Housing Boom´s Full Impact on GDP

Residential construction has been a significant source of jobs and growth for the past four years. In the last four years residential construction contributed about a sixth of the annual average real GDP growth of 2.8 percent, compared to a twentieth over the previous six years.As the housing market is weakening, so is the economy slowing. The direct influence of the slowing residential construction activity should not be a big concern for the overall economic perspectives.

However, there is another direct influnce of the housing boom on the economy, which seems to have had a much larger impact on the econmic growth in the last five years. As pointed out by Lynne Montgomery in the latest FDIC Outlook homeowners have been substituting mortgage debt for consumer debt in the last 5 years, as the growth for mortgage debt has clearly outpaced that of consumer debt (see figure below).
Source: Northern Trust

In recent years, the combination of low interest rates and rapidly appreciating housing values resulted in a surge of mortgage equity withdrawals (MEW), which also called Home Equity Withdrawal (HEW). Mortgage debt grew by nearly $4 trillion from year-end 2000 to yearend 2005, with an estimated one-half of this growth resulting from the refinancing of existing mortgages. Many homeowners who refinanced were able to take advantage of the low mortgage interest rates, taking cash out and still reducing their monthly payments. William Gross, managing director at PIMCO, commentated these changes in PIMCO´s October 2005 Investment Outlook:

"Houses were then turned into ATM machines as refinancing, equity extraction, and a plethora of funny money mortgage innovations placed cash in the hands of consumers."

Dean Baker, co-director of the Center for Economic and Policy Research (CEPR) commented on the latest GDP numbers:

"The weak consumption growth is directly related to the weakness in the housing market. Consumers have borrowed heavily against the growing equity in their homes over the last four years, as the savings rate declined from 2.9 percent in the first quarter of 2002 to -1.5 percent in the second quarter of 2006."

Using Goldman Sachs estimate of about 2/3 of MEW flowing through to personal consumption expenditures, it is possible to estimate the impact of MEW on GDP. The graph below clearly shows the importance of MEW over the last few years.
Source: Calculated Risk

Bill Gross summarized his "sequence for house bubble popping or froth skimming" in PIMCO´s October 2005 Investment Outlook as:

1) Housing prices will cool/stop going up very much/even go down in some cities, WHEN...

a. Interest rates rise to a high enough level to make the purchase of a new home a burden instead of a boon for first time buyers.

b. Mild regulatory pressure begins to reduce the amount of funny-money lending.

c. Speculators sniff the beginning of the end.

2) Home equitization should retreat shortly thereafter.

3) Consumption/the U.S. economy will then weaken when the house ATM starts running out of fresh new $25,000/$50,000/$100,000 home equity loan dollar bills.

4) The Fed will cut interest rates in order to start the game all over again.

Let me state categorically that the above sequence is barely questionable, almost inevitable, 99% unavoidable, and in modern parlance - "slam-dunk."

Now lets see what has happen in the housing and credit market in the past 9 months since Bill Gross stated his predicition.

As the figure below clearly shows housing prices have truly colled/stoped going up.Source: Northern Trust

Econ 101 tells us that when supply exceeds demand ex ante, the price will weaken. The existing home market exemplifies this tenet.
Mortgage rates have been rising so strong, that mortgage loan applications for purchase have decreased by 16 percent from their all-time high in August 2005.
Source: Northern Trust

Regulatory pressure seems to begin to reduce the amount of funny-money lending, as on December 20th Federal Financial Regulatory Agencies proposed Guidance on Nontraditional Mortgage Products. Already in May 2005 they had released a Credit Risk Management Guidance for Home Equity Lending to commercial banks, thrifts and credit unions.

Robert Toll, chief executive of luxury home builder Toll Brothers (NYSE: TOL), told the Wall Street Journal, that speculative buyers, who accounted for about 10 percent of demand one year ago, are now sellers.

Unfortunately, to verify whether the retreat in home equitization has already started, we have to wait until to September 14th when the FED's flow of funds report will be published and the latest MEW figures can be calculated. However, the recent noticeable reduction in home equity loans could be a indication that the retreat in home equitization has already started.

Source: Northern Trust

Additionally the meager gain of 2.5% in consumer spending during the second quarter suggests that the house ATM starts to run out of fresh cash.

So Bill Gross´s sequence for house bubble popping has come true. And he predicted:

"If real housing prices decline in the U.S. in 2006 or 2007, a recession is nearly inevitable."

Data from the National Association of Realtors (NAR) shows that the median sales price of existing 1-family homes is already falling.

Source: Northern Trust

Thus, the question will be:

"When will the Fed start to cut interest rates?"