“Benign Economic Data”
Why is all the recent data which shows that the economy is slowing
talked about as benign? I think the logic is that a slowing economy
will cause the Federal Reserve to stop and possibly reverse their
interest rate policy. While lower short term interest rates will make
bonds less competitive to stocks in terms of yield, the fact the the
federal reserve is lowering rates is a bad sign for the economy. The
Fed tends to lower rates in an effort to stimulate economic growth and
increase the speed at which money flows through our economy. The only
reason for stimulating the economy, however, is that the economy is
already slowing.
So how can a slowing economy be a good thing for stocks? I think the
only answer is that traders believe the economic slowdown will be of
minor scale. They believe it will be a period of slowing growth for a
short period, followed by a resumption of a roaring economy. I tend to
think we are in for more of a shake-up than that.
The housing market is in really bad shape as of late. I read recently
that there is a record high number of sellers in the market. Sellers
have far out numbered the buyers and so prices are falling. Falling
prices encourage potential buyers to wait further until prices fall even
further.
Falling real estate prices are not just bad for the sellers though, they
are also bad for the overextended “owners” who have an overall negative
equity position. For these owners, the value of their home may fall,
but the size of their equity loan will remain the same. They will need
to continue making the same payments, and may even need to increase the
payments as mortage rates rise. Specifically, those with adjustable
rate mortgages may need to prepare for higher payments due to higher
interest rates.
If the economy does go through a significant slowdown, wages will fall.
If wages fall, making mortgage payments will become more difficult.
So what happens if a number of borrowers default on their home
mortgages? Banks will become less willing to lend to new borrowers. I
can’t speak from experience, but my best guess is that lender will
express an unwillingness to extend credit by offering loans at
unattractively high interest rates. What does this do to the adjustable
rate mortgage holder? It increases their interest payments. This could
in turn cause more foreclosures in a vicious cycle. We call this credit
contraction.
As mortgages defaults occur in a falling real estate market, the lender
will lose money on the sale of the home in cases where the borrower had
built little equity. For example, a borrower who had built 30% equity
in their home defaults on their payments. The bank recovers the
property and they can break even on the loan they extended if they can
sell the house for 70% of its value. It is possible for a lending
institution to profit from froeclose in a stable or rising housing
market. Falling markets however, can actaully hurt the lender. If the
price of the home has fallen to 50% of its value at the time the
mortgage was taken, the bank will only be able to secure, at best, a 20%
loss by selling the house for 50% and keeping the borrower’s 30%
equity. This returns 80% of the loan to the lender through the
foreclosure process, which is also quite time consuming.
So in summary, since we have an all time high level of credit in this
country, and a negative savings rate, I think any sign of a slowdown
could be very bad news. The last question is what will cause the real
slowdown? Will it be something obvious such as a political event? Or
perhaps the slow effects of globalization? I’m not sure, but as we say
in the northeast, I’m keeping my eyes peeled.