We sold the cow for beans and the wolf blew down the house when we couldn’t afford the mortgage.
What fairy tales failed to teach us about economics, recession will.
The National Bureau of Economic Research determines when a recession occurs – or has occurred. Usually it is not declared until after the fact. However, the folk definition of recession is two consecutive quarters of declining gross domestic product (GDP).
We’re not there yet, but with a mortgage crisis and a credit crunch on our hands and inevitable decline in consumer spending looming, many economists say this is going to be one bumpy ride to grandmother’s house.
“Whether they call it a recession or not, if GDP falls in the first two quarters of 2008, and I believe it could, that’s bad,” said SDSU finance professor Dan Seiver, who authored the book “Outsmarting Wall Street” and publishes The PAD System Report. “Unemployment will go up, incomes will go down and some people will lose their jobs.”
Fueled by historically low interest rates, housing prices tripled between 1996 and 2006.
Banking on increasingly valuable collateral, lenders lent money to people who might not ordinarily qualify for loans. Buyers took advantage of the new, cleverly packaged financial instruments (interest-only, pay-option and adjustable rate mortgages with low teaser rates among them) that allowed them to buy more than they really could afford.
“People were stretched; they had very little discretionary income left,” said SDSU finance department chair Nikhil Varaiya (pictured in banner). “They thought they could refinance later, but values plummeted and one thing after another went wrong. A perfect storm descended.”
According to SDSU finance professor Xudong An, real estate generates 70 percent of local government revenues, creates nine million jobs nationally and comprises 27 percent of GDP. Consumer spending, the largest component of GDP, is strongly influenced by the health of the real estate sector. Where it goes, so goes the economy.
Last year, as more people defaulted on their mortgages, foreclosures rose 75 percent. This drove prices down further by increasing supply and dragging down neighborhood “comparables.”
“Things are going to be soft, for sure, at least through the end of 2008,” Varaiya said.
Down the rabbit hole
In hopes of averting recession, the Federal Reserve has cut interest rates significantly and several major lenders are offering delinquent borrowers a 30-day grace period to work out foreclosure alternatives.
Additionally, a stimulus package proposed by President George W. Bush is making its way back to his desk after winning approval in the House and the Senate. The main component of the package is a tax rebate of $600 for individuals and $1200 for couples.
If approved, the checks won’t arrive until late spring, and economists are cautious about their potential to reinvigorate the economy.
“It’s not clear whether these government stimuli tend to mitigate the problems,” Varaiya said. “In order to answer that question, you would have to go back to a time when the economy was in a recession and the government provided no stimulus. Fiscal stimulus requires additional spending that increases budgetary deficits and that can adversely affect the economy in the long term.”
While it’s more psychological than scientific, “bottoming out” has proved an important catalyst for economic improvement. When people feel the situation can’t get any worse, consumers re-enter the housing market and businesses resume hiring.
This process happened relatively quickly in recent downturns – in 1991-1992 and 2000-2002 – but economists say this time we don’t know exactly what’s down the rabbit hole.
The new financial instruments many people used to fund their home purchases – and subsequently defaulted – on were bundled into complicated, collateralized debt obligations and sold to banks. It is still unclear how much of this “junk” financial institutions are holding on to. As a result, banks are having greater difficulty obtaining loans.
“This recession would be different because we haven’t had this kind of major credit problem before,” Seiver said. “It’s not just the danger that consumers won’t spend, but also banks not being able to lend, and that’s a serious concern.”
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