Will Subprime Effect Consumer Spending?
From March 23:
The Federal Reserve left the target rate at 5.25% for the seventh consecutive meeting and removed the tightening basis. The statement acknowledged that the housing market is still struggling by stating that "adjustments in the housing sector is ongoing" rather than the statement last month that read, "signs of stabilization have appeared in the housing market." Additionally, core inflation was characterized as "somewhat elevated" instead of "have improved modestly." The big change was the apparent removal of the tightening basis by saying that "future policy adjustments..." instead of the "extent and timing of additional firming." The fact that the market was already pricing in that the next adjustment to the target would be down instead of up didn't matter to economists nor traders that latched on to the idea that the Fed will be cutting rates soon. While the December Fed funds futures contract did move from yielding 4.85% on Tuesday to 4.74% on Wednesday, that is exactly where it was last Wednesday. By yielding 4.74%, the market is expecting two 25 basis point cuts this year. If the inflation picture does not improve, this seems unlikely.
Inflation remains the key focus for the Fed and the latest consumer price and producer price reports did not hold promise that inflation will become yesterday's news anytime soon. The headline CPI rose 0.4% in February, slightly higher than the 0.3% increase economist expected and the core rate increased 0.2%, inline with forecasts. On a year-over-year basis, consumer prices were up 2.4% and 2.7% excluding food and energy. While food costs are usually a volatile series, it should be noted that food costs in February were up 3.1% year-over-year, which was the largest increase since November 2004. Producer prices were much stronger in February. Prices producers paid jumped 1.3% in February and have increased 2.5% over the past twelve months. This was much stronger than the 0.5% and 1.9% increases economists expected.
The Federal Reserve's assessment of the housing sector was likely influenced by the fallout in the subprime mortgage market. While there is a chance it will be contained to subprime, it's much more likely that problems will seep into the Alt-A mortgage market. Alt-A mortgages is the category where the non-standard loans. Examples would include no/low documentation and interest only or option ARMs. Federal Reserve Governor, Susan Bies, commented, "What's happening is the front end of this wave of teaser-rate loans that are coming into full pricing, So what we're seeing in this narrow segment is the beginning of the wave – this is not the end, this is the beginning."
Last week, Credit Suisse issued a research report discussing the potential ramifications of the mortgage market troubles. Here are a few bullet points from the report that captures why this could be a very important development for the housing market and potentially for the economy:
• Overall share of prime conventional loans has declined from about 66% of total purchase originations in 2002 to 45% in 2006.
• The Alt-A market has expanded from 5% of total originations in 2002 to about 20% last year.
• Stated income loans accounted for 81% of the total Alt-A purchase originations in 2006, up from 64% in 2004.
• Interest only and option ARMs were approximately 62% of Alt-A purchase originations last year.
• 1-year hybrid ARMs were 28% of Alt-A originations in 2006.
• Investors and second home buyers were 22% of the Alt-A purchase originations in 2006.
• In 2006, subprime purchase originations had a combined loan-to-value (accounts for the piggy back loan) of 94% with an average loan amount of $200,000.
• In 2006, 78% of all subprime purchase originations were 2/28 ARMs. These loans are fixed for 2 years then adjust for the next 28 years.
Borrowers typically use this to qualify for a higher mortgage using the lower "teaser" rates with the intention of refinancing within the first two year. Recent developments reduce the likelihood of all these loans being refinanced with favorable terms.
Housing starts rebounded 9% in February to a 1.525 million annualized rate. While This was 75,000 more that economists were anticipating, housing starts were down 28.5% from last February. While starts rebounded, the number of building permits issued fell 2.5% to a 1.532 million annual rate which is only 19,000 higher than the nine-year low set in November 2006. The number of home completed fell 9.4% in February and was off 19.1% compared to last year. This was the largest year-over-year decline since May 1991. It was just five months ago that the number of completions were increasing year-over-year. As the number under construction falls, down 15% year-over-year in February, the residential construction industry will continue to contract and will likely ripple into the overall housing industry. Per the February employment report, the number of jobs in the construction industry has only dropped 0.2% compared to a year ago and The jump in the number of housing starts, did not translate into higher optimism. Homebuilder optimism fell three points in February to 36 according to the National Association of Home Builder index, this was also lower than the 38 economists were expecting. January was revised down one point to 39. Personalizing the pessimism, Robert Toll, CEO of Toll Brothers said that the spring selling season was "pretty much a bust." Additionally, his comments on a market rebound, "Who knows? The Shadow knows. I have no idea. I would've thought that it would've rebounded by now and I would've been dead wrong, and I was."
Between the stock market dropping over the past month and the debacle unfolding in the subprime market, the consumer has grown more cautious. The ABC Consumer Comfort survey dropped 7 points matching the largest weekly decline since January 15, 2001. Overall confidence remained high at -5, which is near the top of the range between mid-2002 to mid-2006. The view on the economy was the biggest drag, falling ten points to -16. Personal finances and buying climate both dropped six points and remain within the range established over the past four months.
Retail sales were weaker than expected. Similar to the retailers same store sales results that were reported earlier in the month, weather was the main reason analyst cited for the weak sales. Retail sales increased only 0.1%, missing the 0.3% increase economists expected and compared to last year, sales were only 3.4% higher. This was the smallest year-over-year increase since August 2004. Of course, economists quickly blamed the weather, just as analysts did for the lackluster same store sales results retailers reported two weeks ago. Restaurant sales dropped 1.2% in February after falling 1.1% in January. Restaurant sales increased only 4.6% over the past year, which was on top of a very slow 3.3%. Sales of building materials plunged 7.0% in February and have dropped 7% compared to a year ago as well. The year-over-year decline is the largest since at least 1992, which is when the data series started. Retail sales have rebounded over the past two weeks judging by the ICSC survey. After the year-over-year increase reached a three-and-a-half year low during the last week of February, retails sales have climbed back to 2.7% and ICSC economist, Mick Niemira expects March sales to increase between 4% and 5%, driven by an earlier Easter, which will obviously temper sales in April.
At this point the subprime fallout has been confined and has mostly been a financial development. The economic impact at this point is slight. If the Alt-A market starts to seize up, and it's likely to do so, the economic ramifications could become extensive. We have said before that consumers will retrench only when they lose access to credit. That development is at least on the horizon.
Comments
Plus...just the psychological factors associated with the bubble is making people put their wallets away.
I guess that's why the consumer confidence reports today weren't so "confident"
Quotes of the week from a clients refinancing and employed with a major bio-tech company in Seattle and another who is in the business:
"...sucks when your stock options never materialize. I (tongue in cheek) thought we would be millionaires, but no go."
"Got to pay our IRS taxes. Shouldn't have bought that multi-family property last year."
I don't solicit these conversations, the borrowers offer these comments all on their own and all I can do is just put the poker face on and continue with their paperwork.