SERIOUS MONEY:THE MONTH of February ended on a sour note for equity investors as the stock market in the world's largest economy recorded its fourth consecutive month of decline, leaving prices no higher today than the heady days of the late 1990s.
Ben Bernanke, the current chairman of the US Federal Reserve, contributed to the gloom in his testimony before the House of Representatives Committee on Financial Services, which proved decidedly frank, unlike the indecipherable musings of his predecessor.
Bernanke highlighted the downside risks to economic growth no fewer than three times and he seemed to concur with the concerns espoused by Frederic Mishkin, a member of the Fed's interest rate committee, who commented in January that "decisive actions may be required to reduce the likelihood of an adverse feedback loop".
Further reductions in interest rates are sure to follow but it could be too late to prevent a self-reinforcing downturn.
The US economy has become increasingly dependent on the direction of asset prices in recent years and the pro-cyclical model extends from the financial sector to households. This means that the current consensus envisaging a short, mild recession could prove wide of the mark.
The recession may well be short-lived as fiscal stimulus boosts economic growth during the second half of the year but investors need to cast an eye to 2009 when the continued decline in house prices should act as a significant impediment to a healthy recovery.
A particularly instructive paper by economists Tobias Adrian and Hyun Song Shin demonstrates that the financial sector has become increasingly pro-cyclical in recent years as mark-to-market accounting and traditional risk management techniques have raised the sector's responsiveness to movements in asset prices.
The sector exhibits "a strongly positive relationship between changes in total assets and leverage" because banks target a constant level of leverage at market prices.
A rise in asset prices and the accompanying increase in balance sheet strength have the potential to create a feedback loop as the required adjustment in leverage leads to greater demand for the asset and a further increase in prices, which causes the process to repeat over and over again.
The need to adjust leverage and deploy surplus capital in response to a rapid increase in asset prices leads to an erosion in lending standards and inevitably even the most dubious of borrowers receive credit.
This seems to be an apt description of the reckless lending spree that occurred in the housing market. Unfortunately, the mechanism has now moved into reverse and asset sales combined with the limited availability of credit may amplify the downturn.
The upturn in the housing market was also accentuated by the ease with which banks could convert illiquid loans into marketable securities. Securitisation reduced the amount of capital required to make loans and accelerated lending growth in the process. Unfortunately, the banking sector has since been revealed as the ultimate supplier of credit to the non-banking system and the involuntary increase in risk-weighted assets requires a downward adjustment in leverage, which is being accentuated by the significant write-downs of asset values.
The household sector has also become increasingly sensitive to movements in asset prices in recent years as financial innovation enabled consumers to extract equity more easily from their homes.
Net equity extraction rarely exceeded 3 per cent of disposable personal income during the 1990s but over the past five years the percentage has typically been above 6 per cent and reached a peak of over 9 per cent towards the end of 2004.
The unprecedented use of mortgage equity withdrawals has seen the ratio of home mortgage liabilities to the market value of the outstanding housing stock increase from roughly 20 per cent in the mid-1990s to almost 50 per cent recently despite the surge in house prices.
The increase in leverage propelled household consumption to more than 70 per cent of GDP, an unusually high share for an advanced economy but the housing recession has severely reduced the ability to tap mortgage equity and the share is sure to fall.
The negative impact on consumption will be amplified by the traditional wealth effect. Research shows that, historically, a $100 increase in housing wealth leads to as much as a $9 rise in long-run consumption. Given that the value of America's housing stock has already dropped by $2 trillion, it is hard to believe that the blow to consumption will be immaterial.
The possibility of an adverse feedback loop is real as roughly eight million households already sit on negative equity and have a strong incentive to walk away from their homes. This would place downward pressure on prices and see more consumers in the red. Indeed, a further 10 per cent drop in asset values would see the number of households with negative equity rise to 16 million.
Financial markets continue to languish as they search for clues to the likely future direction of the US economy. Most believe that a recession will be both mild and brief but adverse feedback loops suggest that such a belief may be wrong.
* Liquidity, Monetary Policy, and Financial Cycles - Current Issues in Economics and Finance, Vol. 14, No. 1, January/February 2008 by Tobias Adrian and Hyun Song Shin Federal Reserve Bank of New York and Princeton University - Department of Economics
