EconSouth (Second Quarter 2009)

Disruptions in financial markets have made the current recession difficult to shake off. But new policy tools show signs of breaking the forces that have impeded recovery.

The current recession that began in December 2007 has differed from many previous recessions in at least one important respect: It has been accompanied by a crisis in the financial markets. Excesses in the housing sector triggered the financial sector crisis, which then contributed to problems in the broader economy.

The housing sector's sharp reversal exposed critical weaknesses in the financial sector that have made the downturn much more severe than it would have been otherwise. In turn, credit market dysfunction has blunted the effectiveness of traditional policy responses to economic weakness. For example, the Federal Reserve normally responds to recessionary conditions with policies to engineer lower interest rates, actions that would normally support a return to broad economic growth by reducing the cost of capital and thus increasing spending. But during episodes of financial turmoil last year, credit costs actually increased even as yields on low-risk assets such as U.S. Treasury bonds declined along with the fed funds rate, and credit market functioning became seriously impaired.

With this limitation on the effectiveness of traditional monetary tools, the Federal Reserve, along with other U.S. government authorities and their international counterparts, have devised policies to address specific financial and economic problems. Combined, these policies represent a comprehensive approach, but each policy targets one or more links in a self-reinforcing chain of events.

Too many houses sink the market
In 2005—the peak of the housing construction boom—1.4 million single-family homes were built in the United States. At the time, historically low mortgage rates and rapid house price appreciation helped drive residential investment that was nearly double the pace seen a decade earlier (700,000 in 1995), according to the U.S. Census Bureau.

New residential development was especially robust in some Sun Belt states such as Florida and Georgia. Lenders competed to finance new residential development, and construction boomed in segments of the market such as second homes, inner city condominiums, and suburban starter homes, where developers saw strong demographic growth prospects.

But by 2006 the supply of new homes began to outpace the demand. The months' supply of new homes for sale rose from 4.8 in the fourth quarter of 2005 to 6.8 a year later, and by the end of 2007 the supply had risen to 9.3, according to the U.S. Commerce Department.

Builders responded by putting the brakes on new construction and shedding staff. At its peak in the first quarter of 2006, the residential construction industry employed about 3.5 million workers nationally. By the end of 2006 the industry had shed about 100,000 jobs, according to the U.S. Bureau of Labor Statistics (BLS). But even with a diminished pace of construction, sales of new houses still declined faster, so builders added incentives and even lowered prices in an attempt to boost sales.

Looking ahead at the glut of homes for sale that is likely to persist for the near term, new home construction will likely remain at or near the record low levels seen in April 2009, when new home starts tumbled to 458,000. Employment in residential construction industries is also likely to remain near the 2.5 million level—almost a million fewer jobs than at the peak, according to the BLS. In addition to problems in single-family housing, condominium projects in many markets that were financed and started late in the housing cycle are expected to become available later in 2009, adding to the housing stock. Low mortgage rates and a return to economic growth later this year should encourage buying and gradually slim down housing inventories, and some signs are emerging that the housing market is regaining stability.

How low can house prices go?
In January 2000, the Case-Shiller index—a composite of home sales data from 20 major metropolitan areas in the United States—set its benchmark at 100. Six and a half years later, in July 2006, that price index had climbed to 206.52. During these six years, when house prices nationally more than doubled, appreciation was even more dramatic in rapidly growing markets such as California, Arizona, and Florida.

But once the supply of housing began outpacing demand, price appreciation in some markets began to stall during 2006. Moreover, with the prospects of further price appreciation waning, real estate sales slowed as buyers feared overpaying for homes.

Since its 2006 peak, the Case-Shiller index has declined more than 30 percent, and house prices in markets that experienced rapid real estate appreciation during the boom years fell even more steeply. House prices in Miami, for instance, have declined more than 44 percent since their peak in February 2007, according to the index. While house prices overall are still higher than in 2000, the abrupt and unexpected plunge triggered a chain reaction of problems in the financial sector, inflicting painful consequences on the broader economy.

The upside to declining housing prices is increased affordability, and homebuyers with stable income and good credit histories are responding to a wide selection of homes at favorable prices and low mortgage rates, further enticed by a tax credit for first-time homebuyers. But supply still far exceeds demand, especially in the most overbuilt markets and in places burdened with a large number of bank-owned properties. Moreover, weak labor markets are dampening home buying demand. The most likely path in the coming months is a slowing decline of house prices, followed by stabilization and a long, slow recovery as labor markets improve and housing inventory declines. The outlook for housing remains highly uncertain. While there have been signs of some stabilization in sales, the downward pressure on prices could persist for a while because of the extremely high inventory levels.

Foreclosures close in on homeowners
During the housing boom as homes were becoming less affordable, lenders introduced new mortgage products that enabled buyers to take on more leverage and risk. Some of these products allowed buyers to put less cash into their purchase on the assumption that continued price appreciation would soon restore the buyer's equity position (the difference between the current market value of the home and the remaining balance on the mortgage) in the house.

Mortgage lenders also increasingly extended mortgage credit—at higher interest rates—to borrowers with relatively poor credit histories or to those who did not have reliable sources of income. By 2006, about 20 percent of new residential mortgages were in the so-called subprime category. Many of these loans had “teaser” rates that would reset to a higher level after an introductory period. The hope for many of these borrowers was that continued house price appreciation would put them in a position to refinance into a lower-cost mortgage product.

However, when house prices began declining, the stage was set for a surge in mortgage defaults. Buyers who purchased at or near the top of the market without significant down payments found themselves owing more on their house than it was worth. The more prices declined, the further buyers sank underwater. Subprime borrowers—those with high-interest mortgages—in particular found they were not able to refinance to avoid higher rates. As a consequence, foreclosures among subprime borrowers began to increase. Around 11 percent of conventional subprime mortgages were delinquent in the first quarter of 2006. By the fourth quarter of 2008 the delinquency rate had doubled to 22 percent, according to data from Lender Processing Services (LPS), a mortgage service firm.

The surge in foreclosures added to the glutted housing market as lender-owned properties went up for sale, reinforcing the downward pressure on market prices. Moreover, the increase in defaults helped precipitate the crisis in the financial sector.

While the persistent decline of housing prices has contributed to rising foreclosures nationally, mounting job losses during the last year have compounded foreclosure problems. More than 5 percent of all first-lien mortgage loans in March 2009 were seriously delinquent in the United States, up from 2.75 percent a year earlier, and the rate is even higher in the Southeast (9 percent), according to LPS. In addition to some stabilization in labor market conditions and house prices, policies to restore the flow of credit at the grassroots level and prevent unnecessary foreclosures could help ease the growth of problem loans and provide some relief for distressed homeowners.

Financial crisis squeezes credit markets
Subprime lending found a hospitable environment in the United States in part because of the relative ease with which these loans could be originated with relatively high returns generated through loan securitization. At the height of the housing boom, global investors were hungry for high-yielding assets such as securities backed by subprime RMBS.

But many investors in subprime RMBS assets were themselves using short-term borrowed funds, including off-balance-sheet entities created by banks. When defaults increased, the stage was set for a financial crisis that became apparent in the fall of 2007, when rating agencies subtantially downgraded various assets backed by subprime RMBS.

The surge in subprime mortgage defaults triggered a reassessment of all types of risky assets, including commercial MBS assets. As confidence eroded, banks started to accumulate liquidity to cover projected losses. Uncertainty about the scale of the losses made banks wary of lending to each other as counterparties became unsure about the borrower's ability to repay.

When markets for many risky assets effectively shut down, banks suddenly had difficulty issuing the short-term commercial paper they often used to fund new lending, resulting in sustained credit market dysfunction and restricted lending to businesses, other banks, and consumers.

Financial strains have eased so far in 2009, partly in response to policies geared to restoring liquidity and the flow of credit in the economy. For instance, many Fed policies were designed to foster lending that market dysfunction would have otherwise prevented. Other Fed polices, such as its mortgage-backed security purchase program, have been designed to lower the cost of credit and increase the availability of loans. Although credit market conditions are improving, market functioning has not yet returned to normal. Moreover, the economic recession has dampened consumer and commercial private sector loan demand generally. But further sustained improvement in the functioning of markets will help bolster confidence in the financial system, and the restoration of economic growth will help stimulate more lending activity.

Consumers, businesses rein in spending
The current economic recession is extremely deep and protracted. Since the start of the recession in December 2007, the U.S. economy has lost an estimated 5.7 million payroll jobs through April 2009, according to the U.S. Commerce Department. The preliminary estimates of first quarter 2009 gross domestic product show a decline of 6.1 percent, similar to the decline experienced in the fourth quarter of 2008.

To a significant extent, the recession helps fuel the financial crisis by further reducing demand for house purchases, which contributes to falling house prices, foreclosures, and more problem loans and investments for financial institutions.

The Fed's survey of bank lending standards shows that bank credit standards have tightened considerably since the onset of the recession. At the same time, reduced wealth and increased job insecurity have caused consumers to pull back on discretionary spending. This newly discovered frugality among households has contributed to the decline in economic activity, especially in purchases of big-ticket items involving credit, such as autos and furniture.

Moreover, credit market woes are not restricted to the United States. For instance, as some other developed economies, such as those in Japan and the United Kingdom, have entered recession, their demand for U.S. exports has slumped at the same time as U.S. demand for their exports has waned.

The path to recovery depends in part on curtailing some of the forces that have restrained spending for the past 18 months. Just as housing markets have shown some tentative signs of stabilizing, businesses have been making progress in paring down inventories that accumulated as a result of the sudden collapse of spending late in 2008. Consumer spending may also be stabilizing, and recent readings on consumer confidence are encouraging, according to a survey of consumer sentiment conducted by the University of Michigan. Federal government spending also could boost incomes this year and next. However, the significant headwinds the U.S. economy faces suggest that the path to recovery might be more protracted than usual.

This article was written by John Robertson, a vice president in the research department at the Atlanta Fed, and William R. Smith, a staff writer for EconSouth.

The Expanded Public Policy Toolbox To help normalize credit markets, the Fed has provided liquidity to lenders by accepting certain assets for more liquid ones. The Term Auction Facility (TAF), the Fed's commercial paper funding facility, residential mortgage-backed securities purchases, and the term asset-backed security lending facility are among the programs geared to restore the functioning of credit markets. Also, the U.S. Treasury has been providing capital to banks to reduce concerns about the adequacy of bank capital. Since last fall, nearly $200 billion has been distributed under a U.S. Treasury program that provides government capital investments to banks in stable condition in exchange for stock. Banks' capital put under scrutiny More recently, the U.S. Treasury, in conjunction with the bank supervisory agencies, undertook a program, the Super­visory Capital Assessment Program (SCAP), to ensure that U.S. banking institutions are appropriately capitalized. During this program, examiners tested the capital needs of the 19 largest U.S. banking institutions relative to the losses that more difficult economic circumstances would bring. Where the assessment indicates that additional temporary capital is warranted, these institutions have an opportunity to raise the capital privately. If these efforts are unsuccessful, the government will provide a capital buffer in exchange for stock. By providing additional capital, the government believes it can reduce concerns about the adequacy of bank capital, build confidence in the U.S. banking system, ease financial pressures, and encourage new lending. In addition to providing capital, the government, through the Federal Deposit Insurance Corp. (FDIC), has temporarily guaranteed selected liabilities of insured depository institutions and their holding companies. This program provides a stable source of funds for these institutions, easing the pressures on funding that some of them faced. Finally, the U.S. Treasury recently announced a program to help banks and other lenders reduce their holdings of legacy real estate assets and thereby make room on their balance sheets for new lending. Banks have had trouble selling these assets because potential buyers could not get needed credit and these investors are very risk averse. The intent of the new program is establishing public-private investment funds to purchase legacy assets. This program is designed to provide potential investors with needed leverage as well as afford investors with some protection against downside risks. Propping up a sagging housing sector To provide direct support to the housing sector and household finances, the Fed has committed to purchasing up to $200 billion of debt held by government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. Beyond this support, the Fed has expanded its direct purchase of mortgage-backed securities to a capacity of $1.25 trillion. These activities helped push down mortgage rates. Also, Fed actions to lower the fed funds rate have reduced short-term borrowing costs, thus helping borrowers whose interest payments are tied to the prime rate, as is the case with many home equity lines of credit. Separately, in an effort to jump-start housing purchases, Congress in 2009 passed a home purchase tax credit. The Obama administration is attempting to implement a $75 billion plan to restructure distressed mortgages. The plan is designed to provide government assistance to homeowners who are struggling to make payments to modify their loans and avoid foreclosure. Besides these programs in support of housing finance, the Fed and other authorities have established partnerships with community groups trying to acquire and restore vacant properties. Other efforts are aimed at encouraging lenders and mortgage servicers to work with at-risk borrowers. Regulators also have developed new lending standards to prevent some of the abusive lending practices, develop protocols to standardize loss-mitigation approaches, and improve reporting standards. Policies seek a comprehensive impact Recent events have made clear the inter­connectedness and global nature of financial markets and economic activity; the consequences of the negative feedback loop between the financial sector and the economy have been severe. But the combined policy actions—from central banks around the world as well as other public authorities—are designed to help strengthen and eventually restore strength to financial and economic activity.