The Economy: Problems and Solutions

At "A Dash" we try to stick to what we know.  On some occasions our approach provides information that has been neglected by most market pundits.  We  highlight arenas of opportunity.

The Housing Problem

Everyone is now focused on housing, mortgage resets, losses at financial companies, and potential effects on the consumer.  There seems to be some competition to claim who was first in pointing out these problems.  Before the days of this blog, we warned our clients about over-investment in real estate.  The difference between us and others is that we did not suggest some imminent market collapse.  There was opportunity in equities, on a comparative valuation basis, and there still is.

The Market Perspective

Most market pundits see this as a black-and-white, light switch kind of problem.  There is an economic problem.  It is up to the Fed to act.  They should cut rates aggressively.  The Fed does not see what we do, therefore they are slow in acting.  (We should offer a prize for any article that makes this point without using the phrase "behind the curve.") It is all about the Fed and how fast rates are cut.

Then we see trading like last Friday's, after Bernanke does signal aggressive action is in prospect, the markets start to worry about what that means.  There is a reason for this:  It is not a simple problem of interest rates.

A Multi-Faceted Problem

One of the things that distinguishes our approach is a public policy perspective.  We look at all aspects of problems and consider the possible role of various government institutions in reacting.  This is important for our readers and investors, because it represents how the Fed sees issues.   An investor can pretend to instruct the Fed or can understand the Fed.  To us, the choice is obvious.

A public policy analyst would see the housing problem as having various dimensions, including the following:

The Housing Market.  Prices are falling.  Mortgage resets are forcing refinancing decisions.  Falling prices make refinancing difficult or impossible.

The "old" Mortgage Market.  Structured investment vehicles including both performing and non-performing assets were improperly rated by agencies.  Trading in these securities is now illiquid.  Financial institutions are scrambling to deal with this.  They are holding distressed securities rather than selling because current market conditions do not reflect the likely payout prospects.  Meanwhile, the market for securitized mortgages has seized up.

The Existing Mortgage Market.  The absence of securitization has disqualified many potential buyers.  The limitations on Fannie and Freddie exacerbate the problem.  Those seeking loans of over $417,000 pay a penalty rate of a point or more, if a loan is available at all.  Other willing buyers who qualify for loans, albeit at a lower level than before, have difficulty in getting loans.

Interaction Effects. Falling home prices exacerbate the problems of refinancing, shifting supply curves to lower price levels.  Mortgage unavailability shifts demand curves lower.  Falling prices cause potential buyers to hesitate, also shifting demand curves lower.  There is an interaction effect making each problem worse.

The "new" Mortgage Market. There is and will continue to be a demand for securitized mortgages.  The market will emerge again with cleaner products and better ratings.  It will probably not happen until the "old" market has stabilized.  It is a good idea, which was poorly implemented.

How Long to a Solution?

Our view is that the "static" analysis of the number of homes in inventory and the number of possible foreclosures overstates the problem.  This approach looks at the problem without any view toward possible solutions.  It is a worst case.  We take a critical and analytical eye to anyone who asserts that a bottom will not be found until "late 2009" or similar forecasts.  Without thinking about possible policy reaction, how can one possibly answer such a question?

The Solution We Will Not See

In a different time, without a lame-duck President, and with stronger leadership, one could imagine a comprehensive solution.

We wrote about such a "fantasy solution" in a recent article for TheStreet.com.  It is a dream version of a State of the Union Address to be delivered later this month by President Bush.  If it were a Reagan or a Kennedy or even Bill Clinton, early in the Administration, we might actually see something like this.  Even now, we suspect that the "dream speech" predicts a few things the President will actually say.

Please take a moment to follow the link, and read the article.  It shows one view of a comprehensive solution.

What Will Happen

In the absence of this approach we will see a collection of incremental efforts.  How close will these come to a solution?  We do not yet know, but it provides a scorecard for those following this problem.  Watch the candidates, watch the Congress, and watch the President.

Meanwhile, this is not just a problem for the Fed.  The market attention to the Fed, with limited policy levers available, is a reflection of the vacuum in leadership.  The Fed can only do so much.  The exact pace of interest rate reduction is not terribly important.  Some Fed initiatives, like the TAF, have succeeded in reducing LIBOR and helping institutions take distressed securities on the balance sheet.

Investors who do a little work to understand the complexity of the problem will be well-placed to appreciate steps that signal real improvement.

Comments

[gaius marius]

certainly not many places, jeff, true enough. what you're taking the time to say is very rational and (in some quarters) wholly forgotten. there will be a resolution, and it will be dynamic.

my praise means little, but you maintain a fine blog here. thanks for your efforts!

[oldprof]

Venn --

Well that is a clever idea! My fantasy was designed to stimulate thought. I have a few other notions about how this might be accomplished.

As we have argued on another thread, the problems are easier to see than the solutions.

Thanks for your thoughtful comment.

Jeff

[oldprof]

gaius marius -

Thanks for your interesting observations. Trying to state my viewpoint in a single sentence -- something I should have tried to do, perhaps ---

We cannot forecast housing prices in the future without a better understanding of supply and demand curves.

Current circumstances have thwarted regular economic analysis, so that we count the number of potential foreclosures and the inventory. Falling prices should help to clear the market. Helping qualified buyers get mortgages should shift the demand curve.

I'll bet that you do not read this anywhere else.

Jeff

[VennData]

RE: Idea three of your SOTU address: Instead of an RTC government agency, what about a ETF, private solution.

Call it, the Credit Opportunity ETF?

[gaius marius]

i do agree that timing is an inherently unpredictable future variable -- and that it is less relevant than the level of real prices. but i would offer that there have been several housing booms and busts in the past, and that there is a broadly-drawn and data-derived template based not on theory but past experience for real estate booms and busts just as there is for equity booms and busts.

that template, it seems to me, suggests long-term-mean reversion in relative valuation metrics like price-to-rent and price-to-income is highly probable. i agree that securitization in some revised form will certainly stick, and that it will make credit more available than it would otherwise have been -- and that this will be an extension of a very long-term secular "democratizing" credit trend. but past experience has shown that such trends have not prevented mean reversion in relative valuation metrics in previous dislocations.

nationally, that means something on the order of a 30% average decline in real house prices vis-a-vis real rents. and while that could happen instantaneously, in the past transitions of lesser scale have taken at least 16 quarters.

this seems largely independent of past policy decisions, which (it can be argued) have served less to shorten the duration of market adjustments than to lengthen them. it could well be that any government policy which prevents a natural clearing of the real estate market in the aftermath of a period of manic lending pushes the end of the inevitable return of prices to stable income and rent relationships out in time while seeking to disperse the intensity of the adjustment.

if the underlying point that the article is making is that disaster theories are often fallacious, i certainly agree. and if the point is that predicting the future is subject to very significant error thanks to the unknowability of complex systems, i agree there too.

where my skepticism starts is where we might begin to disbelieve the implications of several eminently-applicable previous examples mostly because the range of possibilities they imply is unpalatable.

it does seem to me a formulation of a "base case" forecast in which housing is still on national average falling in price as the market mean reverts in two years (that is, 4q2009, being just 15 quarters from the 3q2005 mania peak) is not only plausible but the approximate mean of prior experience. of course one must monitor changing conditions going forward to amend as needed, but one could do much less reasonably for a starting point analysis.