Chapter
2
The Current Economic Situation
The current economic situation is quite fragile. The turmoil in financial markets, the drop in house prices, and the rise in energy prices have combined to slow economic activity. Credit flows have dropped significantly as financial institutions have reduced their activity; nonfinancial firms face new constraints on their borrowing as well. The outlook for economic activity in 2008 has worsened, with private-sector payroll employment falling for the past four months and a growing number of economists indicating that the economy is in a recession. Nevertheless, both the tax rebates that will begin arriving late this spring (as part of the recently enacted economic stimulus package) and the Federal Reserve’s reduction of short-term interest rates and injections of liquidity will help boost the economy. It remains unclear at this point whether the National Bureau of Economic Research will ultimately determine officially that there was a recession.
Economic activity has slowed sharply since last summer. Annualized growth of real (inflation-adjusted) gross domestic product (GDP) declined to just 0.6 percent in the fourth quarter of 2007 from a robust 4.9 percent in the third quarter, and growth appears to have slowed even further this year. Employment fell by 300,000 between November 2007 and March 2008; such a decline in employment over several months strongly suggests that the economy has entered a recession. Real consumer spending has been essentially flat between November and February. Some of that weakness is related to high energy prices and slower gains in real disposable income, but some may also be a result of the effect of lower house prices on households’ wealth. The pace of residential construction has been decreasing rapidly, and declining numbers of building permits for new construction suggest that those declines will persist in the near term. Business fixed investment also appears to have contracted in the first quarter, partly because financing for new projects has become more difficult to obtain. Offsetting some of that weakness has been strong growth in exports.
Concerns about inflation may constrain policymakers’ efforts to stimulate the economy further. The sharp drop in the value of the dollar over the past year and the increase in a broad array of commodity prices have raised fears of higher inflation this year. Although most forecasters do not anticipate an increase in inflation during 2008, further monetary stimulus may set the stage for higher inflation in 2009.
House Prices and Mortgage Markets
House prices are falling across the country, with some of the steepest declines occurring in areas that had experienced some of the largest gains. Delinquencies and foreclosures on mortgages are also rising across the nation. Some states experiencing large price declines have also experienced high rates of delinquencies and foreclosures. However, prices of mortgage-backed securities have stabilized close to their recent lows, suggesting that investors’ expectations about future losses on MBSs are no longer worsening.
House Prices. Prices for houses have fallen sharply since their peak in the middle of 2006, and the decline appears to be accelerating. A number of indexes are available to track prices; each has its limitations, but together they give a sense of trends. One measure, the S&P/Case-Shiller national price index for single-family homes, was down by about 9 percent in the fourth quarter of 2007 as compared with the fourth quarter of 2006, after a 4.6 percent decline in the year ending in the third quarter of 2007. In real terms, the decline last year was almost 12 percent. Rapid declines in house prices continued in January: A narrower S&P/Case-Shiller index for 20 cities (reported monthly) fell by 10.7 percent in the year ending in January, while the monthly index for the S&P/Case-Shiller index for 10 cities was down by 11.4 percent over the same period. Those trends are generally confirmed by a third price index, published by Radar Logic, a real estate and data-analysis firm. Another widely used index, the purchase-only index published by the Office of Federal Housing Enterprise Oversight (OFHEO), did not begin to decline until May 2007. The difference between the movement of that index and the movement of the other indexes may reflect the fact that OFHEO’s index excludes homes with nonconforming (for example, subprime) mortgages and thus omits the parts of the market that have seen the greatest difficulties in recent months.1
The outlook for house prices is highly uncertain, but prices are likely to continue to fall, on average, at least through the end of 2008. Expectations of such a decline are widespread. Prices implied by futures contracts, for example, indicate that market participants expect large additional drops in house prices. Futures contracts on the S&P/Case-Shiller index for 10 cities project a decline of about 13 percent in nominal prices over the coming year and 16 percent by November 2009 (see Figure 2-1).2
S&P/Case-Shiller 10-City Composite Home Price Index and Implied Values from Futures Prices
(Percentage change from a year ago)
Sources: Congressional Budget Office; Bloomberg; Chicago Mercantile Exchange.
Note: The S&P/Case-Shiller 10-city composite home price index tracks price changes in 10 metropolitan areas on the basis of a house’s previous sale. Data are quarterly and are plotted through the first quarter of 2009. The figure includes implied values from futures prices for the second quarter of 2008 through the first quarter of 2009.
Another measure, based on Radar Logic’s composite index of 25 cities, projects declines of 13 percent over the next year and 21 percent over the next three years. (However, those indexes may not indicate what is expected to happen to house prices nationwide.)
Private forecasters and investment firms also expect significant declines in nominal house prices. Macroeconomic Advisers, for its March 2008 forecast, assumed a 5.6 percent fall in prices from the end of 2007 to mid-2009. Global Insight, another economic consulting firm, projects a 12 percent decline over the same period in its April forecast.
Delinquencies and Foreclosures of Mortgages. National delinquency and foreclosure rates are rising for both prime and subprime loans, particularly for adjustable-rate loans.3 In the fourth quarter of 2007, 17.3 percent of all subprime loans were delinquent, up from 13.3 percent at the end of 2006. For subprime ARMs, 20 percent were delinquent in the fourth quarter of 2007, up from 14.4 percent in the fourth quarter of 2006. The delinquency rate on prime ARMs has also risen, from 3.4 percent at the end of 2006 to 5.5 percent at the end of last year (see Figure 2-2). In addition, the share of subprime ARMs entering foreclosure more than tripled, increasing from an average of 1.5 percent in 2004 and 2005 to 5.3 percent in the fourth quarter of 2007 (see Figure 2-3). Although the rate of delinquency on fixed-rate subprime loans has also grown, it is still much lower and has risen more slowly than that on subprime ARMs.
Sources: Congressional Budget Office; Mortgage Bankers Association.
Notes: Data are quarterly and are plotted through the fourth quarter of 2007.
ARM = adjustable-rate mortgage; FRM = fixed-rate mortgage.
Subprime loans are made to borrowers with low credit scores or other impairments to their credit histories.
Mortgage Foreclosures Initiated
Sources: Congressional Budget Office; Mortgage Bankers Association.
Notes: Data are quarterly and are plotted through the fourth quarter of 2007.
ARM = adjustable-rate mortgage; FRM = fixed-rate mortgage.
Subprime loans are made to borrowers with low credit scores or other impairments to their credit histories.
Rates of foreclosure are particularly high in areas experiencing economic weakness or large declines in house prices. Of the 10 states with the highest percentage of loans in foreclosure, 5 are among the 10 states with the largest declines in house prices.
Interest Rates on Mortgage Loans. Mortgage interest rates continue to reflect the heightened aversion to risk in financial markets. The interest rate on 30-year conforming mortgages, which can be securitized by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, has fallen below 6 percent (see Figure 2-4). Although that rate is about one-half of a percentage point lower than it was in the past two years, the spread between that mortgage rate and the rate on seven-year Treasury notes—a measure of the market’s current preference for the safest and most liquid collateral—continued to widen earlier this year.4 Moreover, the rate on jumbo loans (those that exceed Fannie Mae’s and Freddie Mac’s loan limits) has moved up sharply since early February and currently is about 2 percentage points higher than the rate on conforming mortgages.
Sources: Congressional Budget Office; Bankrate.com; Bloomberg.
Notes: Data are monthly and are plotted through March 2008.
Jumbo loans exceed the loan limits of Fannie Mae and Freddie Mac.
Initial rates for adjustable-rate mortgages, by contrast, dropped sharply earlier this year. In addition, the benchmark interest rate typically used for resetting the interest rate on subprime ARMs—the six-month Libor rate—has fallen significantly in the past few months and is now back down to levels last seen in the beginning of 2005 (see Figure 2-5).5 That decline reflects the large amount of liquidity added by the Federal Reserve and other central banks in response to the turmoil in financial markets. As a result, the risk that resetting interest rates on subprime ARMs will lead to a substantial number of additional mortgage defaults has fallen.
Popular Adjustable-Rate-Mortgage Indexes
Sources: Congressional Budget Office; Bloomberg.
Notes: The indexes shown are for the one-year constant maturity Treasury bill, the six-month Libor, and the 11th District Federal Home Loan Bank’s cost of funds.
Data are monthly. The Libor and Treasury-bill rates are plotted through March 2008; the cost of funds rate is through February 2008.
Prices of Mortgage-Backed Securities. The very high rates of delinquency on recent subprime mortgage loans surprised investors last year, who pulled back sharply from potential exposure to such lending in their investments during the summer. Lenders have virtually stopped making new subprime loans. Trading of existing subprime MBSs has diminished because of uncertainty about their value, particularly in view of investors’ loss of confidence in the securities’ credit ratings. Indeed, price declines on those MBSs have been striking, especially for subprime MBSs that were issued more recently and whose mortgages have experienced unusually high rates of defaults.
The values of subprime mortgage securities (MBS tranches) can be inferred from ABX indexes related to those securities.6 Those indexes are available for MBS tranches with different initial credit ratings.7 As of late March 2008, the index for subprime MBSs issued in the second half of 2006 and initially rated BBB was 9 cents on the dollar, and the index for those initially rated AAA was 57 cents on the dollar (see Figure 2-6).8 In both cases, index values a year ago were closer to 100 cents on the dollar. For subprime MBSs issued earlier, in the last half of 2005, prices have not fallen as much. Prices ranged from 17 cents on the dollar for the BBB-rated securities to 88 cents for the AAA-rated securities.
Inferred Prices of Subprime Mortgage Tranches
Source: Congressional Budget Office based on data from the Markit Group.
Notes: Prices are inferred from the Markit ABX.HE index for the BBB (next to the lowest investment grade) and AAA (highest investment grade) tranches of mortgage-backed securities. The 2006:1 vintage reflects mortgages available for securitization from July 19, 2005, to January 5, 2006. The 2007:1 vintage reflects mortgages available for securitization from July 19, 2006, to January 5, 2007. Data are daily and are plotted through March 28, 2008.
Subprime loans are made to borrowers with low credit scores or other impairments to their credit histories.
The broader financial markets have also experienced significant turmoil recently. Lending in some markets remains depressed, as financial institutions continue to struggle to find ways of adequately dealing with losses on their leveraged financing of very risky mortgage loans and other risky assets.9 Consequently, the risk of a systemic crisis in financial markets spurred by the collapse of one or more important financial institutions or markets remains elevated.
Credit Markets. Interest rates on investment-grade corporate bonds have remained relatively steady, but because the yield on the 10-year Treasury note has fallen sharply since last June, the interest rate spread has widened. Investors’ tolerance for risk appears to have decreased as yields on below-investment-grade corporate securities have risen, particularly those with the lowest credit ratings (see Figure 2-7). Issuances of new corporate debt have fallen noticeably, as have those for asset-backed corporate paper. The interbank market for short-term loans also continues to experience problems; despite efforts by the Federal Reserve and some foreign central banks to shore up this market, the spread between the three-month Libor rate and the expected federal funds rate has moved upward recently (see Figure 2-8).10
Sources: Congressional Budget Office; Bloomberg.
Note: Data are monthly and are plotted through March 2008.
Spread Between the Three-Month Libor Rate and the Expected Federal Funds Rate
Sources: Congressional Budget Office; Bloomberg.
Note: Data are weekly and are plotted through April 4, 2008. The expected federal funds rate is based on the futures price two months ahead.
The Potential for Mortgage Losses. The ultimate volume of defaulted mortgages, which will affect both homeowners and investors, depends in part on the overall performance of the economy and on the size of the remaining gap between house prices and sustainable levels. A severe recession would result in larger mortgage losses than a mild recession or a short period of slow growth because a substantial recession would further depress house prices and homeowners’ ability to finance their mortgages. Similarly, to the extent that house prices have farther to fall, losses will be larger than if prices have already declined to close to sustainable levels. The wide range of estimates of losses quoted in the media is due in part to the great uncertainty about the outlook for the overall economy and the ultimate level of house prices.
With sluggish but continued economic growth or a mild recession, as well as further declines of roughly 10 percent to 15 percent in average national house prices by mid-2009, the value of all mortgages that will enter foreclosure without further policy action could be about $500 billion to $600 billion over the next two years.11 The ultimate losses on those mortgages will be smaller, possibly in the range of $100 billion to $250 billion, because some of the houses will not end up being repossessed. Also, considerable value will probably be recovered from new agreements worked out between borrowers and lenders and from foreclosure sales, for example. However, the recovery rate will most likely be lower than it has been in the past, particularly in some areas of the country, and sales of foreclosed properties may take several years to materialize.
Financial institutions worldwide have already recognized about $230 billion in losses from the broader credit problem that began last year in subprime loans.12 The International Monetary Fund recently estimated that total losses to all financial institutions around the world would approach $1 trillion, with more than half of that coming from residential mortgages and the rest coming from commercial mortgages, credit card loans, and automobile loans, among others. That amount would represent a notable loss of capital among the world’s financial institutions, enough to significantly reduce the availability of credit.
Risks to the Financial System. The existence of substantial unrealized losses and uncertainty about which institutions are exposed to such losses may further impede the flow of credit in the United States and abroad. The possibility of large undisclosed losses has driven investors away from both the long- and short-term obligations of financial institutions. For the same reasons, financial institutions have become increasingly wary of lending to one another. In addition, institutions with assets of uncertain value on their balance sheets are likely to find it difficult to raise capital until the true value of those assets has been recognized because new investors will not want to share possible losses with current shareholders.
So far, problems in financial markets have not become severe enough to create a complete breakdown in the credit system. Such a breakdown could occur if lenders felt that they could not determine the risk they would be taking by lending to other entities: In that case, lending would stop, at least for a time. In such a scenario, even creditworthy borrowers could find credit difficult to obtain. Markets are still able to distinguish between those institutions that are creditworthy and those that are less so, as evidenced by sharp differences in the movement of stock prices of different banks. However, the near collapse of another major financial institution would further undermine the market’s confidence and could severely cripple the financial system. That possibility is why the Federal Reserve has taken extraordinary actions to prevent such a failure.
Government Actions to Support Economic Activity and Stabilize Financial Markets
Both monetary and fiscal policymakers have taken significant steps to contain the economic damage caused by the turmoil in financial markets, but it remains unclear whether even those actions will prove sufficient to avoid a major recession. Fiscal policymakers have adopted an economic stimulus package whose effects should begin to manifest themselves late this spring. In addition, and perhaps more important, the Federal Reserve has taken extraordinary measures in addition to rapidly reducing the federal funds rate. In essence, the Federal Reserve has used its unmatched credit rating and large lending capacity to serve as an intermediary among financial institutions.
In February, lawmakers enacted the Economic Stimulus Act of 2008.13 That law provides tax rebates of up to $600 to individual filers, up to $1,200 for couples, and $300 per child. In addition, the law allows businesses to take additional deductions for accelerated depreciation and immediate expensing of capital purchases. That legislation will add an estimated $152 billion to the federal deficit in 2008 and another $16 billion in 2009. Overall, the Congressional Budget Office estimates that the law’s provisions will add about 0.7 percentage points to the growth of real GDP in 2008.14
Actions by the Federal Reserve
The Federal Reserve instituted several actions in March to quell a crisis of confidence in the markets. The most extraordinary of those were creating a Primary Dealer Credit Facility and facilitating the acquisition of Bear Stearns by J.P. Morgan Chase.
The Primary Dealer Credit Facility allows all primary dealers to borrow funds overnight directly from the Federal Reserve.15 Previously, that privilege was extended only to deposit-taking commercial banks. That step implies that the Federal Reserve is taking responsibility for ensuring liquidity not just to commercial banks, but also to a much broader swath of the financial market. In less unsettled times, ensuring that commercial banks have enough liquidity would be sufficient because those banks could then lend to the rest of the market. The need to provide liquidity directly to primary dealers is an indication of the breakdown of the usual flow of credit.
In another such indication, during the week ending Friday, March 14, other financial institutions lost confidence in Bear Stearns, the nation’s fifth-largest investment bank, creating a potential liquidity crisis. Over that weekend, the Federal Reserve was involved in negotiations for J.P. Morgan’s acquisition of Bear Stearns. The Federal Reserve lent $29 billion to J.P. Morgan against a portfolio of $30 billion of Bear Stearns’ less liquid assets. In the event of losses on those assets, J.P. Morgan would be responsible for the first $1 billion in losses, and the Federal Reserve Bank of New York—and ultimately taxpayers—would absorb any remaining losses. (Taxpayers would be involved because any such losses would diminish the amount of the Federal Reserve’s surplus that is turned over to the Treasury and recorded as federal revenues.)
The Federal Reserve has also continued to use its conventional tools. At the March 18 Federal Open Market Committee meeting, the federal funds target rate was reduced by 75 basis points, to 2.25 percent. The spread between the discount rate and the federal funds target rate was reduced to 25 basis points.16 In its continuing effort to reduce strains in financial markets, the central bank has also enhanced its mechanisms for lending funds to financial institutions against illiquid collateral (investments that cannot be readily converted into cash). The Federal Reserve enlarged the amount of funds available to be lent under the twice-monthly Term Auction Facility from $30 billion to $50 billion. It also announced that it would lend up to an additional $100 billion to primary dealers in the form of 28-day repurchase agreements—another step to provide liquidity to that market.
Following those actions by the Federal Reserve and other central banks, short-term interest rates have fallen, but the perceived riskiness of the interbank loan market has not changed greatly. The spread between the cost of three-month Libor funding and the expected federal funds rate over the same period did narrow, but only modestly, and that spread remains well above typical levels.
Measures of house prices differ substantially in their coverage and how they handle changes in quality. OFHEO’s index covers all areas of the country and has a relatively sophisticated adjustment for quality—which is a big issue in house prices—but it is restricted to houses with conforming mortgages (those eligiblefor purchase by Fannie Mae and Freddie Mac, two government-sponsored enterprises). The S&P/Case-Shiller indexes use the same adjustment for quality but cover fewer geographic areas. However, they include all homes in a covered area, whatever the type of mortgage. The Radar Logic composite index covers just 25 metropolitan housing markets and is not intended to represent the national market. It reflects all transactions, including sales of condominiums, and is updated daily. Its only quality adjustment, however, is for the size of the residence.
Futures contracts based on that index trade on the Chicago Mercantile Exchange. Trading in those contracts is akin to taking a position on what the value of the index will be in the future, say 12 months ahead. If, after that time, the value of the index is above the futures price the buyer paid, the seller pays the buyer the difference between the index and the futures price. However, if the value of the index is below the futures price, the buyer pays the seller the difference. Such contracts may be useful as a hedge against the real estate market. Futures prices may not be a reliable guide to expectations, though, particularly for longer periods. Futures contracts of this kind do not trade frequently or in large numbers and therefore may not represent a consensus of investors.
The S&P/Case-Shiller 10-City Composite Home Price Index tracks changes in the value of residential real estate in 10 metropolitan regions. No futures markets are associated with the S&P/Case-Shiller 20-city or national price indexes.
A loan is delinquent when a borrower misses a contractual payment. The numbers cited in the text refer to loans that are at least 30 days overdue. Foreclosure is a legal proceeding to terminate a borrower’s interest in a property, instituted by the lender either to gain title or to force a sale to satisfy the unpaid debt secured by the property.
On average, mortgages actually last only about seven years because people sell or refinance. Thus, the appropriate comparison is to a seven-year Treasury note rather than to an investment with a longer term to maturity.
Libor, the London Interbank Offered Rate, is the rate at which banks lend to each other for short terms.
ABX.HE indexes are calculated by the Markit Group Limited. ABX index values are based on the up-front premiums for credit default swaps on underlying subprime MBSs. The values of ABX indexes move inversely with the cost of ensuring that the holder of an MBS will receive all principal and interest payments.
Mortgage-backed securities are repackaged in tranches, or securities of different seniority, in payment from the MBSs. An MBS with higher seniority, such as the most senior of the AAA-rated tranches, is entitled to payments before those in tranches with lower seniority, such as a less senior AAA tranche or any lower-rated tranche. In other words, a less senior tranche realizes a loss on an MBS before a more senior tranche.
Usually it is the most junior tranche of a given credit rating that is selected for the index. There are no indexes for MBSs based on subprime securities originated in the second half of 2007 because almost no such mortgages were originated.
See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2008 to 2018 (January 2008), Chapter 2, for a fuller discussion of recent problems in financial markets.
The spread between those two rates is an indicator of credit risk. The three-month Libor provides funding among participants who may not have access to Federal Reserve liquidity facilities. Federal funds, in contrast, are overnight and shorter-term funding between banks with access to the Federal Reserve discount window. They typically have higher collateral standards than for Libor.
The $500 billion figure is calculated by CBO from estimates in David Greenlaw and others, "Leveraged Losses: Lessons from the Mortgage Market Meltdown" (U.S. Monetary Policy Forum Conference Draft, February 2008). That figure represents 4.6 percent of the value of outstanding mortgages. The $600 billion figure was calculated on the basis of the statement of Mark Zandi, Moody’s Economy.com, "The Looming Foreclosure Crisis: How to Help Families Save Their Homes," before the Senate Committee on the Judiciary (December 5, 2007), in which the author estimated 2.8 million mortgages, or over 5 percent, would enter foreclosure through 2009.
Bloomberg LLC, Asset write-downs and credit losses table, April 1, 2008.
Public Law 110-185; 122 Stat. 613.
The law’s provisions will subtract about 0.4 percentage points from growth of real GDP in 2009, CBO estimates, as most of the stimulus is removed.
Primary dealers are banks or securities broker-dealers who may trade directly with the Federal Reserve System.
The discount rate is the rate paid by banks borrowing from the Federal Reserve. The Federal Reserve sets a target rate for the federal funds, the rate banks charge each other for overnight loans. The Board of Governors of the Federal Reserve System can cut discount rates only when it has a request to do so from a Federal Reserve Bank. By March 20, all banks had requested cuts to a new spread of 25 basis points over the target for the federal funds rate. (A basis point is one-hundredth of a percentage point.)
