Is Now Facing The True Cost Of Quantitative Easing (Business Insider, 9/25/2013)

IMF Warns Japan About Using Monetary Policy as Crutch (WSJ, 10/23/2013)

Norway’s Sovereign Wealth Fund Shuns Stocks on Reversal Bet (Bloomberg, 10/25/2013)

AAII Sentiment Survey: Pessimism at Lowest Level since January 2012 (Pragmatic Capitalism, 10/24/2013)

Goldman: "Weaker Than Expected" Jobs Report Means No Taper Before March (Zero Hedge, 10/22/2013)

Goldman: Entire S&P Move Higher Is Due To Multiple Expansion; Shiller P/E Says 30% Overvalued So... Buy (Zero Hedge, 10/19/2013)

David Tepper: Fed won't taper for 'a long time' (CNBC Video, 10/15/2013)

Tepper: Looking for normal stock multiples (CNBC Video, 10/15/2013*sees P/E of 18-20 at some point with a 4% interest rate and 2.75% growth rate

Ray Dalio says Japan needs another "big round" of stimulus (Reuters, 9/7/2013)

Where does the Future of Investments Lie? Ray Dalio on the Japanese & World Economies (Japan Society Video, 9/6/2013) *he's particularly bearish on France

Central Banks Drop Tightening Talk as Easy Money Goes On (Bloomberg, 10/23/2013)

Comparison to an earlier period of accommodative monetary policy (Sober Look, 10/24/2013)

You Can Thank Ben Bernanke for 100% of the Stock Market Gains Since 2009 (Forbes, 10/17/2013) *"RT @boblenzner: Stock Prices Have Risen Every Week the Fed Bought Bonds Since 2009"

Jobs Report Keeps Fed on Hold for Now (WSJ, 10/22/2013)

Philadelphia Fed's October 2013 Business Outlook Survey (phil.frb.org, 10/17/2013)

Indicators Suggest Continuing Expansion

The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, edged down from 22.3 in September to 19.8 this month (see Chart). The index has now been positive for five consecutive months. The percentage of firms reporting increased activity this month (36 percent) was greater than the percentage reporting decreased activity (16 percent).

The demand for manufactured goods, as measured by the current new orders index, increased 6 points, to 27.5, its highest reading since March 2011. Shipments continued to expand: The index fell 1 point to 20.4, following a 22 point increase last month. The diffusion indexes for inventories, delivery times, and unfilled orders were all positive and higher than last month.

Labor market indicators showed improvement this month. The current employment index increased 5 points, to 15.4, its highest reading since May 2011. The percentage of firms reporting increases in employment (23 percent) exceeded the percentage reporting decreases (8 percent).
Six-Month Indicators Reflect Optimism

The survey’s future indicators have suggested markedly improved optimism among the reporting manufacturers in recent months. The future general activity index increased 3 points, from 58.2 to 60.8, exceeding its previous highs since the end of the recession in 2009 (see Chart). Slightly over 63 percent of firms expect increases in activity over the next six months; only 2 percent of firms indicated that they expect decreases over the next six months. The indexes for future new orders and shipments also remained at relatively high levels. Over 67 percent of firms expect increases in new orders and 57 percent of firms expect increases in shipments over the next six months. The future employment index fell 4 points; however, nearly 37 percent of the firms expect to increase employment over the next six months.


Updates on Canada, the UK and Eurozone:

Three Charts That Make Us Scared For Canada's Future (Business Insider, 10/10/2013) *Percent of Labour Force Employed in Construction; Residential Construction as a Percentage of GDP; Household Debt-to-Income Ratio versus the U.S.

Three Charts That Show Why Canada’s Future Is Bright (Business In Canada, 10/14/2013)

Citi forecasts Greek devastation, unstoppable debt spirals in Italy and Portugal (The Telegraph, 10/24/2013)

Martin Wolf on the contained depression (Macrobusiness.com.au, 10/19/2013)

UK jobless total falls by 18,000 to 2.49m (BBC, 10/16/2013) *"almost 1.5 million people were part-time because they could not find full-time jobs, the highest figure since records began in 1992."


China watch:

China Major Cities Home Prices Jump, Fanning Bubble Concerns (Bloomberg, 10/22/2013)

Hong Kong Home Prices to Drop 30% as Barclays Joins UBS, Merrill (Bloomberg, 10/28/2013) *added

Top China Banks Triple Debt Write-Offs as Defaults Loom (Bloomberg, 10/23/2013)

China steps up market reforms with new prime lending rate (Reuters, 10/25/2013)

Looming China debt crisis resurfaces as a market fear (MarketWatch, 10/23/2013)

Hidden debt must still be repaid (China Financial Markets / Michael Pettis, 10/22/2013)

China Seeks Clearer View of Government Debt Mountain (WSJ, 10/20/2013) *"Local Governments Have Borrowed a Pile of Money in Recent Years, Leaving Even Beijing Wondering How Much"

Report Warns of Chinese Municipal Debt Risks (NYT, 9/26/2013)


Updates on U.S. housing, rent inflation, farmland, the credit market, oil, employment, and household savings:

Magnetar Goes Long Ohio Town While Shorting Its Tax Base (Bloomberg, 10/21/2013)

Blackstone Unit Wins in No-Lose Codere Trade: Corporate Finance (Bloomberg, 10/22/2013) *Loans/Credit Default Swaps

High-End Houses Lure Flippers From New York to California (Bloomberg, 10/17/2013)

63% of International Buyers Pay Cash (NAR, 10/17/2013)

Families With Kids Go Homeless as U.S. Rents Exceed Pay: Economy (Bloomberg, 10/18/2013)

The dark side of rising rental costs in the US (Sober Look, 10/19/2013)

Blackstone Funding Largest U.S. Single-Family Rentals (Bloomberg, 10/23/2013)

ABS market is on a roll again (Sober Look, 10/20/2013*subprime auto loans

LBO Multiples: The Latest Credit Bubble 2.0 Record (Zero Hedge, 10/26/2013)

What do CLO managers and retail investors have in common? (Sober Look, 9/24/2013)

Citi: Loans Not Always Immune To Rising Rates (Barron's, 10/8/2013)

Fed Loan Warning May Hurt Riskiest Borrowers, Trade Group Says (Bloomberg, 10/25/2013) *Leveraged Loans

DOJ probes nine banks on mortage-backed securities -FT (Reuters, 10/23/2013)

Bank of America to eliminate up to 4,200 mortgage jobs (Reuters, 10/24/2013)

Wells Fargo: Middle Class Americans Face a Retirement Shutdown (BusinessWire, 10/23/2013)

CHARLOTTE, N.C.--(BUSINESS WIRE)--As U.S. lawmakers engage in an ongoing fight over how and when to pay the country’s debts, more than half the middle class (59%) are very clear that their top day-to-day financial concern is “paying the monthly bills,” an increase from 52% in 2012. Saving for retirement ranks a distant second place, with 13% calling it a “priority,” as four in ten middle class Americans (42%) say saving and paying the bills is “not possible.” As a result, 48% are not confident they will be able to save enough for a comfortable retirement, and 34% of the middle class say they will work until they are “at least 80” because they will not have saved enough for retirement, up from 25% in 2011 and 30% in 2012. These results come from the latest annual Wells Fargo (NYSE:WFC) Middle Class Retirement study, a telephone survey conducted by Harris Interactive of 1,000 middle class Americans between the ages of 25 and 75 and interviewed July 24 to August 27, 2013.

The Grim Math of the Working-Class Housing Crisis (The Atlantic, 10/22/2013)

Farmland bubble? 10-year rise raises red flags; Price rally faces ‘moment of truth’ as tailwinds become headwinds (MarketWatch, 10/21/2013)

Rail Traffic Growth Hits New 6 Month Highs (Pragmatic Capitalism, 10/25/2013)

Oil’s $5 Trillion Permian Boom Threatened by $70 Crude (Bloomberg, 10/24/2013)

Reasons behind the sell-off in crude oil (Sober Look, 10/23/2013)

U.S. Shale-Oil Boom May Not Last as Fracking Wells Lack Staying Power (Bloomberg, 10/10/2013)

Machines Trading $400 Billion of Bonds as Humans Retreat (Bloomberg, 10/15/2013)

Credit default swaps run out of road (FT, 10/15/2013)


JCP Watch:

Fairholme Buys J.C.Penney Debt, Fannie And Freddie Preferreds In Q3 (ValueWalk, 10/28/2013) *added

Hedge Fund Manager Kyle Bass Bets on a J.C. Penney Stabilization (Institutional Investor, 10/18/2013*"We're not investing in a turnaround. We're investing in a stabilization."

J.C. Penney CDS Spreads Spike, Reflecting Ongoing Strife (Fitch Ratings, 10/24/2013)

Penney Stress Could Pressure U.S. Malls But Not CMBS (Fitch Ratings, 10/24/2013)

JC Penney Bonds Fall; Sell Short And Buy Long? (Imperial Capital on JCP's bonds) (Barron's Income Investing, 10/21/2013)

JCPuking All The Way To Penneystock Status / JCP's CDS spiked (Zero Hedge, 10/21/2013)

JC Penney: Shares Worth a Buck? (Barron's Stock Action, 10/21/2013)


Federal Reserve/Janet Yellen:

Janet Yellen Exposed - The Truth Behind The Myth (Zero Hedge, 10/17/2013*Peter Schiff video. He went through her 2005-6 speeches. 

Here were Janet Yellen's views on the housing and credit markets in 2007 from her speech transcripts at the San Francisco Fed. She (and the Fed) finally understood what was happening in September of 2007. Of course by then it was way too late.

September 2007 (9/10/2007 and 9/28/2007)

The ostensible trigger seems to have been concern about growing delinquencies on subprime mortgages. There are legitimate and serious concerns about the extent to which subprime delinquencies are traceable to predatory lending practices and a deterioration in underwriting standards over the last few years. However, some of these delinquencies arguably resulted from environmental changes—rising market interest rates, as the Fed removed accommodation in the stance of policy, and intensifying weakness in housing markets, which slowed or reversed the long-standing trend of significant house-price appreciation.

In this new environment, borrowers with variable-rate mortgages have started to see their rates reset much higher than they may have expected, and most borrowers have seen their home equity building up much more slowly than expected or even shrinking. Among these are some—many in the subprime category—who were barely able to make the original terms of their mortgages, in part because these loans incorporated features like “piggyback” loans to cover down payments, loans requiring low or no documentation, interest-only loans, and adjustable-rate loans with the option to make reduced payments for a time resulting in negative amortization. For many of these borrowers, particularly those who bought homes during 2005 and 2006, the environmental changes have been enough to push them to delinquency or default.

While the problems with subprime mortgages have understandably received a lot of attention, it is important to remember that the whole subprime market itself is only a relatively small part—10 to 15 percent, depending on the exact definition—of the overall mortgage market. How, then, could problems in this relatively small market infect so much of the financial sector, and possibly real economic activity? The answer appears to lie in the characteristics of some of the complex financial instruments that have been developed as a means to diversify and spread risk. These instruments include not only mortgage-backed securities, including subprime mortgages, but also CDOs—collateralized debt obligations that package bonds, including mortgage-backed securities—and CLOs—collateralized loan obligations that package business loans—and a variety of associated derivatives, such as credit default swaps and indices based on such swaps. These instruments are obviously very complex, which makes them difficult to understand and evaluate, not only for the average investor, but even for sophisticated investors. In particular, it is difficult to determine the risk embedded in these instruments and how to price them.

Investors have relied on a variety of means to assess their exposure to them—from high-powered mathematical models to agencies that assign ratings to them. But models are, at best, approximations, and, because these instruments are relatively new, there were not necessarily enough data available to estimate how they would do under the stress of a downturn in housing prices or economic activity. As for the rating agencies, once recent developments began to break, they quickly began announcing sharp downgrades, which intensified awareness of the uncertainty surrounding the risk characteristics of many of these instruments.

As delinquencies have risen in the subprime market, the complex instruments associated with those mortgages have come under question. Moreover, questions have arisen concerning the underwriting standards used by financial firms that received fees to originate and package mortgages for sale rather than holding them for their own account. In consequence, holders of these securities, many highly leveraged, have been forced to sell into illiquid markets, realizing prices that are substantially below their model-based estimates, or to sell liquid assets as an alternative. Significant losses have been realized in the process.

Once other investors saw how quickly and unpredictably such markets could cease to function well, those who used similar complex instruments likely grew concerned about how quickly and unpredictably their own exposures might change for the worse, leading them to pull back, too. One might say that these developments bring us back to Latin 101 and the root of the word “credit.” The root is “credo,” which means “I believe” or “I trust”—that is, investors’ belief was shaken, both in the information they had on the degree of risk these instruments embodied and in the price they were going for, and they are pulling back from these markets, presumably until they understand these instruments well enough to restore that belief.

Even with corrections to credit underwriting standards, it still may turn out that these innovations don’t actually spread risk as transparently or effectively as once thought, and this would mean—to some extent—a more or less permanent reduction of credit flowing to risky borrowers and long-lasting shifts in patterns of financial intermediation. It also could mean an increase in risk premiums throughout the economy that persists even after this turbulent period has passed. In a speech I gave a few months ago, I focused on the phenomenon of low risk premiums in interest rates throughout the world.2 In fact, there was considerable debate about what might be causing the very low price for taking on risk. What we are seeing now could be the beginning of a return to more normal risk pricing. As such, this development would not be disturbing for the long run. However, as we are seeing, the transition from one regime to the other can be quite painful.

The Fed has three main responsibilities that pertain to these developments: promoting financial stability to help financial markets function in an orderly way, supervising and regulating banks and bank holding companies to ensure the safety and soundness of the banking system, and conducting monetary policy to achieve its congressionally mandated goals of price stability and maximum sustainable output and employment. With regard to its responsibilities for financial market stability, the Fed recently lowered the discount rate by 50 basis points and encouraged banks to borrow at the discount window, emphasizing the broad range of collateral that is acceptable for such loans. Such collateral includes mortgage-backed securities and asset-backed commercial paper that have become illiquid.

As a supervisor and regulator of banks, the Fed has long focused on insuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil. The Fed is carefully monitoring the impact of recent financial developments on the banking system and on core institutions involved in the payments system. Importantly, the Fed’s supervisory role has facilitated the collection of timely and reliable information on developments in banking and capital markets, and the insights gained through this process have been critical in shaping the Fed’s response in recent weeks.

For the conduct of monetary policy, the main question is how recent financial developments and other economic factors affect the outlook for the U.S. economy and the risks to that outlook. The reason this is the main question is that monetary policy’s unswerving focus should be on pursuing the Fed’s mandated goals of price stability and full employment. Monetary policy should not be used to shield investors from losses. Indeed, investors who misjudged fundamentals or misassessed risks are certain to suffer losses even if policy is successful in keeping the economy on track.

July 5, 2007

Of course, a big drag on growth over the past year has come from residential construction. Housing is likely to remain an important source of weakness, so let me take a few moments to discuss it in detail. The cooling in the housing sector has, of course, been in part a response to a rise in financing costs. Interest rates on variable-rate mortgages have risen in recent years along with other short-term rates. However, until a few weeks ago, traditional fixed mortgage rates were actually down somewhat from their level at the beginning of the Fed rate tightening in mid-2004. With the recent increases, these rates now also are up. I should note that higher borrowing costs are not the only explanation for the recent cooling; it’s likely that it also is a drop in demand that will be reflected in a necessary correction in house prices after years of phenomenal run-ups that ultimately proved to be unsustainable.

Since the end of 2005, activity in this sector has contracted substantially. Indeed, over the past four quarters, the level of residential investment spending declined more than 16 percent in real terms. And during that period, this sector—which represents only a little more than 5 percent of U.S. GDP—has taken a large toll on overall activity, subtracting a full percentage point from real GDP growth.

The more forward-looking indicators of conditions in housing markets have been mixed recently. Housing permits and sales have been weak. House prices at the national level either have continued to appreciate, though at a much more moderate rate than before, or have fallen moderately, depending on the price index one considers. Looking ahead, futures markets are expecting small price declines in a number of metropolitan areas this year. Finally, and importantly, inventories of unsold new homes remain at very high levels, and these most likely will need to be worked off before we see a rebound in housing construction.

The prospects for the housing market may also be affected by developments in the subprime mortgage market. I should note that the Fed pays close attention to these developments, not only because of their potential impact on the economy, but also because of our roles in bank supervision and regulation and in consumer protection.

From the standpoint of monetary policy, I do not consider it very likely that developments relating to subprime mortgages will have a big effect on overall U.S. economic performance, although they do add to downside risk. The types of subprime loans of greatest concern are variable-rate mortgages. Delinquency rates on these loans have risen sharply since the middle of last year—they are now nearly 12 percent—and there are indications that lenders are tightening credit standards for these borrowers. Looking more broadly across all types of mortgages, however, delinquency rates have remained low; this includes prime borrowers with fixed-rate and variable rate mortgages and evensubprime borrowers with fixed-rate loans. Tighter credit to the subprime sector and foreclosures on existing properties have the potential to deepen the housing downturn. I am nonetheless optimistic that spillovers from this sector will be limited, because these mortgages represent only a small part of the overall outstanding mortgage stock.

The bottom line for housing is that it has had a significant depressing effect on real GDP growth over the past year. While I wouldn’t want to bet on a sizable upswing, I also wouldn’t be surprised to see it begin to stabilize late this year or next. Furthermore, if and when it does stabilize, it could contribute to a pickup in overall growth in the future, as the negative force of its contraction turns neutral."

April 26, 2007

The cooling in the housing sector has, of course, been in part a response to a rise in financing costs. Although traditional fixed mortgage rates have actually fallen somewhat in recent years, rates on variable-rate mortgages have risen along with other short-term rates. I should note, however, that higher borrowing costs are not the only explanation; it’s likely that the recent cooling also is a necessary correction in house prices after years of phenomenal run-ups that ultimately proved to be unsustainable.

Residential investment grew quite strongly for several years, but the pace of growth began to weaken toward the end of 2005. Since then, growth has turned negative. Indeed, the level of residential investment spending declined almost 13 percent in real terms during 2006, with especially steep drops over the last two quarters. In fact, during each of those quarters, this sector alone—which represents only a little more than 5 percent of U.S. GDP—subtracted a hefty 1¼ percentage points from real GDP growth.

The more forward-looking indicators of conditions in housing markets have been mixed recently. Housing permits fell sharply from the summer of 2005 through the summer of 2006, but have flattened out since then. Sales of new and existing homes have continued to fall. House prices at the national level either have continued to appreciate, though at a much more moderate rate than before, or have fallen moderately, depending on the price index you look at. Looking ahead, futures markets are expecting small price declines in a number of metropolitan areas this year. Finally, and importantly, inventories of unsold new homes remain at very high levels, and these most likely will need to be worked off before we see a rebound in housing construction.

The latest twist in the housing sector story is the trouble involved with subprime mortgages. Hardly a day goes by without a news story about the financial difficulties now faced by borrowers and some large lenders in this market. Certainly, these problems warrant our close attention and raise significant issues for bank regulators and supervisors. After all, so-called exotic financing instruments—like interest-only loans, piggy-back loans, and loans with the possibility of negative amortization—were often designed to allow subprime borrowers into the market. So it will be important to find the balance that not only protects borrowers but also provides them opportunities to secure loans to buy homes and refinance mortgages.

The types of subprime loans that present the biggest problem are variable-rate mortgages. Delinquency rates on these loans have risen sharply since the middle of last year—they now exceed 11 percent—and there are indications that lenders are tightening credit standards for subprime borrowers. Looking more broadly across all types of mortgages, however—including prime borrowers and even subprime borrowers withfixed-rate loans—delinquency rates have remained low. While a tightening of credit to the subprime sector and foreclosures on existing properties have the potential to deepen the housing downturn, I do not consider it very likely that such developments will have a big effect on overall U.S. economic performance. I say this, in part, because these mortgages represent only a small part of the overall outstanding mortgage stock.

The bottom line for housing is that it has had a significant depressing effect on real GDP growth over the past six months or so. While I wouldn’t be surprised to see it begin to turn around in the latter half of this year, I also wouldn’t want to bet on it. In other words, housing remains a significant drag on the economy and a source of uncertainty in the outlook—much as it has for some time now.

February 23, 2007 (they should have at least shut down the banks at the end of 2006/early 2007, at the very latest)

Despite the continued weakness in housing construction, which as I said enters directly into the calculation of real GDP, there are some signs of stabilization in other aspects of housing markets, suggesting that construction activity may level out before too long. For example, home sales have steadied somewhat after falling sharply for a year or so. Considering this in combination with the continued drop in housing starts that I mentioned earlier, it is not surprising to find that inventories of unsold homes have begun to shrink. This development suggests that the process of resolving the imbalances between demand and supply in the housing market may be underway, and, as a result, we could very well see the drag on real GDP from housing construction wane later this year.

Of course, such a turn of events is by no means a given, because the improvements we’ve seen may just be temporary. For example, it is possible that they were related to a decline in fixed mortgage rates since the middle of last year, a development that probably supported home sales, at least to some extent. However, the decline in mortgage rates came as a bit of a surprise to me in a period when the FOMC maintained the funds rate target at 5¼ percent, especially in view of the widely discussed “conundrum” about why long-term interest rates were already so low.2 Therefore, we can’t count on further declines in mortgage rates to bring the housing market back.

In addition to concerns about weakness in housing construction, there has been worry that difficulties related to housing markets could spread to consumer spending more generally. Since consumption expenditures represent two-thirds of real GDP, even a relatively modest impact from housing markets on this big sector could put a noticeable dent in overall economic activity.

Up to this point, we haven’t seen signs of such spillovers. Consumption spending has been well maintained, showing a robust growth rate for all of 2006. However, going forward, there are at least a couple of ways that spillovers from weakness in housing could depress consumer spending, and these channels bear watching. First, housing makes up a significant fraction of many people’s wealth, so a significant change in house values can affect consumer wealth and therefore consumer spending. As you know, there have been fears about plummeting house prices. But so far, at least, house prices at the national level either have continued to appreciate, though at a much more moderate rate, or have fallen moderately, depending on the price index you look at. Looking ahead, futures markets are expecting small declines in a number of metropolitan areas this year. While these modest movements are undoubtedly imparting less impetus to consumer spending now than during the years of rapid run-ups, their effects are not likely to be dramatic.

The slowdown in housing market activity has certainly been noticeable here in the Sacramento area. Previously, the local housing market had been very hot, with home prices growing consistently at a double-digit pace from 2000 to 2005, reaching a peak growth rate of about 25 percent in 2004. This was fueled in part by substantial in-migration from other parts of California, notably the Bay Area, and other states; during the first half of this decade, Sacramento was ranked very highly among the nation’s metropolitan areas in its rate of domestic in-migration. This process slowed down as home prices rose and the region’s affordability advantage was eroded. Indeed, Sacramento was one of the first areas in the state to show signs of the current housing slowdown. Prices in this area started to flatten out in early 2006 while they were still rising in most of the rest of the state, and building permits fell substantially even before that, in 2005. The slowdown in the local housing market intensified as 2006 progressed, and the latest available numbers indicate that in the fourth quarter of last year, sales of existing homes were down about 25 to 30 percent, and prices were down by about 4 percent.

The price decline has been small so far, but it raises fears about a more significant drop. Such fears are understandable, based on the historical experience: between 1991 and 1996, Sacramento area home prices fell about 15 percent. However, a key difference between then and now is the overall health of the local economy. While the pace of employment growth slowed last year in the Sacramento area, as it did in the rest of the state, the state government’s fiscal situation has improved over the past few years, helping to create new jobs locally and keeping the area economy on a stable expansion path. Continued economic growth of this sort can only help the adjustment in your area proceed in an orderly fashion.

Returning to the national economy, housing market developments also could spread to consumer spending if enough homeowners experienced financial distress. For example, rising variable mortgage rates could strain some consumers’ cash flow. What we find, however, is that, because of the rapid appreciation of home prices in prior years, most homeowners are sitting on a substantial amount of equity, a financial resource that they can fall back on. In particular, adjustable-rate borrowers with equity can avoid a rate reset by refinancing. Moreover, only a small fraction of outstanding variable rate mortgages are scheduled to be reset in each of the next few years.

Of course, financial distress could be a bigger problem for some borrowers who used so-called exotic financing—like interest-only loans, piggy-back loans, and loans with the possibility of negative amortization. These instruments are often designed to allow subprime borrowers into the market. In fact, there are signs of trouble for some households. Delinquencies on variable-rate mortgages to subprime borrowers have risen sharply since the middle of last year and now exceed 10 percent. But fortunately, delinquency rates for other types of mortgages—including all prime borrowers and even subprime borrowers with fixed-rate loans—have edged up only very modestly. I know that it’s common to see newspaper stories about homeowners who have run into trouble, and those situations are, indeed, regrettable. From a national perspective, however, the group with rising delinquencies still represents only a small fraction of the total market, with little impact on the behavior of overall consumption.

A forward-looking view of the credit risks associated with subprime mortgages can be obtained from a new financial instrument related to these mortgages.3 These instruments suggest a big increase in the risk associated with loans made to the lowest-rated borrowers, but little change in risk for other higher-rated borrowers. Based on these results, it appears that investors in these instruments expect the losses to be fairly well contained. Of course, a shift in market sentiment about the risk of some of these securities is always possible. Such a shift would have ramifications for mortgage financing and housing, likely through tighter credit standards and higher mortgage rates for certain borrowers. In fact, we already have seen some tightening among commercial banks in recent months.4

The bottom line for housing is that the concerns we used to hear about the possibility of a devastating collapse—one that might be big enough to cause a recession in the U.S. economy—while not fully allayed have diminished. Moreover, while the future for housing activity remains uncertain, I think there is a reasonable chance that housing is in the process of stabilizing, which would mean that it would put a considerably smaller drag on the economy going forward.

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