I Know He's Bearish

Nouriel's post on the state of the housing market is unusually bearish, even for him. If the housing slump deepens, all bets are off:

... Even more ominously, futures markets now expect that house prices will fall during 2007. Following the lead and prodding of Robert Shiller – the maverick Yale professor who predicted the 2000 stock bust and is now predicting a housing bust - the Chicago Mercantile Exchange opened this spring a new futures market for house prices in ten U.S. cities. While this market is very new and still relatively illiquid, it is now predicting that U.S. house prices will fall in 2007 at the national average level, for the first time in over fifty years. The index of this futures’ market for the entire US is projecting a 5% price fall in 2007. And the futures contracts for individual cities show expected declines in housing prices even larger than 5% for Miami, New York, Boston, San Francisco, Boston, San Diego, Miami, New York and Las Vegas.

The likely fall in median home prices in 2007 may actually turn out to be larger than the 5% priced in the futures markets. In fact, one of the peculiar features of the latest housing cycle has been the presence of a large housing bubble: prices were going up well above economic fundamentals because of the speculative demand coming from expectations of increased housing prices that were feeding further speculative demand: "condo flipping" is the popular term for this speculative demand. Now that the bubble is bursting the fall in prices will be sharper than the one implied by medium term fundamantals as the initial price increase was due to a bubble that is bursting and leading to a fall in speculative demand: with prices now falling homeowners and speculators have no incentive to buy new homes as they expect prices to be lower in the future. So, expected prices fall leads to fall in speculative and fundamental demand and triggers actual larger than otherwise fall in actual prices. The speculative excess of a price bubble will now bring the bust of this price bubble. While the effect will be slower than in asset markets where prices adjust instantaneously (due to the sluggish nature of housing prices and their slow adjustment to increased inventories) eventually this price adjustment will occur - as it is now - and it will be very persistent over time. So, you can expect falling housing prices throughout most of 2007.

So, the simple conclusion from the analysis above is that this is indeed the biggest housing slump in the last four or five decades: every housing indictor is in free fall, including now housing prices. By itself this slump is enough to trigger a US recession: its effects on real residential investment, wealth and consumption, and employment will be more severe than the tech bust that triggered the 2001 recession. And on top of the housing bust, US consumers are facing oil above $70, the delayed effects of rising Fed Fund and long term rates, falling real wages, negative savings, high debt ratios and higher and higher debt servicing ratios. This is the tipping point for the US consumer and the effects will be ugly. Expect the great recession of 2007 to be much nastier, deeper and more protracted than the 2001 recession.

And the housing bust is not going to be only a US phenomenon. As I will discuss in another blog, housing bubbles festered in many other economies including many European ones. Thus, the combination of high oil prices, delayed effects of rising interest rates and slump of housing that is now leading to a US recession is a phenomenon that is common to many other economies, including several European ones. So, expect the same deadly combinations of three ugly bears (slumping housing, high oil prices and rising interest rates) to hammer Goldilocks and sharply hurt Europe and other economies in the world.