During the course of the financial crisis, the banking system experienced the most dramatic contraction in consumer credit since record-keeping began in 1943.
At the same time, the securitzation market completely shut down, eliminating a huge source of funding for all kinds of consumer loans as well as commercial real estate loans.
The impact on economic growth from this contraction in credit has been dramatic.
Still today, bank balance sheets continue to contract (ie, loan balances are shrinking) with each quarter that passes. Nearly 100% of new mortgage loans are being either funded (through Fannie Maeor Freddie Mac) or guaranteed (through FHA) by the federal government. While banks remain reluctant to lend for a variety of reasons (capital shortages, uncertain regulatory landscape, closure of securitization market, high unemployment), we believe the most plausible explanation is the possibility of further housing price declines and their impact on residential real estate-related loan losses.
Given that up to 30% of existing mortgage loans are now underwater, we believe bank management teams are acting rationally and that their fears may be justified.
And finally, we have long been concerned about the long-term financial condition of consumers, especially baby boomers.
Given that consumer debt levels have barely budged from record highs and that many boomers had been depending on home price appreciation for retirement, we believe the recent housing price declines will cause somewhat of a permanent shift in the saving and spending patterns of middle Americans.
It is true that savings rates have already rebounded a bit from the near-zero levels posted in the 2005-2007 time frame. However, the ratio of total consumer debt to personal income is still near record levels of over 100%. The average baby boomer is ill-prepared for retirement, and further home price depreciation will exacerbate the crisis.
Therefore, we must go through an inevitable long-term process of "deleveraging" such that consumer debt levels recede, retirement savings are rebuilt, and confidence is restored. This process is likely to play out over a period of years rather than months, and the prospect of higher future tax rates to cover massive government spending may increase the urgency felt by retiring boomers.
Our prognostications about the housing market were and are based on a variety of different indicators we regularly track (inventories, foreclosures, delinquences, repricing schedules of adjustable-rate morgages, etc.), but they all come down to simple supply and demand.
In a nutshell, the massive housing bubble was possible due to a dramatic liberalization in lending standards.
Easy money through widespread use of exotic mortgages such as "no-doc" and option ARM loans, combined with generationally-low mortgage rates, caused demand for housing to soar and the homeownership rate in the US to go from a long-term average of about 64.5% to over 69% in a little over a decade. This source of funding is now gone, and demand has collapsed. In the latest sign of this collapse, new home sales for May fell 32.7%. The important point to remember is that the easy money that enabled housing prices to rise so dramatically is not coming back any time soon.