Ben Bernanke has been sounding more upbeat on the US economy recently. Last week, the chairman of the US Federal Reserve downplayed the risk of a “substantial economic downturn” and said he was more worried about inflation.
The market took that as a hint that Bernanke was preparing the way for rate hikes. With shop prices rising, commodity prices soaring, the dollar falling and a huge federal deficit to finance, rate hikes may well be what America needs. But while it may suit Bernanke to talk tough, I wonder if he really intends to act tough.
Bernanke no doubt draws comfort from the fact the US economy hasn’t yet slumped as badly as some feared. Over a year after the start of the subprime debacle, it’s still not clear whether America has entered recession – technically defined as two quarters of negative growth.
Even so, the latest data from the housing market are ugly and suggest the housing slump may be getting worse. There are currently five million homes for sale in the US, of which more than two million are empty. And according to the latest data from the Mortgage Bankers Association, a record 2.5% of all mortgage loans were in the foreclosure process at the end of the first quarter, which suggests another 1.1 million homes could soon hit the market.
Another 6.4% of mortgages are in arrears. The rule of thumb is that one third of homes in arrears end up being repossessed. That suggests another one million could end up for sale. To put that in perspective, total home sales in April amounted to just 458,000. As hedge fund manager Annaly Capital Management puts it: “anyone hoping for a bottoming [to the housing cycle] anytime soon is, we believe, whistling past the graveyard”.
There are only three ways this glut of properties is going to be cleared: either sellers will have to capitulate and slash their asking prices, the banks will have to start offering ridiculous mortgages again, or someone is going to have to get busy with a bulldozer. None of these look likely – especially not if the Fed raises rates.
The prospect of further falls in house prices creates two big headaches for the Fed. First, it is likely to lead to weaker consumer spending. The total net worth of households fell by $2.2trn in the six months to the end of March. That’s more than it fell in any of the post dotcom years from 2001 to 2003. The decline in net worth in the first three months of this year alone was $1.7bn. So far, consumer spending has held up better than many expected, but that could easily change.
Second, bigger house price falls means pain for the banks. By the end of May, banks had already written off a combined $380bn as a result of the subprime debacle, according to Bloomberg. But most banks have still not written down their mortgage securities to the levels implied by market prices, which they assume are firesale prices and not representative of what is likely to happen. More losses would require banks to raise yet more capital and would make it harder for them to ramp up their lending.
It’s hard to imagine Bernanke raising rates while all this hang over the economy. For now, he will surely cross his fingers and hope that his tough words will convince the market that he won’t let the dollar slide and inflation rip.
But how much longer can he play this game? Increasingly, he no longer calls the shots. The European Central Bank is refusing to abandon its hairshirt approach to inflation, which is strengthening the euro. And the Chinese efforts to control domestic out-of-control inflation without raising interest rates are becoming increasingly frantic. The same is true of the various Middle Eastern countries that still peg their currencies to the dollar. At some point – perhaps after this summer’s Olympics in China – something’s got to give. And Bernanke will find himself in the uncomfortable position of having to act on his threats.
What about Britain?
If the US housing market is grim, how bad is it going to get in Britain? Over the last few weeks, the headlines have become increasingly lurid, with one report this week suggesting prices could fall 50% in four years. But it’s worth pointing out that Britain is not America; and nor is it Britain in the early 1990s.
The biggest victims of the house-price crash in the early 1990s were over-mortgaged first-time buyers. In 1990, there were one million first-time buyers, representing 50% of all house sales, of whom 35% had 100% mortgages. But in 2007, there were only 300,000 first-time buyers (30% of transactions) and just 5% had 100% mortgages. And the Bank of England reckons only 6% of home owners have equity of less than 20%.
It does suggest that UK homeowners have more of an incentive to hang on, rather than send their keys back to the bank via “jingle mail”. It also suggests British banks should not be exposed to such big losses. Of course, this will not stop prices falling if no one can get hold of mortgages. Nor will it help if people lose their jobs and can’t pay their mortgages.
Simon Nixon is executive editor of Breakingviews.com