house prices and vicious cycles
It seems like the current economic situation in US will not improve unless there is some stabilization in the housing market that is continuously being subjected to several vicious cycles which depress the house prices.
Here are some cycles that come to my mind:
(All “house prices” refer to house prices in US unless otherwise stated.)
1) Lower house prices -> The debtor decides to default on his mortgage when the value of the house under his ownership is less than the present value of the future mortgage payments he will be making. -> The defaults lead to higher interests rates on the new mortgages issued. -> Due to higher financing cost some prospective buyers withdraw from the market. -> Less number of buyers –> Lower house prices
2) Lower house prices -> The debtor decides to default on his mortgage when the value of the house under his ownership is less than the present value of the future mortgage payments he will be making. -> Bank seizes the house and puts it on sale. -> More houses on the market. -> Lower house prices
3) Lower house prices -> The creditors are not contractually allowed to ask the mortgage debtors to put up more collateral. Hence lower house prices imply lower recovery values in case of default. -> Assuming that the default probabilities do not decrease, the value of these mortgages decline. -> Banks which hold the mortgage backed securities try to dump them all at the same time. -> Liquidity in the secondary markets dry up. -> Investors demand more discount when they are offered to buy new mortgages. (This is conceptually similar to paying less for a car whose second-hand market is smaller.) -> Higher mortgage rates -> Due to higher financing cost some prospective buyers withdraw from the market. -> Less number of buyers –> Lower house prices
4) Lower house prices -> … See Cycle 3 … -> Liquidity in the secondary markets dry up. -> Due to the drastic decrease in the volume of trades, the prices of these mortgage backed securities can no longer be efficiently determined. -> Banks are stuck with losses that they can no longer mark to market. -> Some of these banks immediately default. Some others default due to speculative attacks by traders who claim that the banks are hiding their losses by employing accounting gimmicks. -> Depositors lose confidence in the financial system and withdraw their money which would otherwise be available to prospective consumers through the banking system. -> Due to higher financing cost some prospective buyers withdraw from the market. -> Less number of buyers –> Lower house prices
5) Lower house prices -> … See Cycle 4… -> Banks are stuck with losses that they can no longer mark to market. -> Each bank uses a different model to value its positions and makes a subjective judgment regarding the amounts to be written off. Each bank thinks that the other banks are underestimating their losses. -> Loss of trust among banks. -> Interest rates in the interbank lending markets go up. –> Since most commercial loans are indexed to interbank lending rates, the cost of capital for the corporations goes up. -> Corporations find it harder to roll-over their previous debts. -> Corporations default. -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> … See Cycle 1 or 2… -> Lower house prices
6) Lower house prices -> … See Cycle 3 … -> Funds which hold the mortgage backed securities try to dump them all at the same time. -> The value of these securities depreciate even further. –> Investors of these funds start to panic. Some of them demand their money back. -> Since the market for mortgage backed securities dried up, the fund managers have no other choice but to sell assets in unrelated markets. -> The fire sale of positions in corporate bond markets increases the cost of capital for corporations. -> Corporations find it harder to roll-over their previous debts. -> …See Cycle 5… -> Lower house prices
7) Lower house prices -> …See Cycle 6… -> Since the market for mortgage backed securities has dried up, the fund managers have no other choice but to sell assets in unrelated markets. -> The fire sale of assets in non-dollar denominated markets leads to an appreciation of dollar against the relevant currencies. (Here we assume that investors want their money back in dollars.) -> The prices of commodities that are traded in dollars go down because buyers with non-dollar denominated incomes can no longer afford the older prices. -> Traders and producers which carry inventories of these commodities are forced to write off some of the value of their stocks. -> These write-offs may be large enough to force the corporations into default. -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> …See Cycle 1 or 2… -> Lower house prices
8) Lower house prices -> …See Cycle 7… -> The fire sale of assets in non-dollar denominated markets lead to an appreciation of dollar against the relevant currencies. (Here we assume that investors want their money back in dollars.) -> Foreign companies which have no income in dollars have harder time paying their dollar denominated liabilities. -> Some of these companies default on their dollar debts or are forced to cut costs to avoid bankruptcy. –> They purchase less goods and invest less. In particular they purchase less imports from US. -> Production cuts in US ->Employees laid off in US -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> …See Cycle 1 or 2… -> Lower house prices
9) Lower house prices -> Wealth of consumers who own houses is decreased. –> Less propensity to spend money on durable goods like automobiles -> Durable goods manufacturers’ revenue expectations now look overly optimistic . Both prices and sales go down. -> These companies find it harder to roll-over their previous debts. Some of them default. -> Sector wide defaults triggers a chain of defaults among the sector’s suppliers, the suppliers’ suppliers etc. -> Massive layoffs -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> … See Cycle 1 or 2… -> Lower house prices
10) Lower house prices -> …See Cycle 9… -> Durable goods manufacturers’ find it harder to roll-over their previous debts. Some of them default. -> Part of these defaulted companies have unfunded pension liabilities. -> Loss of pension savings is equivalent to a reduction of wealth for the fired employees. -> …See Cycle 9… -> Lower house prices
11) Lower house prices -> …See Cycle 9… -> Durable goods manufacturers’ find it harder to roll-over their previous debts. In order to raise cash, some of them prefer to do a fire sale of their inventories. -> The fire sale causes greater deflation in prices. -> Revenues fall further. -> Massive layoffs -> …See Cycle 9… -> Lower house prices
12) Lower house prices -> Wealth of consumers who own houses is decreased. –> Less propensity to spend money on imports -> Production declines in foreign economies. -> In order to raise funds for stimulation packages at home, the foreign governments sell their holdings of US government bonds. (e.g. China and Japan have massive amounts of US treasuries.) -> Interest rates on US government bonds increase. -> Interest rates across all instruments in US increase. (The present value of $1 obtained a year later is worth less since the opportunity cost of spending $1 now has become greater.) -> The value of all cash generating assets gets depressed. -> Lower house prices (Note that a house is essentially a rent generating asset.)
13) Lower house prices -> Wealth of consumers who own houses is decreased. –> Less propensity to spend money on imports -> Foreign currencies depreciate against dollar. -> Imports are now cheaper in dollars. -> US producers need to cut prices to compete with imports. -> Revenues fall and some of these companies default. ->Massive layoffs -> …See Cycle 9… -> Lower house prices
14) Lower house prices -> …See Cycle 13… -> Foreign currencies depreciate against dollar. -> US investors pull back from foreign commercial bond and stock markets as they worry about the depreciating dollar value of their portfolios. -> Cost of capital for foreign corporations goes up. -> These corporations find it harder to roll-over their previous debts. -> Some of these companies default on their debts or are forced to cut costs to avoid bankruptcy. -> …See Cycle 8… -> Lower house prices
15) Lower house prices -> Consumers rationally or irrationally expect this trend to continue. -> They postpone their housing purchases and wait for lower prices. –> Less consumption now -> Lower house prices
16) Lower house prices -> House sellers rationally or irrationally expect this trend to continue. -> They try to front run each other: The one who manages to sell first will do so at a higher price than a late-seller does. -> More houses are put on sale now. -> Lower house prices
Several important things to note:
1) The cycles that are hardest to break are the ones which are based on expectations about future price movements. (e.g. Cycles 15 and 16) The government will need to alter perceptions and manipulate beliefs.
2) Some cycles will dissolve by themselves. In Cycle 11 the manufacturers cannot continue dumping their inventories forever since they only have finite amount of stocks.
3) Defaults, production cuts, layoffs and declining house values decrease the tax base of municipalities and governments. These bodies may increase taxes or issue more bonds in order to prop up their finances. Their actions will have various consequences for the above cycles.
4) Unemployment benefits may act as a safety net that cushions the sudden fall of consumption during layoffs. However the exact effect will vary according to the way the government chooses to raise the necessary money for the unemployment benefits.
5) Private pension funds directly invest in stocks. Hence their value will be adversely affected by corporate defaults and massive fire-sale of stocks. As in Cycle 10, this will lead to lower house prices.
6) World trade is conducted mostly in dollars. For example, in Cycle 13 the net effect on exchange rate movements would be minimal, if the foreign company had never felt the need to convert its dollar denominated income into home currency.
7) So far we have ignored the entire spectrum of derivatives which are instruments that allow economic actors to shift various risks among each other. It would been a much harder task to conduct the above analysis within a world (such as ours!) where various financial risks are cut up, magnified and scattered among unidentifiable investors and speculators. Here are some noteworthy examples:
- A corporation may pass its exchange rate risk onto an investor by entering into an exchange rate forwarding agreement. (Consequently in Cycle 8 instead of the corporation the investor may go bust.)
- If a corporation desires to eliminate its exposure to the fluctuations in the interbank lending rates, it can enter into an interest rate swap agreement and replace its floating debt obligation with a fixed one. (In that case Cycle 5 would need to be revised.)
- A raw materials supplier can reduce its credit risk exposure to its largest customer by purchasing credit default swaps on the customer’s debts. (In that case Cycle 9 would need to be revised.)
Here are some cycles that come to my mind:
(All “house prices” refer to house prices in US unless otherwise stated.)
1) Lower house prices -> The debtor decides to default on his mortgage when the value of the house under his ownership is less than the present value of the future mortgage payments he will be making. -> The defaults lead to higher interests rates on the new mortgages issued. -> Due to higher financing cost some prospective buyers withdraw from the market. -> Less number of buyers –> Lower house prices
2) Lower house prices -> The debtor decides to default on his mortgage when the value of the house under his ownership is less than the present value of the future mortgage payments he will be making. -> Bank seizes the house and puts it on sale. -> More houses on the market. -> Lower house prices
3) Lower house prices -> The creditors are not contractually allowed to ask the mortgage debtors to put up more collateral. Hence lower house prices imply lower recovery values in case of default. -> Assuming that the default probabilities do not decrease, the value of these mortgages decline. -> Banks which hold the mortgage backed securities try to dump them all at the same time. -> Liquidity in the secondary markets dry up. -> Investors demand more discount when they are offered to buy new mortgages. (This is conceptually similar to paying less for a car whose second-hand market is smaller.) -> Higher mortgage rates -> Due to higher financing cost some prospective buyers withdraw from the market. -> Less number of buyers –> Lower house prices
4) Lower house prices -> … See Cycle 3 … -> Liquidity in the secondary markets dry up. -> Due to the drastic decrease in the volume of trades, the prices of these mortgage backed securities can no longer be efficiently determined. -> Banks are stuck with losses that they can no longer mark to market. -> Some of these banks immediately default. Some others default due to speculative attacks by traders who claim that the banks are hiding their losses by employing accounting gimmicks. -> Depositors lose confidence in the financial system and withdraw their money which would otherwise be available to prospective consumers through the banking system. -> Due to higher financing cost some prospective buyers withdraw from the market. -> Less number of buyers –> Lower house prices
5) Lower house prices -> … See Cycle 4… -> Banks are stuck with losses that they can no longer mark to market. -> Each bank uses a different model to value its positions and makes a subjective judgment regarding the amounts to be written off. Each bank thinks that the other banks are underestimating their losses. -> Loss of trust among banks. -> Interest rates in the interbank lending markets go up. –> Since most commercial loans are indexed to interbank lending rates, the cost of capital for the corporations goes up. -> Corporations find it harder to roll-over their previous debts. -> Corporations default. -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> … See Cycle 1 or 2… -> Lower house prices
6) Lower house prices -> … See Cycle 3 … -> Funds which hold the mortgage backed securities try to dump them all at the same time. -> The value of these securities depreciate even further. –> Investors of these funds start to panic. Some of them demand their money back. -> Since the market for mortgage backed securities dried up, the fund managers have no other choice but to sell assets in unrelated markets. -> The fire sale of positions in corporate bond markets increases the cost of capital for corporations. -> Corporations find it harder to roll-over their previous debts. -> …See Cycle 5… -> Lower house prices
7) Lower house prices -> …See Cycle 6… -> Since the market for mortgage backed securities has dried up, the fund managers have no other choice but to sell assets in unrelated markets. -> The fire sale of assets in non-dollar denominated markets leads to an appreciation of dollar against the relevant currencies. (Here we assume that investors want their money back in dollars.) -> The prices of commodities that are traded in dollars go down because buyers with non-dollar denominated incomes can no longer afford the older prices. -> Traders and producers which carry inventories of these commodities are forced to write off some of the value of their stocks. -> These write-offs may be large enough to force the corporations into default. -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> …See Cycle 1 or 2… -> Lower house prices
8) Lower house prices -> …See Cycle 7… -> The fire sale of assets in non-dollar denominated markets lead to an appreciation of dollar against the relevant currencies. (Here we assume that investors want their money back in dollars.) -> Foreign companies which have no income in dollars have harder time paying their dollar denominated liabilities. -> Some of these companies default on their dollar debts or are forced to cut costs to avoid bankruptcy. –> They purchase less goods and invest less. In particular they purchase less imports from US. -> Production cuts in US ->Employees laid off in US -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> …See Cycle 1 or 2… -> Lower house prices
9) Lower house prices -> Wealth of consumers who own houses is decreased. –> Less propensity to spend money on durable goods like automobiles -> Durable goods manufacturers’ revenue expectations now look overly optimistic . Both prices and sales go down. -> These companies find it harder to roll-over their previous debts. Some of them default. -> Sector wide defaults triggers a chain of defaults among the sector’s suppliers, the suppliers’ suppliers etc. -> Massive layoffs -> Fired employees are forced to default on their mortgages which they can no longer afford to pay or refinance. -> … See Cycle 1 or 2… -> Lower house prices
10) Lower house prices -> …See Cycle 9… -> Durable goods manufacturers’ find it harder to roll-over their previous debts. Some of them default. -> Part of these defaulted companies have unfunded pension liabilities. -> Loss of pension savings is equivalent to a reduction of wealth for the fired employees. -> …See Cycle 9… -> Lower house prices
11) Lower house prices -> …See Cycle 9… -> Durable goods manufacturers’ find it harder to roll-over their previous debts. In order to raise cash, some of them prefer to do a fire sale of their inventories. -> The fire sale causes greater deflation in prices. -> Revenues fall further. -> Massive layoffs -> …See Cycle 9… -> Lower house prices
12) Lower house prices -> Wealth of consumers who own houses is decreased. –> Less propensity to spend money on imports -> Production declines in foreign economies. -> In order to raise funds for stimulation packages at home, the foreign governments sell their holdings of US government bonds. (e.g. China and Japan have massive amounts of US treasuries.) -> Interest rates on US government bonds increase. -> Interest rates across all instruments in US increase. (The present value of $1 obtained a year later is worth less since the opportunity cost of spending $1 now has become greater.) -> The value of all cash generating assets gets depressed. -> Lower house prices (Note that a house is essentially a rent generating asset.)
13) Lower house prices -> Wealth of consumers who own houses is decreased. –> Less propensity to spend money on imports -> Foreign currencies depreciate against dollar. -> Imports are now cheaper in dollars. -> US producers need to cut prices to compete with imports. -> Revenues fall and some of these companies default. ->Massive layoffs -> …See Cycle 9… -> Lower house prices
14) Lower house prices -> …See Cycle 13… -> Foreign currencies depreciate against dollar. -> US investors pull back from foreign commercial bond and stock markets as they worry about the depreciating dollar value of their portfolios. -> Cost of capital for foreign corporations goes up. -> These corporations find it harder to roll-over their previous debts. -> Some of these companies default on their debts or are forced to cut costs to avoid bankruptcy. -> …See Cycle 8… -> Lower house prices
15) Lower house prices -> Consumers rationally or irrationally expect this trend to continue. -> They postpone their housing purchases and wait for lower prices. –> Less consumption now -> Lower house prices
16) Lower house prices -> House sellers rationally or irrationally expect this trend to continue. -> They try to front run each other: The one who manages to sell first will do so at a higher price than a late-seller does. -> More houses are put on sale now. -> Lower house prices
Several important things to note:
1) The cycles that are hardest to break are the ones which are based on expectations about future price movements. (e.g. Cycles 15 and 16) The government will need to alter perceptions and manipulate beliefs.
2) Some cycles will dissolve by themselves. In Cycle 11 the manufacturers cannot continue dumping their inventories forever since they only have finite amount of stocks.
3) Defaults, production cuts, layoffs and declining house values decrease the tax base of municipalities and governments. These bodies may increase taxes or issue more bonds in order to prop up their finances. Their actions will have various consequences for the above cycles.
4) Unemployment benefits may act as a safety net that cushions the sudden fall of consumption during layoffs. However the exact effect will vary according to the way the government chooses to raise the necessary money for the unemployment benefits.
5) Private pension funds directly invest in stocks. Hence their value will be adversely affected by corporate defaults and massive fire-sale of stocks. As in Cycle 10, this will lead to lower house prices.
6) World trade is conducted mostly in dollars. For example, in Cycle 13 the net effect on exchange rate movements would be minimal, if the foreign company had never felt the need to convert its dollar denominated income into home currency.
7) So far we have ignored the entire spectrum of derivatives which are instruments that allow economic actors to shift various risks among each other. It would been a much harder task to conduct the above analysis within a world (such as ours!) where various financial risks are cut up, magnified and scattered among unidentifiable investors and speculators. Here are some noteworthy examples:
- A corporation may pass its exchange rate risk onto an investor by entering into an exchange rate forwarding agreement. (Consequently in Cycle 8 instead of the corporation the investor may go bust.)
- If a corporation desires to eliminate its exposure to the fluctuations in the interbank lending rates, it can enter into an interest rate swap agreement and replace its floating debt obligation with a fixed one. (In that case Cycle 5 would need to be revised.)
- A raw materials supplier can reduce its credit risk exposure to its largest customer by purchasing credit default swaps on the customer’s debts. (In that case Cycle 9 would need to be revised.)
