US Views: How Deep and How Long?
There is no longer much doubt in my mind that the economy is now in recession. First, employment seems to be contracting. This is not just because of the decline in January payrolls, but also because the unemployment rate and continuing jobless claims over the past few months have risen at a pace that typically indicates falling employment. Second, the business surveys have weakened sharply over the past month. That’s particularly visible in the omfg. ISM and the Fed’s Senior Loan Officers survey, but second-tier surveys such as the Philly and Richmond Fed tell a similar tale (only the mfg ISM was a bit better). Third, the negative feedback loops that define a recession are now in full swing, especially the links between falling house prices, rising mortgage credit losses, rising credit restraint, falling homeownership and employment, and further declines in house prices.
The key question is now the depth and length of the recession. I continue to think it will be relatively mild, much closer to the 1990-1991 and 2001 downturns than the 1973-1975 recession or the 1980-1982 double dip. However, I am less confident in terms of length. Sure, the fiscal and monetary stimulus should produce positive growth in 2008 H2, but the question is whether growth falters anew when the stimulus has passed. Accordingly, we have a 0% GDP quarter in early 2009, not quite a double dip but awfully close.
The reason why the economy is likely to stay weak for quite a while is that it’s hard to see a genuine acceleration while home prices are still falling and estimated mortgage credit losses are still rising. Since last fall, our working assumption has been a total mortgage credit loss of $400bn. But I think the risks to this estimate have shifted to the upside because house prices are currently falling even faster than we had expected. By our estimates, the 20-city composite Case-Shiller index for November shows a 20% annualized rate of decline in seasonally adjusted terms. The national decline is probably a bit slower (bubble markets are over-represented in the 20-city index), but this does suggest that the risks to our estimate of a 10% decline in all of 2008 are skewed to the upside.
The basic problem is that a $400bn estimate doesn’t leave a lot of room for losses on non-subprime mortgages, which are likely to rise sharply if home prices drop a lot. Most mortgage strategists currently expect $200-$300bn of losses on the subprime mortgages alone but see non-subprime losses of less than $100bn. The latter is probably too optimistic. If home prices decline another 15% from current levels, we estimate that there will be about 15 million homeowners (or 30% of all households with mortgages) who have negative equity, i.e. mortgage debt that exceeds the value of their house.
Of these, about $1 trillion will be held by subprime borrowers, but the remaining $2 trillion will be held by other borrowers. A significant share of these borrowers– hard to know how many, but very likely more than the less than the roughly 10% suggested by a $100bn non-subprime loss estimate – is likely to default. This is either because they lose their jobs and have insufficient financial resources (yes, this can also happen to non-subprime borrowers) or because they decide to “walk away” from their mortgage.
The latter behavior isn’t at all common under normal circumstances, but one lesson of the Texas and California housing downturns of the 1980s and early 1990s is that some homeowners decide to “mail in the keys” when they are deeply in negative equity and see little chance of returning to a positive-equity situation. (Note that many states, including California and Texas, prevent mortgage lenders from seizing assets other than the house itself.)