Several items out this week confirm that the consumer is still bulletproof. Today, housing starts for February rose 2.58% to 1.769 million unit rate. Not only was the rise better than estimates, estimates actually called for a decline, but it was the highest level since December 1998. Pundits all seemed a little confused how housing can remain so active. We need to remember that economic activity will follow the money. Just like speculative internet companies popped up when capital was recklessly backing any dot-com idea. Now that mortgage financing rates are so low, is there really any wonder why housing continues to outperform the rest of the economy? The robust housing and refinancing activity has bolstered other areas of the economy as consumers are using their houses as ATMs.
With interest rates starting to move up, the boost to the economy from refinancings should diminish. This could actually have a rather dramatic effect. In a research report published by CSFB revealed just how much economic activity can be credited to refinancings in relation to historic norms. CSFB calculates that household sector income and net worth can usually explain consumer spending to within $100 billion. Currently the difference is $300 billion, six standard deviations from the expected amount of spending and the largest deviation ever recorded going back to 1953, and in all likelihood - ever. (On a side note, it was a "six-sigma event" that caused the collapse of Long Term Capital Management) CFSB looks into shifts in households balance sheets and refinancings for explanations. CSFB concludes that the wealthy have been the biggest dis-savers and since they have more assets and income there will not be any negative implications from the increased debt load. The report indicated that the cash withdrawn already will be enough to bolster the economy until the end of the second quarter. Since everyone knows the economy will be recovery in the second half of the year, consumer spending will not decline.
One problem with this analysis is comparing the level of debt vs. the level of assets when the debt is assumed after a rise in asset prices. But more importantly, in order for the economy to continuing chugging along, there needs to be incremental growth. Even if the debt is concentrated in the higher income households, consumer spending is already six standard deviations from the norm. For the economy to maintain growth, personal income will have to grow, net worth will have to increase or consumers will have to assume more debt.
There is more than an outside chance that the current recovery is the first "/" of a "W" shaped recovery. While there appears to be a pick up in manufacturing activity, there is not enough for business to start recalling workers on a large scale. Plus companies continue to announce layoffs. With investors starting to focus on profitability instead of revenue growth, companies will be reluctant to recall workers and wait until there is more evidence that a recovery is underway and sustainable. Employers are also facing higher healthcare costs, which will damper wage gains. Without an increase in incomes, the economy will have to rely on further asset growth or increased debt spending.
The report from CSFB included their estimates on the amount that has been "cashed-out" from refinancing. The report also included the percent of refinanings that cashed-out a portion of equity, the mean cash-out, and the number of loans refinanced. The number of refinancings that cashed-out was 53% in 2001, way below the 81% in 2000, but very close to the average of the previous six years, 52.8%. The last two refinancing booms were very different. During 2000, only 2.4 million loans were refinanced, compared to 6.7 million in 1998 and 4.4 million in 1999. However, 81% of the loans cashed-out a portion of equity, compared to about 53% during the previous six years. Additionally, the median appreciation of the property was 26%, double the appreciation rate experienced in the past. This appreciation led to a mean cash-out amount of $47,340, again twice the mean from the previous years. CSFB estimates that a cumulative $92 billion was cashed-out during 2000, which was more than 50% above the previous year. Clearly the 2000 refinancing boom was driven by the appreciation of the property and the desire to cash-out. In 2001, the percent of refinancing that cashed-out was close to the historic, at 53%. The amount cashed-out was only $25,200, still above the average but substantially below the previous years'. The 2001 boom was mainly due to the number of loans, 11.2 million, almost five time the number in 2000. This resulted in a whopping $152 billion being cashed-out in 2001, 63% more than 2000. The refinance booms of 2000 and 2001 added $242 billion to the U.S. economy. According the CSFB, only $201 billion was cashed-out from 1993 through 1999 cumulatively. Remember this only includes the amount cashed-out, it does not include the billions in additional discretionary income due to lower monthly payments for those that simply refinanced to pay a lower interest rate. Clearly, there has been an historic influx of discretionary money to the consumer.
The number of loans refinanced during 2001 is noteworthy because it indicates that the number of loans available to refinance in the future is very small. In fact, CSFB calculates that 90% of the mortgage loans are paying 7.5% or lower. With current 30-year rates around 6.5% and the common benchmark of requiring at least 100 basis points improvement in the interest rate to make refinancing attractive, only 10% of the outstanding mortgages are prime for refinancing. It is likely that these mortgages are much older and have paid a significant amount of the principle, which makes them less likely to get refinanced. With refinancing being unattractive to practically all mortgages, consumers will start running out of the extra octane that spurred the consumption binge. When consumption returns to normal levels based on income, there is little doubt that the economy will struggle. Consumer spending provided a constant tailwind as manufacturing and technology weakened last year. This tailwind will turn into a headwind as the economy attempts to gain traction coming out of the recession.
The influx of refinancing has benefited makers of durable goods and luxury items. Last week, Maytag raised forecasts for the first quarter as the company benefited from selling higher priced products. Maytag now forecasts a 20% increase in sales this quarter. The whole appliance industry experienced a 10% increase in shipments in January and February. One heck of a recession!