Wednesday, January 03, 2007


Stagnant Real Estate Market Affects GDP

The following was taking from John Maudlin's weekly eletter (His book is on Amazon) covering the economy. It was written by Barry Ritholtz. Sorry no link. I have discussed the twin bubbles in stocks and real estate before. Mr. Ritholtz quantifies the effect of unlocking home equity has had on consumer spending. Consumer spending accounts for 70% of GDP and even a small decline will have a large effect on the economy.

The boom had a positive impact on jobs, and the income and spending that goes along with it. And the wealth effect it created was very real. But the most significant impact to the economy was Mortgage Equity Withdrawal (MEW) and the Consumer spending it enabled. This has been the single biggest element of the economic expansion. Without it, the nation would have had a flat to 1% GDP, and be on the verge of a recession.

Consider what MEW had been like in the past: For most of the 1990s, the Net Equity pulled out by homeowners - either through sales, or through home equity refinancing - were fairly modest. It accounted for ~$25 billion dollars per quarter, and was about ~1% of disposable personal income.

After slumping in the late '80s and early '90s, home prices began to rise modestly. By the late 1990s, gains had returned to the historical mean. That allowed some withdrawal of equity. But even then, it remained a relatively modest amount, at $25-50B per quarter - about 2% of disposable income. Given the total GDP of the US is $12.3 trillion (2005), this amounted to only a small blip on the economic radar screen.

The impact of MEW began to accelerate once the Fed cut rates so spectacularly. By mid-2002, the quarterly average MEW was north of $100 billion - that's greater than 4% of disposable income, up nearly 400% since 1997. By 2003, those quarterly numbers were $150 billion and 6%.

Then, things exploded in 2004, as quarterly withdrawals were almost 1/4 trillion dollars, and MEW hit a peak - it was over 10% of disposable personal income. To put that into context, that's a 1000% gain since 10 years before in 1995. (see chart below)

MEW, Net Extraction and Percentage of Disposable Personal Income

Graphic courtesy of Calculated Risk

What was the impact of MEW on the economy? It was absolutely essential to the expansion. Without it, the economy would have been expanding at a 1% rate - or worse. The psychological impact of this anemic growth could very likely have caused that double-dip recession the Fed had feared.

Consider the following chart of annual GDP. It is calculated with and without MEW, using data from the Federal Reserve. The amount of MEW is calculated via the Greenspan-Kennedy method (Note that the statistical system developed by Fed economist James Kennedy and former Fed Chair Alan Greenspan is not officially recognized by the Fed).

Using Greenspan's estimate of approximately 50% of MEW flowing through to personal consumption, it is possible to estimate the impact of MEW on GDP. As the chart below shows, the impact on the economy has been nothing short of breathtaking. Since rates hit their lows in 2003, Mortgage Equity Withdrawal has been responsible for more than 75% of GDP growth:

Graphic courtesy of Calculated Risk
(*2006 estimates)

This is a radical change from prior periods. In the second half of the 1990s, equity extraction was good for "only" about 25% of GDP growth (plus or minus). In the current cycle, it is three times that.

And, it is falling. As rates have ticked up, two things have happened: equity extraction has trended downwards; it had fallen to $113.5 billion in Q3 2006. This is off by ~50% from the 2004/05 peaks. It is no surprise that GDP has trended downwards along with MEW.



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