The Panic Is Over but Don't Expect Quick Recovery in Housing

The World panicked when Lehman Brothers collapsed. Credit markets froze and stock markets nosedived as investors fretted about the risk of a second Great Depression. Inevitably, the housing market got caught up in the crisis of confidence. Starting from already low levels, most indicators of housing activity fell to record lows in the opening months of 2009.

Several months later, it appears that disaster has been averted. The direst indicators of distress have returned to levels that are merely concerning, and not terrifying. It shouldn’t come as a surprise, therefore, that housing market indicators have bounced back from recent lows. But stepping back from the brink of disaster isn’t the same thing as recovery. The housing market downturn was well underway before the panic started, and may still have some ways to go now that the panic is over.

Consider the following series of charts, which illustrate the spike in panic levels. The first chart, below, shows the so-called TED spread.

The TED spread is the difference between the interest rates on 3-month interbank loans and 3-month Treasury bills. The former is the interest rate that (non-US) banks pay when they borrow from each other; it’s commonly known as LIBOR. The difference between LIBOR and the Treasury rate is an indicator of the perceived riskiness of lending money to commercial banks.

By September of 2008, the TED spread had already widened significantly from pre-crisis levels. When Lehman Brothers collapsed, however, the spread spiked to more than ten times its pre-crisis levels. Evidently, major banks suddenly became concerned that if Lehman could fail, so could any other major bank. Indeed, almost every bank in the country has since received federal bailout money to keep it afloat.

The TED spread has fallen steadily over the last several months. It’s still at elevated levels – suggesting that banks aren’t out of the woods yet – but the worst of the crisis has subsided. Some of the larger banks have actually begun returning their bailout money.

The stock market also went into a panic in September. Take a look at the chart, below, which shows the VIX volatility index.

Volatility is a measure of stock price fluctuations. High volatility indicates that stock prices are changing rapidly. When Lehman Brothers collapsed, the VIX index went from around 20 to a record of over 60. The index has declined significantly since then, to its current level of around 25. That’s still higher than the levels that prevailed immediately before the crisis, but it’s not much higher than the long-run average of around 19.

It’s instructive to make a quick detour into option theory. Options can be thought of as insurance against big stock price movements. When volatility rises, the insurance gets more expensive. What the VIX index actually measures is not current volatility, but the volatility that’s implied by option prices. In other words, the VIX index is essentially measuring the cost of insuring against big stock price movements. Immediately before the crisis, insurance was much cheaper than it had been historically, suggesting that investors may have been overly complacent about risk. When the crisis was in full swing, the cost of insurance hit record levels.

The bond market provided what was perhaps the most alarming indicator of panic. Take a look at the chart, below, which shows the difference between the yields on ordinary 10-year Treasury notes and 10-year inflation-indexed Treasurys.

When investors lend money to the Government, they usually demand a certain base rate of return (the so-called ‘real return’) and then add something extra to compensate for expected inflation. For instance, if investors normally require a 3% real return, they’ll demand a yield of 5% on Treasury notes if they’re expecting an inflation rate of 2%. That’s because inflation will erode the purchasing power of their loan principal by 2% per year. The extra 2% interest is compensation for the 2% annual erosion of the purchasing power of their principal.

Inflation-indexed Treasurys are designed to compensate investors directly for the eroding effect of inflation. If inflation runs at 2%, the Government automatically increases the loan principal at the same rate of 2%. Since the purchasing power of the loan principal is protected from inflation, the regular interest payments don’t need to include any extra compensation. The yield on inflation-indexed Treasurys can therefore be taken as a direct measure of the real return that investors require on loans to the Government.

The difference between the yields on ordinary 10-year Treasury notes and 10-year inflation-indexed Treasurys provides an indication of the inflation rate that’s expected to prevail over the next ten years. Before the crisis began, expected inflation was running at around 2.5%. That was in line with the historical average for (expected) inflation. It was also consistent with the 2%-3% inflation range that the Federal Reserve seems to have targeted in the past.

When the crisis began, expected inflation fell essentially to zero, reflecting investor concerns that the US might experience a ‘lost decade’ similar to what Japan went through in the 1990’s. As with the TED spread and the VIX index, however, inflation expectations have reverted toward normal levels lately, and are now only somewhat lower than they were before the crisis. Presumably, investors are no longer concerned about the possibility of a protracted recession (although many economists believe that there is still a substantial risk that the US will experience a lost decade).

What does all of this have to do with housing? Much has been made of the recent upturn in housing market activity. Housing starts have increased for several months in a row, as have sales and even, in some markets, prices. Take a look at the chart, below, which shows the Housing Market Index, published by the National Association of Home Builders.

The Housing Market Index (HMI) is a measure of builder confidence. It’s a good proxy for residential construction activity.

The HMI index fell significantly when Lehman Brothers collapsed. From a level of 17 in September, it fell to a record low of 8 in January. Unlike the other distress indicators above, however, the HMI index had begun deteriorating long before the panic began. It bounced back to 15 in the latest survey, but the bounce is mainly attributable to the end of widespread panic, not a general recovery in the housing market. The index is still far below the neutral level of 50, which would indicate an even balance of optimism and pessimism among builders.

Bay Area home prices have risen from their recent lows. Is that an indication that demand is finally turning around, or is it a one-time bounce, resulting from the end of the panic? My money is on the latter hypothesis. Considering the severity of the panic, it would be surprising if home prices didn’t bounce back when the panic subsided. The recession is still in full swing, however, and jobs are still being lost at a rapid pace. (Unemployment rose by 0.5% in May alone.) People who are banking on a continuing recovery in home prices are likely to be disappointed.