There is no shortage of opinion on the wealth effect and the degree to which home price swings impact consumer spending. A recent study suggests the impact on consumer spending from housing wealth is overstated. For us, it is hard to look past the results of the recent housing cycle and not see a direct and sizeable impact on consumer behaviour. For this reason we want to refresh where we believe housing stands. Moreover, given the broad reach of housing, it is little surprise this sector commands so much attention from the Fed. The October 2008 ascension of the Chinese as the largest owners of Treasury securities has propelled the Chinese investor base to the forefront of Treasury market psyche. And the recent discussion about the $2 trillion of the country’s FX reserves being diversified has left Treasury yields well off their lows. The idea of a wealth effect is appealing since it seems to fit neatly with straight forward thinking. If your most important asset is falling in price you are likely to pullback on spending. The problem is that the detailed analyses of this phenomenon are essentially all over the place.

What we do know with some certainty is the ability to extract equity from a home impacts homeowners on a number of levels. A Federal Reserve study found that such extractions were distributed broadly: 35% was used for home improvement, 26% was used for repaying other debts, 21% was used for making other investments, 16% was used for broad consumer spending and 2% was used for taxes. Ultimately, as this Fed survey shows, housing reaches broadly into various economic sectors, which only increases its importance on the broader economic backdrop. Currently, however, a number of challenging headwinds exist in the housing market.

Where we stand on imbalances

The housing market remains plagued by an oversupply of homes. This is true in both the new and existing home markets. The outstanding months of supply have come off their cyclical peaks (which were at or close to historical highs around year end) but remain elevated at around 10 months. There is typically a balance between buyers and sellers when these figures are near 6 months. The recent improvement in this supply measure is due in large part to the stabilization in sales. However, in the existing home market, about 40% of recent sales are considered distressed. This will only act to suppress home prices in the near-term.

There have been various estimates of how much further home prices could decline. An indicator we like to use is the home price to income ratio. During the late 1980’s home prices rose about 1 standard deviation (SD) above the longer-term average with the subsequent decline dropping about 1 SD below the average. In the recent episode the rise over the average was about 2 SD and presently we stand 1 SD below the average. If the move up is followed by a near equal move lower, then to get to 2 SD below the average would require an additional decline of about 10%, all else equal. Realistically, such a dramatic move may not be forthcoming given the aggressive fiscal and monetary response targeted toward housing, but the exercise is instructive and indicates that a further significant unwind still needs to occur. And, of course, as house prices ease further, this will only add to loan delinquencies and foreclosures, and the balance sheet problems of the financial sector. This is one negative feedback loop that is far from exhausted.

The façade that is housing affordability

If we were to believe the housing affordability index, we would be in a period of record affordability. A key driver of this seemingly positive development is the fact that up until recently, mortgage rates had declined sharply. However, this improvement in mortgage rates tended not to matter since few potential homeowners were able to take advantage of low rates thanks in part to tighter lending standards. Moreover, with mortgage rates up sharply since mid May, the affordability index is set to fall. The moral of the story is an improvement in this indicator is only useful if the gains are realized. In this instance, few were able to take advantage of the improvement.

Housing and the Fed

Even though home sales are no longer declining, as discussed above a number of issues still need to be worked through. From the Fed’s perspective, housing is a key transfer mechanism for monetary policy, so it comes as no surprise housing has received a good portion of its attention. The Fed focused on buying MBS to fill the void created by the lack of foreign investors and GSEs at the end of last year. They originally planned to purchase $500 billion mortgages but have since revised their purchase amount to $1.25 trillion by year end in an attempt to revive the market.

The Fed effectively controls mortgage rates relative to Treasury yields through these purchases by buying the majority of gross supply. The Fed now has about $590 billion left to purchase out of a maximum of $1.25 trillion. The Fed has typically been purchasing more than the gross issuance of mortgages issued by Fannie and Freddie. The issuance numbers for Fannie most recently include securitization of whole loans held on their books into securities (this is not really supply into the market as Fannie retains these pools). Going forward, we believe the Fed is likely to allow the mortgage purchase program to slowly tapper off into 2010 to gradually reduce the MBS markets dependence on the combined Fed and Treasury purchase programs.