Deutsche Bank on Digesting the Credit Crunch
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Deutsche Bank on Digesting the Credit Crunch

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Central Scenario: Mild Recession, sluggish recovery ...

Central Scenario: Mild Recession, sluggish recovery
􀂃 Risks: Deep/prolonged recession vs. inflation.
􀂃 Critical Recession Risk factor: Home prices (HP).
􀂃 HP Drivers: and why they point to mild Recession
􀂃 HP Effects: Credit crunch and Wealth Loss
􀂃 What the Fed has done, and what more might be done.
􀂃 Inflation risk.

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Deutsche Bank on Digesting the Credit Crunch Deutsche Bank on Digesting the Credit Crunch Presentation Transcript

  • Digesting the Credit Crunch Home Prices Are Key Presentation to UCSD Economics Roundtable Peter Hooper April 22, 2008 Chief Economist Deutsche Bank Securities DISCLAIMER AND ANALYST CERTIFICATION ARE LOCATED ON THE LAST PAGE
  • Key Issues Central Scenario: Mild Recession, sluggish recovery Risks: Deep/prolonged recession vs. inflation. Critical Recession Risk factor: Home prices (HP). HP Drivers: and why they point to mild Recession HP Effects: Credit crunch and Wealth Loss What the Fed has done, and what more might be done. Inflation risk. Conclusions 2
  • Consumer sentiment in mild recession territory Index Index 160 160 Conference board’s 140 140 consumer confidence 120 120 100 100 80 U. Michigan 80 consumer sentiment 60 60 40 40 1978 1983 1988 1993 1998 2003 2008 Source: University of Michigan, Conference Board, DB Global Markets Research 3
  • Key components of consumer spending have been slowing 3M %chg, 3M %chg, AR AR Core retail sales (ls) 10 30 20 5 10 0 0 -10 -5 Light vehicle sales (rs) -20 -10 -30 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 Source: BEA, Autodata Corporation, DB Global Markets Research 4
  • Business spending softening too 3M %chg, AR QoQ %chg, AR 22.5 22.5 Capital goods 15.0 orders (ls) 15.0 7.5 7.5 0.0 0.0 Real private -7.5 nonresidential -7.5 investment (rs) -15.0 -15.0 2005 2006 2007 2008 Source: BEA, Census, DB Global Markets Research 5
  • Labor market pointing to recession % % 12 12 Unemployment 10 rate 10 8 8 6 6 4 4 2 2 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008 Source: BLS, DB Global Markets Research 6
  • Mild Recession Scenario Real GDP Q4/Q4 2007 2.8 2008 0.8 Spending contributions 2009 2.3 Q/Q%, AR Consumer spending (PCE) Nonres investment Q/Q%, AR Res investment Change in inventories 7 7 Net exports Government 6 6 Forecast 5 5 Trend 4 Real GDP growth 4 3 3 2 2 1 1 0 0 -1 -1 -2 2003-06 -2 average -3 Q3 Q1 Q2 Q3 Q4 Q4 -3 Q4 2007 2008 2009 Source: BEA, DB Global Markets Research 7
  • Key Components of GDP Spending components of GDP in 2007 Net exports, Change in -5% inventories, 0.00% Government spending, 19% Business fixed investment, 11% Consumer spending, 70% Residential investment, 5% Source: BEA, DB Global Markets Research 8
  • Risk of deeper/more prolonged recession: Critical factor is how far and how fast home prices fall Fall in housing equity affects aggregate demand through: Drop in household wealth depressing consumer spending. Credit crunch: Loss on foreclosures, decline in MBS values, de-leveraging, credit cutbacks. 9
  • Renormalization of home price/rent ratios points to substantial drop in home prices 1991-2003=1.0 2.0 Home price/rent ratios* 2.0 Case-Shiller, 1.8 composite 10 1.8 1.6 1.6 1.4 1.4 OFHEO Purchase 1.2 only price 1.2 1.0 1.0 0.8 0.8 1990 1994 1998 2002 2006 2010 *Uses Owners’ equivalent rent from CPI Source: Census, DB Global Markets Research 10
  • Case-Shiller futures not anticipating full renormalization 1991-2003=1.0 2.0 Home price/rent ratios 2.0 Case-Shiller, 1.8 1.8 composite 10 1.6 C-S 1.6 futures 1.4 1.4 OFHEO Purchase 1.2 1991-2003 average* 1.2 1.0 1.0 0.8 0.8 1990 1994 1998 2002 2006 2010 *Also in line with longer-term trend for Case Shiller price/OER rent ratio. Source: Census, DB Global Markets Research 11
  • Conventional home price indexes may overstate the problem—price run-up reflected improving quality 1991-2003=1.0 2.0 Home price/rent ratios* 2.0 Case-Shiller, 1.8 composite 10 1.8 1.6 1.6 C-S futures 1.4 1.4 OFHEO Purchase Constant Quality 1.2 New Home Price 1.2 1.0 1.0 0.8 0.8 1990 1994 1998 2002 2006 2010 *Uses Owners’ equivalent rent from CPI Source: Census, DB Global Markets Research 12
  • Factors Driving Home Prices Lower 1.Underlying supply and demand fundamentals: Excess stock of housing = total no. of housing units minus no. of households Change in excess housing stock = housing completions – (household formations + demolitions (removals)) 2. Shift in demand from owner-occupied to rental units, due to: Rising foreclosure rate. But increase in home affordability is beginning to shift demand back from rental to owner-occupied, a plus for prices. 13
  • Stock of vacant homes inversely correlated with HPA Ratio yoy% Vacant houses for 7.0 Real conventional 12 sale: months mortgage price 6.5 supply (ls) 10 inflation (rs) 6.0 8 6 5.5 4 5.0 2 4.5 0 4.0 -2 3.5 -4 3.0 Correl. = -0.70 -6 2.5 -8 1968 1973 1978 1983 1988 1993 1998 2003 2008 Source: Census, Realtor, DB Global Markets Research 14
  • Excess Housing Stock now at about 900k units Thousands Thousands 12000 12000 Vacant homes* 11000 11000 10000 10000 Trend calculated from 1965 to 2003 9000 9000 8000 8000 7000 7000 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 * Includes homes for sale, homes for rent, and homes held off the market; excludes seasonal homes and second homes not used a primary residence. Source: Census, DB Global Markets Research 15
  • Growth of housing stock has now fallen below long-run average growth in demand Thousands Thousands 2500 2500 Home completions Housing permits 2000 2000 1500 1500 Trend growth in demand 1000 1000 500 500 0 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Census,NAR, DB Global Markets Research 16
  • “Demand” fluctuates around trend; returns to trend implies runoff of excess stock could exceed 500k AR. Thousands Thousands 2500 “Demand” (household 2500 formations + removals New home completions Housing permits 2000 2000 1500 1500 1000 1000 500 500 Household formations 0 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Census,NAR, DB Global Markets Research 17
  • Shift from owner-occupied to rental units: Foreclosures are soaring and depressing prices % % 2.5 2.5 Percent of US residential mortgages 2.0 2.0 1.5 1.5 Homes in foreclosure 1.0 1.0 Foreclosures started (per qtr) 0.5 0.5 0.0 0.0 1979 1983 1987 1991 1995 1999 2003 2007 Source: MBA, DB Global Markets Research 18
  • Strong bounce-back in housing “affordability” will help Index Index 150 200 Housing affordability (ls) 190 140 180 130 170 160 120 150 110 140 100 130 120 90 Mich Survey: home buying conditions (rs) 110 80 100 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Source: UM ICH, NAR, DB Global Markets Research 19
  • Affordability has improved as home prices have declined relative to income. Index Index, Housing affordability index (inverted, ls) 2002=100 95 125 100 120 105 115 110 110 115 105 120 100 125 95 130 Existing home sales 135 price/ income ratio (rs) 90 140 85 2001 2002 2003 2004 2005 2006 2007 2008 Source: REALTOR, BEA, DB Global Markets Research 20
  • Affordability index uses median existing home sales price 1991-2003=1.0 Home price/rent ratios* 2.0 2.0 Case-Shiller 1.8 1.8 1.6 OFHEO Purchase 1.6 price C-S futures 1.4 Median sales price 1.4 for existing single family 1.2 homes 1.2 1.0 1.0 Quality-adjusted price index 0.8 0.8 1990 1994 1998 2002 2006 2010 *Uses Owners’ equivalent rent from CPI Source: OFHEO, NAR, BLS, Census, DB Global Markets Research 21
  • Home sales may be starting to respond to improvement in affordability Thousands Thousands 8000 8000 7500 Total home sales 7500 7000 7000 6500 6500 6000 6000 5500 5500 5000 5000 4500 4500 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Realtor, Census, DB Global Markets Research 22
  • How lower home prices impact the economy Wealth Effect: effect of declining housing wealth on consumer spending Credit crunch Effect: effect of declining housing asset values on mortgage-related financial losses; implications for cost of credit as de-leveraging occurrs. 23
  • Household saving rate should rise as wealth/income ratio recedes % ratio Stock -25%, House 14 6.5 prices -15% from peaks 12 Personal saving rate (ls) 6.0 10 8 5.5 6 Wealth-to-income ratio (rs) 5.0 4 2 4.5 0 -2 4.0 1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 Source: BEA, FRB, DB Global Markets Research 24
  • The Credit Crunch 25
  • Interbank risk spreads have remained wide despite Fed rate cuts % % 6.0 3 month LIBOR 6.0 5.5 5.5 5.0 5.0 4.5 4.5 3 month USD swap OIS 4.0 4.0 3.5 3.5 3.0 3.0 2.5 2.5 Fed funds target 2.0 2.0 1.5 1.5 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Source: Bloomberg, Haver, FRB, DB Global Markets Research 26
  • Private long-term rates rising, or declining only slowly % Home equity loans % 12 US home mrtgage 30 yr Jumbo national avg 12 US conventional 30 yr mortgage 11 High yield corp. 11 10 10 9 9 8 8 7 7 6 6 5 5 High grade corp. 4 4 3 3 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 Source: Bloomberg, Haver, FRB, DB Global Markets Research 27
  • Corporate funding costs up sharply Credit spread (Baa Corp - 10yr Treas) bp Yield curve (10yr Treas - 3mo T-bill) 560 600 500 400 340 320 300 180 185 200 100 175 220 140 10 0 50-year average 2006-07 average Latest week Source: FRB, Bloomberg, DB Global Markets Research 28
  • Securitized mortgage lending has disappeared $ bn, AR $ bn, AR Alt-A Subprime Jumbo 900 900 800 800 700 700 600 600 500 500 400 400 300 300 200 200 100 100 0 0 2001 2002 2003 2004 2005 2006 2007 2007 2007 2007 2008 1Q 2Q 3Q 4Q (Jan & Feb) Source: MBA, DB Global Markets Research 29
  • But bank credit conditions for households are tightening % Fed Survey: banks tightening lending standards % 70 Mortgages (ls) -60 60 Consumer Loans (ls) -50 50 Credit Cards (ls) -40 40 -30 Banks' willingness to make consumer 30 loans (inverted, rs) -20 20 -10 10 0 0 10 -10 20 -20 30 1996 1998 2000 2002 2004 2006 2008 Source: Federal Reserve Senior Loan Officer Survey, DB Global Markets Research 30
  • Residuals show relationship to banks willingness to extend consumer credit around recessions Banks’ willingness to make consumer % d log installment credit loans (ls) 100 0.03 80 Residuals (rs) 0.02 60 40 0.01 20 0 0.00 -20 -0.01 -40 Estimated coef on BW is signif and -60 indicates that -10 on BW reduces PCE growth by 0.4% pt. -0.02 -80 -100 -0.03 1966 1972 1978 1984 1990 1996 2002 2008 Source: FRB, DB Global Markets Research 31
  • Summing up Downside Risks For every 10% additional drop in home prices: – Household wealth falls by $2 trn – Consumer spending is reduced by 1% via wealth effects – Financial sector losses on foreclosures increase by $50- 100bn – Tightening of credit conditions associated with de- leveraging could reduce GDP by an additional 1/4-1/2% There is considerable uncertainty surrounding the magnitude of these wealth and credit effects. 32
  • Fed has cut unusually aggressively in response to downside risks % % 10 10 Actual Fed funds rate 8 8 6 6 4 4 2 2 Taylor rule specification with employment gap* 0 0 1987 1990 1993 1996 1999 2002 2005 2008 * FFnom = 2.5 - 2*(UR - NAIRU) + 0.5*(Core PCE inflation - 1.75) + Core PCE inflation Source: FRB, BEA, CBO, DB Global Markets Research 33
  • US Policy Actions to Address Housing and Credit Crunch Fed rate cuts: 300 bps. Liquidity enhancements: Fed Discount Window penalty cut 75bps, term increased to 90 days TAF 28-day credit to banks, broad (DW) collateral, auction det. rate TSLF 28-day credit to primary dealers, AAA-rated collateral, auction det. rate PDCF Overnight loan facility for primary dealers BBB or better collateral, DW rate Large scale FHLB advances to banks, favorable rates, broad collateral. Fed $29bn rescue package for Bear Stearns Swap arrangement with ECB and other central banks. Measures to bolster mortgage market. Agency loan limits raised to reflect diff. median home price levels across regions Agency capital limits increased and requirements relaxed, allowing $400bn more Agency purchases. FHLB purchases of Agency MBS doubled ($100+ bn) Fiscal stimulus package: $168bn tax rebates to households, credits to firms. Possible further measures. Fed purchases of Agency MBS. Mortgage write-down proposals. Government purchases of private mortgages and MBS.. 34
  • Inflation: Headline running well above comfort zone yoy% Consumer prices (PCE) yoy% 4.0 4.0 3.5 Core (ex 3.5 food and 3.0 Headline energy) 3.0 2.5 2.5 2.0 2.0 Fed’s 1.5 Comfort 1.5 zone 1.0 1.0 0.5 0.5 1996 1998 2000 2003 2005 2008 Source: BEA,DB Global Markets Research 35
  • Surge in oil prices still poses inflation risk yoy % yoy % Crude oil price 160 160 CPI: energy PPI: energy goods 120 120 80 80 40 40 0 0 -40 -40 -80 -80 1997 1999 2001 2003 2005 2007 Source: BLS, WSJ, DB Global Markets Research 36
  • Food prices still look troublesome too yoy% yoy% CPI: food 50 CRB Commodity price index: Food 50 Core CPI 40 40 PPI: Intermediate foods and feeds 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 1997 1999 2001 2003 2005 2007 Source: BLS, CRB, DB Global Markets Research 37
  • Falling dollar means more import price inflation yoy% yoy% 6 5.0 Import price index: excl. fuels (rs) 4 4.0 2 3.0 0 2.0 -2 1.0 -4 0.0 -6 -1.0 Nominal broad trade-weighted -8 exchange value of US$ (ls) -2.0 -10 -3.0 2004 2005 2006 2007 2008 Source: BLS,FRB, DB Global Markets Research 38
  • Longer term inflation expectations moving upward % % 5Y5Y breakeven 3.5 inflation expectations 3.5 UMich 5-10 year inflation expectations 3.0 3.0 2.5 2.5 Philly Fed (SPF) CPI inflation expectations 2.0 2.0 Philly Fed (SPF) PCE inflation expectations 1.5 1.5 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Source: U.Mich,Bloomberg,Phil Fed, DB Global Markets Research 39
  • Labor market easing % % 11 11 Unemployment 10 rate 10 9 Estimated NAIRU range 9 8 8 Mild Recession 7 7 6 6 5 5 4 4 3 3 1970 1980 1990 2000 Source: BLS,CBO,DB Global Markets Research 40
  • Unit labor cost inflation receding % % 6 6 Unit labor cost 5 (4q % change) 5 Core PCE price index 4 4 3 3 2 2 1 1 0 0 -1 -1 -2 -2 1990 1993 1996 1999 2002 2005 2008 Source: BLS, DB Global Markets Research 41
  • Conclusions US economy likely in mild recession. Housing overhang should begin to drop significantly in next several quarters. This should limit further drop in home prices, and along with monetary and fiscal stimulus, help keep recession mild. Risks to this view are weighted more to the downside than the upside, given ongoing credit crunch. Inflation risks still present, but receding as growth slows and labor market softens. Fed likely to cut rates moderately further. Expect a relatively sluggish recovery through 2009. 42
  • Peter Hooper Managing Director, Chief Economist Deutsche Bank Securities, Inc. Peter Hooper oversees a team of economists that analyze and forecast developments in the US economy and financial markets. Dr. Hooper joined Deutsche Bank Securities in the fall of 1999 as Chief US Economist, and was appointed Chief Economist in 2006. Dr. Hooper frequently comments on US economic and financial developments in the news media. Prior to joining the firm, Dr. Hooper enjoyed a distinguished 26-year career at the Federal Reserve Board in Washington, D.C. He held numerous positions at the Fed, including as an economist on the FOMC and as Deputy Director of the Division of International Finance. In doing so, he developed an informed view of the Fed's policy making process. Dr. Hooper earned a BA in Economics (cum laude) from Princeton University and an MA and Ph.D. in Economics from University of Michigan. He has published numerous books, journal articles, and reviews on economics and policy analysis. 43
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