US housing crisis could spark serious economic downturn

It seems that if interest rates drop there will be even more borrowing and although the rate of interest will be lower this may be offset by the greater amount of debt upon which is paid.
Perhaps Bush can keep the economy going by spending more on wars and the military!

WSWS : News & Analysis : World Economy
US housing crisis could spark serious economic downturn
By Nick Beams
3 September 2007

The US economy could experience a deep recession as a result of the
housing crisis, according to National Bureau of Economic Research
president Martin Feldstein.

Feldstein told the annual symposium of central bankers and economists
at
Jackson Hole Wyoming over the weekend that the housing sector was at
the
root of three distinct but related problems confronting the US economy.

The decline in house prices and the fall in home-building could lead to

a recession across the economy; the sub-prime mortgage crisis could
lead
to a freeze in much of the credit markets; and the decline in home
equity loans and mortgage refinancing, triggered by the fall in house
prices, could cause further declines in consumer spending.

Feldstein’s remarks, which came at the end of the three-day
discussions,
were aimed at ensuring a rate cut by the Federal Reserve at the next
meeting of its open market committee on September 18, if not before.

In his opening speech to the gathering, Federal Reserve chairman Ben
Bernanke insisted that while the Fed would act to limit the adverse
effects on the broader economy of the disruptions in financial markets,

it would not be appropriate to protect lenders and investors from the
consequences of their financial decisions.

While he accepted this argument, Feldstein insisted that “it would be
a
mistake to permit a serious economic downturn just in order to avoid
helping those market participants.”

He noted that while the Fed and other central banks had emphasised
their
roles as lenders of last resort and had provided increased liquidity
there were many important financial institutions, including investment
banks and large hedge funds, which did not have access to Fed funds.

While the Fed had encouraged the commercial banks to lend to them,
Feinstein said, it was not clear whether this policy would succeed
“since much of the credit market problem reflects a lack of trust, an

inability to value securities, and a concern about counterparty risks.
The inability of credit markets to function adequately will weaken the
overall economy over the coming months. And even when the credit market

crisis has passed, the wider credit spreads and increased risk aversion

will be a damper on future economic activity.”

Even with the best policies to increase liquidity, future demand would
be weakened by lower levels of housing construction, depressed consumer

spending and impaired credit markets.

Calling for a “major reduction” in the federal funds
rate—possibly by as
much as 100 basis points (1 percentage point)—Feldstein said the
sharp
decline in US residential construction provided an “early warning of
a
coming recession” and that if the “triple threat” from the
housing
sector materialised “the economy could suffer a very serious
downturn.”

In the course of his speech, Feldstein cited statistics which showed
the
potential impact of the collapse of the housing bubble on the US
economy. Up until the year 2000, real house prices and rents had stayed

together, after which real house prices surged to a level 80 percent
greater than the equivalent rents.

This divergence was fuelled by the policy of cheap credit pursued by
the
Fed, which cut the federal funds rate to just 1 percent in 2003 and
then
promised to increase it only very slowly thereafter.

If house prices were to fall enough to re-establish the traditional
relationship with rents, there would be “serious losses in household
wealth” and a consequent decline in consumer spending. With housing
wealth now estimated at $21 trillion, a 20 percent decline in nominal
prices would reduce wealth by $4 trillion leading to a possible cut in
consumer spending of about $200 billion or 1.5 percent of gross
domestic
product (GDP)—enough to push the economy into recession.

A decline in nominal prices of 20 percent would mean that home-buyers
could end up with a mortgage debt greater than the value of their
house.
This would lead to defaults that would increase if house prices were
expected to fall further.

“Once defaults became widespread, the process could snowball, putting

more homes on the market and driving prices down further. Banks and
other holders of mortgages would see their highly leveraged portfolios
greatly impaired. Problems of illiquidity of financial institutions
would become problems of insolvency,” Feldstein said.

There was also a potential for a “substantial decline” in
consumption
because of the decline in home equity withdrawals. Under conditions of
rising home prices and falling interest rates, home-buyers were able to

refinance their mortgages and obtain an increase in funds which was
used
to pay down other debts or finance additional consumer spending.

In 2005, some 40 percent of existing mortgages were refinanced, with
national flow of funds data indicating that between 1997 and 2006 these

mortgage equity withdrawals were greater than $9 trillion, an amount
equal to more than 90 percent of disposable income in 2006.

In a clear indication of possible action on interest rates by the Fed,
Frederic Mishkin, a Federal Reserve governor, told the Jackson Hole
symposium that policymakers should not wait until a decline in house
prices led to a fall in GDP but should “react immediately to the
house
price decline when they see it.”

Mishkin warned that while housing and mortgage markets had not been
“close to the epicentre of previous cases of financial instability”
the
current situation in the US “could prove to be different.”

While the crisis has been centred in the United States, the fallout has

extended around the world. Germany has been one of the countries
hardest
hit with two banks having to be bailed out because of their exposure to

US subprime mortgage debt.

The head of the German Bundesbank, Axel Weber, a leading member of the
governing council of the European Central Bank, told the symposium that

the turmoil in financial markets had all the characteristics of a
classic banking crisis. The only difference was that it was taking
place
outside the traditional banking sector.

Weber noted that the classic conditions leading to a banking
crisis—borrowing short and lending long—had been created by
off-balance
sheet transactions in which so-called conduits and structured
investment
vehicles, set up by the banks and other financial institutions,
borrowed
money on the commercial bond markets.

These entities were inherently vulnerable to a sudden loss of
confidence
on the part of their funders because there was a “maturity
mismatch”
when short-term finance was used in invest in long-term mortgage-backed

or asset-backed securities.

If the sentiments expressed at the Jackson Hole summit are any guide,
the Fed will concede to growing market demands for a significant
interest rate cut on September 18, if not before. But even if such a
cut
does bring a halt to the current turmoil—and there is no guarantee of

this happening—it will only do so by creating even greater problems
for
the future, in the same way the present crisis resulted from previous
decisions to boost the economy and financial markets with an injection
of liquidity.