Quantifying the Economic Impact of Housing Declines

Everyone wants to know about housing and the economy.  Is the sub-prime lending issue something that will extend to other mortgage classes?  How much might home prices fall?  Will the impacts lead to reduced consumer spending and an even greater economic effect?

Doug Kass, the popular hedge fund manager noted for his skill in short selling, has been one of the leading voices on this topic.  His view is that this is a major economic problem and one that will affect the home prices and portfolios of individual investors. 

Writing today in Street Insight, the valuable premium service of theStreet.com, Doug does a "back-of-the-envelope" calculation of the likely housing effects.  At "A Dash" we are big fans of such an approach.  Trying to think about quantities and actual impacts is essential.  Market participants often have knee-jerk reactions to news, mostly because they cannot estimate the real effect.

To get Doug's entire argument, you need to be a member at theStreet.com, but they might republish it later for the general public.  Since he is such a frequent and popular TV guest, you will also see it soon on CNBC.  I am quoting just one section, the place where he quantifies the likely impact of what we all read about every day:

Quantifying the Impact of Tightening Credit
I would conservatively estimate that about 55% of the subprime borrowers, 25% of the Alt-A borrowers and 15% of the prime mortgage lending borrowers will no longer be able to secure financing for new homes because of tightened conditions. (This will produce about a 25% drop in housing demand). Speculators and investors - who were responsible for nearly 20% of all home purchases in 2004-06 - will also find it more difficult to secure borrowings and it is likely that this buying category will revert back close to their historical demand role of about five percent of all homes. (This will result in another 10%-15% drop in housing demand). Finally, end of economic cycle conditions (lower consumer confidence, slowing economic growth and moderating job growth) should contribute to another 10% drop in housing demand - as it has done historically. In total (adding the above three influences), new home demand should fall off by almost 50% (vs. the rolling 12- month average showing a 17% drop off in 2007) - even before the effect of a market inundated by record foreclosures is considered.

What is Wrong?

This estimate will sound frightening and persuasive to most who hear it.  For students of economics, the problem leaps out.

A statement like "a 25% drop in housing demand" has no economic meaning.

Non-economists speak in terms like Doug.  Someone is either in the housing market or he/she is not.  A home is either on the market or it is not.  Completely lost is the concept that a buyer may not qualify for a loan of one size, but will qualify for a smaller loan.  Homes for sale at one price are withdrawn from the market if the price is lower.

The century-old concept  is shown in the supply-demand curve that one sees the first day of Econ 101.

As price declines, the quantity demanded increases.  As price increases, the quantity supplied increases.  The actual exchange price clears the market at the  quantity where the curves intersect.

When one wishes to describe underlying changes in either supply or demand, these are characterized as "shifts" in the curve.  Reduced demand, for example, shifts the downward-sloping blue curve to the left, meaning that there are fewer sales at a lower price.  Reducing prices shifts the supply curve to the right, increasing the quantity.

Is this News for Doug Kass?

Readers should understand that Doug Kass knows everything we have written here.  He has an MBA from Wharton and he certainly studied economics.  He knows full well that one cannot describe supply and demand as a binary function -- either in or out.  One of the first things you learn in economics is that shifting the curve has a much smaller price effect than one would think at first.  So why is he writing this?

Conclusion

We wish we could provide a good answer about the impact of housing and mortgages on price and quantity, but we cannot.  To do that, one would need some data about the shape of both curves, at least enough to make an estimate.

We can say with confidence, however, that the Doug Kass scenario is extremely unlikely  The relevant curves would need unusual shapes and make massive shifts to have the impact that he forecasts.

Comments

[Marlyn Trades]

Another excellent post - also an excellent answer to a rude question - anyone who reads you long enough should know that you are apolitical in your posting.

I will simply say thank you for your continuing efforts to educate us in different ways of "seeing the economy".

[oldprof]

Hi Ray,

Thanks for stopping by with your provocative comments and questions.

It led to some laughter here in Naperville, because you could not be more wrong.

Let me start by saying that investment management should not be political. Anyone who has political blinders will lose opportunity.

It is also not good for an investment manager to talk politics (or religion or any polarizing topic) so I do not do it. Most of my investors know that I am a registered Democrat in Illinois, but choose particular votes on an individual basis.

It is quite possible for one to recognize the economic progress of the last few years, believe in treating dividends and capital gains equally, and still think that the Democrats might do as well or better on the economy.

In short, I respect Malpass for his arguments, insight, and consistently accurate predictions. I think his training and experience is excellent. I read his work directly from Bear. Where it gets published outside is not my province.

I did not predict a recession in 2001. I just followed our models and my fundamental valuation methods. Both led us and our investors to safety in good time. The recession itself was rather mild -- not the cause of the major stock market decline. That was due to excessive valuation.

Thanks again for a good question that others probably also had but did not raise. I respect you for asking it, and it deserved an honest answer.

Thanks again,

Jeff

[ray_gibbles]

is because you are a republican that you thought there would be a recession in 01 (you claim) and not one now? before you answer yes or no, please let it be known if you tend to vote republican or donkey. i for one am guessin that you're partial to republicans...(the tip off is all your citations of National Review contributor Malpass).

also why don't you pick on rutledge for intellectual integrity?