Economic Update:  The Housing Sector - where it all began and why

-10.09.2009

It is widely known now that the current recession began in the housing sector.    Why did it all begin in housing?  World-wide investors were in search of higher yields following the dot bomb earlier in the decade.  In their quest for higher yields, investors stumbled upon CDOs (collateralized debt obligations).   Some of these CDOs were promising double digit returns, and investors felt safe because many of these CDOs were structured to receive a AAA rating.

A key ingredient in building a CDO was a mortgage.   Due to the relative high yields and safety, CDOs were digested with rapidity.    Higher demand for CDOs required more mortgages, and the issuance of additional mortgages created additional demand for housing.   Higher demand resulted in higher prices.  Foreign investors gobbled up many of these CDOs and so the capital was there to produce more mortgages.  The population of prime borrowers is limited.  So once the CDOs exhausted the population of available prime mortgages, sub-prime mortgages became the next source of mortgage paper for CDO construction. 

The origins of the current recession can be traced to the proliferation of these sub-prime mortgages.   More lending (prime and sub-prime) resulted in even higher property values, and higher property values made additional borrowing possible.   The homeowner’s equity created as a result of the credit boom also induced more consumption.  Home equity loans were used to buy nice furniture, gourmet kitchens, and sporty cars too.  Think about the states that produce furniture, appliances, and automobiles?

All this continued to work just fine as long as property values continued to increase. 

Problems began to surface when some of these sub-prime adjustable rate mortgages were reset, and homeowners were then faced with higher monthly payments.   At this stage, trouble was occurring primarily in Arizona, Nevada, Florida, and California.   Delinquencies and then defaults followed these initial rate resets.   Defaults drove property values lower in these geographical regions, and CDO securities (remember these are constructed from mortgages) began to suffer price declines.  These price declines contributed to bank losses, reductions in bank capital, and consequently less lending.   At that point, we began the downward spiral of less lending, lower property values, and lower spending, less lending, etc.  The recession then ensued and officially began December 2007.

The initial wave of foreclosures occurred with an unemployment rate that in the 5 to 6 percent range, and were not necessarily labor market induced.  During 2009 however, foreclosures continue to increase in many regions across the country, and the increases can likely be attributed to current labor market challenges.

The Federal Reserve of New York provides data on loan delinquencies by state and county.  This information allows us to get a glimpse of loan repayment activity at the county level, and provides some insight on household and consumer challenges. 

The graph below shows the percent change in delinquent loans from the 2nd quarter of 2008 to the 2nd quarter of 2009.   Data are available for mortgages, auto loans, bank cards, and student loans.

As the figure shows, conditions for mortgage delinquencies have worsened.   Crawford and Scott counties are showing the largest percent change in 90+ day mortgage delinquencies.    Floyd and Clark also show a year over year increase in mortgage delinquencies.

It is interesting to note that the greatest variation among counties occurs with student loans.    The largest increases and decreases occur with student loan repayments.    Harrison and Scott show the largest declines, and Orange, Jefferson, IN and Jefferson, KY show the largest increases.

Interestingly, bank cards and auto loans are showing the smallest increases in delinquencies, and in several counties, actual declines in delinquencies are occurring.

Even though we continue to see improvements in the housing sector, labor market challenges are increasingly impacting mortgage delinquencies.  These data show that all counties have experienced an increase in mortgage delinquencies from the previous year.   We also see that bank cards and auto loan payments have not experienced the change in delinquencies of either mortgages or auto loans.

Last Week’s Employment Report

 Last week, the U.S Department of Labor announced acceleration in month over month employment losses.   As we have written on numerous occasions in this column, it was the belief of this writer that employment losses had reached a bottom sometime during mid-year, and up until last week, everything was falling in line.      

Last week’s report provides additional evidence on the wide U shape recovery we have discussed previously.   The concern now is that sustained employment losses will adversely impact consumption and sectors such as housing.   The U shape recovery discussed previously was based primarily on the slow growth in consumption spending due to household deleveraging and higher savings rates.  When you combine this consumer retrenchment with the weak labor market, you have a recipe for a wider U.

Suggestions

If you have any suggestions on future columns or research about specific industries or other economic data, please send me an email at udufrene@ius.edu.

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This information is provided by

Uric Dufrene. 

Uric Dufrene, Ph.D. holds the Sanders Chair in Business in the School of Business at Indiana University Southeast.  He conducts research on local and regional economic trends, and teaches corporate finance at the undergraduate and graduate levels.   He previously served as dean of the School of Business.