Economist Feldstein on the Recession:
‘There is a Risk It Could Be Very Bad’

“The key question for me is not are we in a recession, but how long and how deep will it be?” economist Martin Feldstein told a gathering of steel industry executives last month in Scottsdale, Ariz.

Feldstein, professor of economics at Harvard University and president and CEO of the National Bureau of Economic Research, was a featured speaker at last month’s annual meeting of Metals Service Center Institute and American Iron and Steel Institute members.

“Despite long-term structural problems like the fiscal situation, Medicare and Social Security, I think the U.S. economy is basically sound, strong and effective,” Feldstein said. “Short-term, the situation in the U.S. economy today is bad and it’s getting worse. There is a risk it could be very bad.”

Rising unemployment and the increasing cost of food and energy have led to reductions in personal disposable income. Household wealth has declined because of declines in the stock market and, more importantly, because of the falloff in home values. Consumer sentiment was recently reported at a low not seen since 1982, dampening retail sales.

In the business sector, industrial production and new orders for manufactured goods are on the decline. Residential construction is down nearly 40 percent vs. a year ago.

Some expect a modest slowdown and that the economy will rebound this summer due to the delayed effects of interest rate cuts, the tax rebates and the falling value of dollar, which has boosted exports. But Feldstein is not among them. “While all three will have a positive effect, I don’t believe they will be enough, individually or together, to keep this economy on a long-term expansion, given the other problems at hand.”

Though the Federal Funds rate has declined from 5.25 to 2.0 percent, long-term rates, especially mortgage rates, have not followed suit. “Monetary policy in this downturn doesn’t have the traction it had in previous downturns because of the conditions in the housing and credit markets,” Feldstein said.

The tax rebates will give a temporary boost in the third and fourth quarters, but once that money has been spent, the economy will see a corresponding decline in GDP, he predicted. “I was a supporter of that tax rebate, and I thought it would particularly help to strengthen consumer confidence. But consumer confidence has fallen sharply month after month.”

The weakening of the dollar is clearly helping to boost business among companies that sell overseas, but exports represent only 7 percent of U.S. GDP. So even a substantial improvement in exports is not going to have much of an effect on overall economic activity, Feldstein said.

Looking at history, the last two U.S. recessions were short, about eight months from peak to trough. The early 1980s saw a more protracted downturn that lasted 16 months. “The current recession could be as severe or even more severe than that recession in the early ‘80s, because this recession is different than the last three,” Feldstein explained. “In each of those three previous recessions, the economy turned down because the Federal Reserve was fighting inflation and pushed short-term rates up to a very high level. Once the economy slowed, they reversed direction and allowed the interest rates to fall. This time the Fed didn’t cause the recession by tightening money, so it cannot simply reverse its policy and bring us out of it.”

This time, the downturn is caused by the interaction of unprecedented events in the housing and credit markets. In the housing sector, the 40 percent slump in new-home construction is a symptom of three factors: the pricing bubble earlier in the decade, high loan-to-value ratios and the syndication of mortgages, he said.

Home prices jumped 60 percent from 2000 to 2006. “Prices were so out of line relative to construction costs and rents, it was inevitable that they would start to correct, and they did in mid-2006,” Feldstein said. Since then, housing prices have declined in every major region of the country by an average around 15 percent. In the last few months, they’ve been dropping at an accelerated 25 percent annual rate. Housing experts say there are more declines to come before prices reach a sustainable level.

Meanwhile, millions of mortgage holders are finding that they now owe more than their homes are worth. Unlike in the past when banks required a 20 or 30 percent down payment on a home, lenders of late were willing to issue 100 percent mortgages, assuming that the real estate would soon appreciate and the loan-to-value ratio would recede to a comfortable level.

“That worked early in the decade when housing prices increased 10 to 15 percent per year. Then in 2006, when housing prices started to decline, loan-to-value ratios started to climb,” said Feldstein. Recent estimates suggest that more than 8.4 million mortgage holders now have negative equity, a figure that could soon top 10 million. More than 1.8 million mortgages are in default, and that number is growing.

In the United States, a mortgage is a non-recourse debt. If a mortgage holder defaults, the creditor can take the property but cannot attach other assets or earnings. So once their mortgage obligation is worth more than their house, negative equity homeowners have an incentive to simply walk away from the debt. “Past experience shows that most Americans don’t walk away even when they have negative equity, but I’m afraid with the current situation there could be a change in the social norms of this country with respect to defaults,” Feldstein said.

In the past, if a person suffered a financial setback such as a lost job or major medical bills, he could sit down with his banker and ask for help. Usually the banker would lower the interest rate or extend payment terms to avoid a default. Today, because of mortgage securitization, there is no understanding banker to negotiate with. Most mortgages have been sliced up and sold to third parties such as government-sponsored entities like Fannie Mae or Freddie Mac. These third parties pool millions of mortgages and sell the payment rights to investors as mortgage-backed securities.

“This combination—-sharply declining prices, high loan-to-value ratios and securitization of mortgages—is extremely dangerous,” Feldstein said. “One of the biggest risks our economy faces is a continuing downward spiral of housing prices. No one really knows how this is going to end, but as house prices fall, household wealth falls, and so does consumer spending.”

With widespread uncertainty about the value of assets and the solvency of financial institutions, the credit markets are in turmoil. “We are seeing a dramatic shrinking in the willingness of financial institutions to create credit. Without credit, it’s hard to have economic growth,” Feldstein said.

How is government policy responding? “In a word, inadequately,” he continued.

Slow to recognize the problem, the Fed eventually cut short-term lending rates. Typically, long-term mortgage rates would follow, boosting residential construction, “but who wants to build new housing when the market is overwhelmed with existing homes.”

Indeed, mortgage rates have remained relatively flat. Due to the dysfunctional nature of the credit market, and because so many borrowers no longer qualify for loans, reductions in interest rates have not created much additional lending. “If you can’t get a loan, it doesn’t matter if the interest rate has been lowered. So a primary effect of reducing interest rates to stimulate the economy is simply not there,” Feldstein said.

One positive effect of the Fed’s rate reduction is a weakening of the dollar, causing it to become more competitive vs. foreign currencies and helping to boost U.S. exports. But it has also fanned the increases in commodity prices, which have added to inflation pressures.

“At this time there is nothing more the Federal Reserve can do to stimulate the economy or prevent the downward spiral in home values,” Feldstein said.

Congress and the Bush administration are debating various proposals for government intervention in the mortgage and credit markets designed to keep thousands from losing their homes. So far they’ve all met opposition from taxpayer groups who rightfully ask, “Why should we bail out irresponsible lenders and borrowers who chose to gamble on risky mortgages?”

Feldstein advocates a loan substitution program in which the federal government would lend participants 20 percent of their current mortgage. “To lower the risk of a downward spiral of house prices and to revive the frozen credit markets, the government must move quickly to reduce the potential number of mortgage defaults. A loan substitution program would act as a sort of circuit breaker,” he said.