A Macro View: Will the Shape of Recovery be V or W?

By Ron Rutheford, Sabrient Corporate Macroeconomist

In my last blog post, I quoted a section of Econoday stating that the ISM report was a sign of a V recovery. Mark Perry of Cape Diem shows other V-Signs of Economic Recovery graphically. But we still have the housing market to deal with, and some believe that a recovery is not possible without housing at least being on stable ground. Although as stated before I do not expect the construction industry to be a growth sector as noted in the Calculated Risk blog, Construction Spending Declines in December.

One of the factors that could in fact determine this outcome between a W or V recovery has to do with some moral questions. In the New York Times article No Help in Sight, More Homeowners Walk Away David Steitfeld quotes homeonwner Benjamin Koellmann:

Most of all, though, he struggles with the ethical question.

"I took a loan on an asset that I didn't see was overvalued," he said. "As much as I would like my bank to pay for that mistake, why should it?"

Another post at the Calculated Risk blog (Tanta on Let's Talk about Walking Away) criticizes some of the reporting on the "walk away" home owners and provides some good insights into these concepts of home foreclosures. Part of this moral dilemma arises from the fact that mortgages in the USA are non-recourse loans, unlike a car loan. If you turn in your keys and walk away from a car loan the bank can sell the vehicle and still collect, or try to collect, from you the balance still owed, including interest. In a housing loan the bank can-not go after the buyer for any difference between what is owed and the proceeds of the sale. Morgan Housel at Motley Fool asks the question "Could This Prevent Another Housing Blowup?" His thesis is that if the US (like most countries) reverted to "full-recourse" housing loans, then it is less likely that will form. He compares changes in housing prices in the US and Australia to illustrate the point. In this scenario, we would also not face the moral questions that we as a nation are discussing now.

Matt Koppenheffer, also at Motley Fool, provides a counter-intuitive argument that underwater homeowners should in fact make strategic defaults on their mortgages, and he introduces the subject by asking tactfully "Why Are Homeowners Idiots?"

Why don't they walk away?
An interesting quirk of economics is that the dismal science generally assumes that all agents in an economy work in their own best interest. But this doesn't always happen in real life.

The mortgage crisis is a case in point. For many of the underwater homeowners in today's market, paying down their mortgage isn't really in their best financial interest. Particularly in states like Arizona - where mortgages are nonrecourse, meaning the lender can't go after any of the homeowner's assets other than the property itself - it makes little sense to continue paying a large mortgage on a devalued house when comparable rental rates are far below the monthly mortgage payment.

The answer to the headline question is that housing is more than just an investment and thus consumers are not "profit maximizers" and do not act always in "their best financial interest" but according to the dismal science are "utility maximizers". Thus staying in a home maybe better for the family than moving away from the familiarity of the neighborhood as well as the amenities of home ownership. This is where morality comes in that individuals also have a desire to be "good citizens" and to abide by the customs and practices of the community he/she chooses to live in. When those standards change then a vicious cycle can form as this passage from Mish's Global Economic Trend Analysis post entitled Will "Walk Aways"; Increase Discretionary Spending? shows.

After reading your work, I began to examine the attitudes of my neighborhood. The first foreclosure was one of those borderline families you often write about. They were in over their heads and couldn't afford the house they were living in. Most likely mortgage reset. In any event, the scuttlebutt around the neighborhood was one of scorn, shame, and embarrassment. No thought was given to the negative impact to the value of all our homes in this subdivision. With each subsequent "pre-foreclosure," people's attitudes softened about their ex-neighbors. Gone was the Scarlet F; it was replaced with empathy, understanding, and even compassion. Maybe the attitudes have changed because people now realize that the value of their homes have fallen off a cliff. They don't have time to shame their ex-neighbors when they are worrying about their wealth is being vaporized or a $400 natural gas bill or car payment or the kids or whatever.

Now, I understand that this is one neighborhood in one small town in the Midwest. I also know this is anecdotal evidence. But as I have learned covering retail stocks for so many years: I trust my eyes and common sense and ignore people with a vested interest in the outcome of a situation. My eyes and common sense tell me that times are changing. It has become more socially acceptable to walk away from your house. If one of my neighbors walked away today, most of the remaining neighbors would shrug their shoulders, say that's too bad and move on. I will be looking for the next phase of this shift in attitude, when remaining homeowners think or say I wish that was me moving-getting out from this 3,000 square foot rock that has ruined me financially.

Matt Koppenheffer provides more reasons for why underwater homeowners should in fact walk away from their debts in another tactful article entitled "Why We Care About Idiot Homeowners?" After presenting a good analysis of formation of a vicious cycle in housing under the banner of "Adding fuel to the flames", he presents the counter arguments starting with the point we will just be delaying the inevitable. But, that in fact, maybe what the market needs now-a "bank holiday" or a cooling off period. Markets can overshoot the equilibrium price which some define as "animal spirits". Momentum players try to ride the wave as long as possible and even George Soros used something similar when overshooting the equilibrium exchange rate prices to make money. But the problem is that overshooting can be just as harmful for efficient allocation of resources in an economy as undershooting the equilibrium price. And of course, high social costs may develop, as was the case of collapse of the British Pound.

While some homeowners do in fact need to move, surely not all underwater homeowners need to move now. The situation that precipitated the need to move could just as easily change again for the family. Preemptively defaulting can only lead to overshooting equilibrium price and creating a vicious cycle of declining home prices.

If mortgages were not nonrecourse, then the investment decision would not be based at all on the equity of the asset but in fact would ignore sunk costs and only focus on which direction the asset is likely to follow or in other words whether it will gain in value or decrease. So I am not sure the distinction has merit when considering this as strictly as an asset under reasonable moral guidelines.

Matt does provide some guidance as to what may be the equilibrium prices of housing stock by noting average home sales as a multiple of average annual rental rates based on the historical average of 14.6. While it is true that the multiple is higher still, I think this piece of information is while interesting it does account for sufficiently for changes in how home ownership is valued. That is, the benefits from home ownership may be higher now than historically and also interest rates are bound to affect this ratio especially with the very low rates now. A better gauge, for determining if housing prices are out of normal range, is provided by Morgan Housel at This Is Killing Housing Prices. Morgan created his own index based on a price-to-income ratio. From 1987 to 2000 the index was close to the index date of 1987 at 1. But since 2000 when it was back to the starting index of 1, it rose to a high of 1.64 in 2007 and now has dropped to 1.04 in 2009. I suspect even here there is some room to fall further but a lot less than the approximately 19% suggested by Matt's numbers.

What does this all mean?

As Calculated Risk noted, we do not have enough data to get a good enough model for understanding what is going on in the housing market, but, whatever happens, if what is acceptable changes then all bets are off on how low the housing market may go. Matt states that "homeowners living in houses that are vastly underwater is a problem for the housing market". This is not correct as these are issues dealing strictly with private consumption. The social costs come into play if all the underwater home owners (as well as the banks holding properties off the market) decide to sell in the short term and that is when we can see the animal spirits come alive.