Economic update: a semiannual economic forecast for bankers

The economy is performing well. Real GDP and job growth are sturdy, and inflation and interest rates, while edging higher, still remain low. Creditors are benefiting from the good economy, as loan growth is strong and credit quality is good and improving.

The economy does face challenges, however. Surging energy prices are the most recent threat. Oil prices of $50 per barrel have sapped some of the strength in consumer spending. Vehicle sales have been most affected. While unit sales have held up as automakers have added more discounts to compensate for record gasoline prices, buyers are switching from larger, less energy-efficient SUVs to cars. Consumer confidence and core retail sales, which exclude spending on vehicles and gasoline, have also moderated. Lower-income households that spend more of their budgets on energy and have fewer other financial resources are particularly worried.

Judging by a recent surge in inventories, the less aggressive consumers have taken some businesses by surprise. Manufacturing production and jobs will suffer a bit in coming months as businesses work to get inventories back in line with sales.

Manufacturers also continue to struggle in their competition with China. The trade deficit with China is ballooning and unlikely to improve any time soon, even if the Chinese begin a much-anticipated process toward a freely floating currency. China's cost advantages are large, and the Chinese yuan is not substantially undervalued.

One constant throughout the economy's ebbs and flows in recent years has been the housing market. Housing activity has pushed steadily higher and is arguably now as strong as it has ever been. Single-family homebuilding, new and existing home sales, and real house price gains continue to shatter previous records.

The contribution of the housing boom to the economy's growth has been enormous, accounting for an estimated one-fourth of real GDP growth over the past five years. The most obvious link between housing and the broader economy is through construction activity, real estate transactions, and mortgage finance. The multiplier benefits are substantial, as this activity generates demand in numerous supplying industries, and the earned income drives spending elsewhere in the economy.

An even more important link has been through massive mortgage equity withdrawal. Homeowners took an estimated $700 billion out of their homes last year through home equity borrowing, cash-out refinancing, and capital gains realizations from home sales. This is up from less than $600 billion in 2003 and only $250 billion in 2000. Based on Federal Reserve studies of what homeowners did with the cash raised in previous refinancing waves, approximately one-third of this cash is being used for debt repayment, one-third for home improvement and other investments, and the remainder on a wide array of consumer goods and services.

Housing is also driving broader growth through the nation's lenders. Residential mortgage loans-whether whole or securitized--are approaching one-third of commercial bank assets. Given the currently pristine loan quality, the banking system is well capitalized and thus willing and able to provide credit to all borrowers.

Local governments flush with rising property tax revenues are also spending aggressively. This has been particularly fortuitous given the rapidly expanding demands on the school system from the aging baby-boom-echo generation and cuts in grants from financially stressed state governments.

Housing will be increasingly hard-pressed to support the economy's future growth, however. While housing demand has been driven by solid fundamental forces--most importantly, low mortgage rates and the explosion in mortgage credit--it appears to be increasingly driven by speculation.

Speculation infects demand when buyers purchase an asset based only on the expectation that its historically strong price gains will be repeated long into the future. While it cannot be known for sure that speculation is driving asset demand until prices for the asset break, there are often signs.

In the housing market, one clear sign is a rising share of homes being purchased by investors. The investor share is indeed rising rapidly in hyped-up markets in California, Florida, and the Northeast. Another sign is the willingness of buyers to taken on more leverage and risk to purchase a home. Interest-only mortgages, which were the domain of a handful of high-end homebuyers just a few years ago, accounted for more than one-sixth of mortgage originations during the last half of 2004, according to the Mortgage Bankers Association.

One approach to measuring the degree of speculation in housing markets is to estimate a model of house prices based on the various factors that determine demand and supply. While no model can completely capture all of the forces driving the housing market, if actual prices are measurably different from what the model expects, then the market may be affected by speculative fervor. Based on such an approach, markets accounting for nearly half of the nation's housing stock now appear speculative.

Speculation is not easily wrung out of asset markets, as hardened expectations are slow to change. When expectations finally do change, however, they tend to shift quickly, sending prices tumbling. There also has to be a catalyst for such a shift. Usually, one fundamental force driving demand and supply has to change. In the housing market, the likely catalyst almost certainly must be higher mortgage rates.

Mortgage rates are expected to rise in coming months. This can be stated with much certainty with regard to rates on adjustable mortgages, as they are tied closely to Federal Reserve policy. Policymakers are engaged in a series of tightening moves that seem set to push the federal funds rate target up from its current 3% to well over 4% by this time next year.

With adjustable rates rising, pressure on homebuyers will build, but housing will remain resilient until fixed mortgage rates rise. Fixed rates are also expected to rise, but precisely when and by how much can not be stated with any certainty. Fixed rates are tied to long-term Treasury bond yields, which have remained surprisingly low. The weights on long-term rates, however, including a halting job market, a lack of business borrowing, and aggressive foreign central-bank buying, appear to be lifting. Even a small rise in fixed rates will have a substantial impact on housing activity and thus on broader economic growth.

How this impending adjustment unfolds depends on when, and how high, long-term rates rise. If long-term rates soon begin to rise and increase moderately over an extended period, then the current expansion may stumble but it will not falter. This is the baseline and most likely outlook. Long-term Treasury yields are expected to move from near 4% currently to over 5% a year from now. lf long-term rates remain stubbornly low and the housing market becomes further juiced-up, however, the eventual and inevitable adjustment will be much more painful.

Be Prepared

Lenders must prepare for the coming adjustment in the housing and mortgage markets. Given the currently stellar credit conditions, fierce competition, and substantial capacity to extend credit, pressures to further extend the mortgage credit envelope are intense. These pressures must be deflected, however, by holding the line on underwriting standards, carefully managing staffing levels, searching for other avenues of revenue growth, and doubling-up efforts to develop better tools to quickly detect shifts in housing market conditions. Lenders who may appear a bit stodgy in the coming year are likely to enjoy much greater success over the coming decade.

Contact Zandi by e-mail: mzandi@economy.com. [c] 2005 & RMA. Mark Zandi, Ph.D., is chief economist at Economy.com in West Chester, Pennsylvania.

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