2011 2Q Flow of Funds Update - Feds Need to Pay Attention to Housing
(September 22, 2011)
Dear Subscribers and Readers,
Important Note: Our regular guest commentator, Rick Konrad, will be penning his commentary for us this weekend instead. Thank you, Rick!
Yesterday's FOMC statement indicates that the Federal Reserve will pay more attention to housing through the reinvestment of agency debt and agency MBS principal payments. Unfortunately, there's no way to tell how this will affect mortgage rates; or for that matter, the ability/willingness of banks to originate housing loans. With as much as 25% of all U.S. mortgages “underwater,” the Feds simply cannot dump more housing inventories into a declining market. As a result, the stabilization of U.S. housing is very important from an economic standpoint, as U.S. households simply will not spend if their mortgages are underwater. As the Federal Reserve's Flow of Funds data shows (we have been tracking this for the last several years), there is a need for more deleveraging in the U.S. mortgage/housing sector—whether through principal repayments over time or an inflation in housing prices.
Let us now discuss the 2Q 2011 Flow of Funds update published by the Federal Reserve last Thursday. The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year. Data is available for most statistics since 1952. Since the inception of MarketThoughts.com, a main theme we have tracked through the Flow of Funds information has been the idea of overleveraged U.S. households, as well as the inevitable deleveraging resulting from the financial/housing crisis and the subsequent decline in household credit growth. In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we noted that U.S. households' asset-to-liability ratio hit a new post WWII low, and that despite the rally in asset prices during the 2Q 2009, it will take at least several years before U.S. households will finish rebuilding their balance sheets.
Since then, the state of U.S. households' balance sheets has improved–with U.S. household net worth rising by $8.94 trillion over the last nine quarters (despite a $1.30 trillion decline during 2Q 2010). As of the end of 2Q 2011, U.S. households net worth stood at $58.5 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.50 to 5.22 over the last nine quarters. As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth still needs to rise by $7.4 trillion before it regains its prior peak, even assuming U.S. housing prices have bottomed. Note that the absolute net worth scale on the right is a log scale:
Based on the above chart and as discussed in our previous commentaries on the Fed's Flow of Funds date, U.S. households should continue to deleverage for the foreseeable future. As mentioned in similar commentaries three and six months ago, while I believe the Fed will not adopt a “QE3” policy, the Bernanke-led Fed should not tighten until the asset-to-liability ratio of U.S. households rises back to 5.50 or higher. Interestingly, U.S. households' liabilities have “only” declined by $691 billion from its peak in 3Q 2008. This is interesting as global financial institutions have written off more than $1.5 trillion from their mortgage holdings and as U.S. commercial bank and consumer credit has grown by a minimal amount over the last nine quarters. Why did US households' liabilities only decrease by $691 billion from its peak? The likely answer is that many U.S. households who had mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices). This likely means that true deleveraging (and home foreclosures) is not yet over—as empirical evidence is proving. That is, actual mortgage defaults will likely remain elevated until the end of the year, despite a relatively low national housing-price-to-disposable-income ratio, a near all-time low in mortgage rates, and an improving employment picture.
Indeed, as we have mentioned, the U.S. housing sector still needs to deleverage over the next several years. This is one reason why U.S. housing remains very weak. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 2Q 2011. While Americans have indeed been “gorging” on credit, most of this gorging has occurred in the mortgage markets over the last 20 or so years:
For every percentage growth in assets that U.S. households accumulated over the last 59 years, U.S. households incurred 3.23 times as much in mortgage debt (although down from a peak of 3.88 times as of 1Q 2009), while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.) was “just” 2.06 times as much. Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen LCD TVs (or into “investments” such as education spending), but this does not change the fact that the vast majority of future deleveraging should occur in the U.S. mortgage market. While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the next decade and act as a “cushion” to the housing market, U.S. housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or relocate to smaller or cheaper living areas. In addition, a significant amount of residential housing demand in the major coastal cities (e.g. New York, Los Angeles, San Francisco, etc.) has come from international investors over the last several years. With many emerging market countries now slowing down, and combined with ongoing deleveraging in the U.S. mortgage market, I expect most U.S. regional housing markets to underperform other asset classes for the next decade (although assisted living properties should outperform). The empirical evidence, as suggested by the continuing weakness in the U.S. housing market, confirms this view so far.
Conclusion: As we asserted over the last 2 ½ years, deleveraging within U.S. households, especially in U.S. housing, will be an ongoing theme for at least the next several years. The latest U.S. Flow of Funds data is indicative of this, and I expected the Bernanke-led Fed to remain accommodative until the asset-to-liability ratio of U.S. households rises to 5.50 or higher. In the meantime, I expect the U.S. stock market action to remain tough going into early Fall. We remain neutral in our DJIA Timing System, although we may initiate a 50% long position should the Dow Industrials fall below its recent lows. Subscribers please stay tuned.
Henry To, CFA, CAIA