Greenspan Virtual Q&A

Here’s a brief and incomplete reaction to Alan Greenspan’s most recent comments on the housing market and the question of if there is a bubble and if there is a housing bubble. The Greenspan quotes and paraphrases are cut out of today’s WSJ article by Joseph Rebello (complete article included below):

GREENSPAN: “Most Americans who bought houses more than a year ago now have enough equity to ‘withstand any price decline other than a very deep one.’”

CUBETRADER.COM: What about people who bought this year?

GREENSPAN: “The vast majority appear able to calibrate their borrowing and spending to minimize financial difficulties.”

CUBETRADER.COM: What about the others? It’s like stock investors on margin, most of them manage their accounts so as to minimize financial difficulties, but when a “normal” decline turns into something more than that it usually doesn’t stop until it wipes the over-leveraged accounts. Those distress sales feed on each other as people rush to get out before things drop further. It’s called a self-reinforcing trend and the same thing develops (to the upside and to the downside) whenever you have groups of people making decisions and trying to anticipate the future decisions of others. Consider the “run on the bank” analogy, or run-of-the-mill currency crisis, investment rated bond cliff (ratings triggers), or Enron collapse. Same story, different players. It will happen as long as humans are making decisions in dynamic environments.

GREENSPAN: The debt-to-income ratio paints an unduly gloomy picture of the state of household finances. A more appropriate measure, he said, is the ratio of household net worth to income. Net worth is now five times household income, he said, up from a ratio of 4.5 for most of the last 60 years.

CUBETRADER.COM: But on a leverage balance sheet changes in net worth caused by changes in asset prices are magnified to the extent of the debt. For example on a balance sheet with 0% debt, a 25% change in asset value produces a 25% change in net worth. But on a balance sheet with 75% debt a 25% change in asset value entirely wipes out the equity. If balance sheets are now more leveraged, then, by definition, net worth is now more volatile. Leverage cuts both ways, Alan, remember Long Term Capital Management LTCM. And speaking about hedge funds, what about all of them that have sprung up since LTCM self destructed. Many of these hedge funds are actually funds of funds, often using leverage to invest in other leveraged hedge funds. And when hedge fund investors themselves use leverage to make their investments you’ve got leverage on top of leverage on top of leverage. That’s real nice on the way up, but when the herd spots danger there will be a stampede and the weak will get trampled.

GREENSPAN: Rising U.S. interest rates aren’t likely to change the outlook much. “Most consumer and mortgage loans have fixed rates, suggesting that debt-service payments respond only gradually to interest-rate changes … ,” he said. “Even in a rising interest-rate environment, debt-service ratios at least for a while should rise only modestly.”

CUBETRADER.COM: But asset prices, including house prices, are set at the margin, so what matters at transaction time is the rate at which a new borrower can get a mortgage, not the rate that the next door neighbor has. If rates go up, the price of assets, especially those that are financed with as much debt as houses, are pressured lower. It’s a simple teeter-totter. Of course other trends can overpower the interest rate effect, but unless those other trends never fade then eventually interest rates will matter and things will fall into balance.

GREENSPAN: Mr. Greenspan also expressed doubt that the recent rise of U.S. house prices constitute a speculative “bubble” that could be destabilizing if it pops. “While local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely in the United States, given its size and diversity,” he said.

CUBETRADER.COM: One of the signs you’re in a bubble is that people of Mr. Greenspan’s (current) stature are saying there is no bubble.

ECONOMY
Greenspan Downplays Worry About Rising Consumer Debt
By JOSEPH REBELLO
DOW JONES NEWSWIRES
October 19, 2004 10:50 a.m.

WASHINGTON — Federal Reserve Chairman Alan Greenspan on Tuesday played down fears that the rapid growth of U.S. household debt could trigger a crash in house prices, saying household finances appear strong enough to withstand a gradual increase in interest rates.

In the text of remarks prepared for delivery to a group of bankers, Mr. Greenspan said that although “some households are stretched to their limits” most are in “reasonably good shape.” Most Americans who bought houses more than a year ago now have enough equity to “withstand any price decline other than a very deep one,” he said. Besides, the ratio of household net worth to income has risen recently.

“The vast majority appear able to calibrate their borrowing and spending to minimize financial difficulties,” Mr. Greenspan said in prepared remarks to America’s Community Bankers. “Thus, short of a significant fall in overall household income or in home prices, debt-servicing is unlikely to become destabilizing.”

U.S. household debt has climbed rapidly over the last five years, raising the ratio of debt to disposable income to a record high of 1.2. Those numbers worry some economists who say households will find it increasingly hard to service that debt as the Federal Reserve raises interest rates. The Fed has raised its key interest rate by three-quarters of a percentage point since June and is expected to make another quarter-point increase next month. That would put the rate at 2%.

But Mr. Greenspan said the debt-to-income ratio paints an unduly gloomy picture of the state of household finances. A more appropriate measure, he said, is the ratio of household net worth to income. Net worth is now five times household income, he said, up from a ratio of 4.5 for most of the last 60 years.

“Some of the rise in the ratios of household debt to income may not be evidence of stress,” Mr. Greenspan said. “The dramatic increase during the past decade in home purchases by previous renters has expanded both the assets (that is, owned homes) and the liabilities (mortgages) of the total household sector without significantly affecting either overall household income or net worth.”

Mr. Greenspan said Fed researchers have found that about a tenth of the outstanding home-mortgage debt is attributable to renters who have bought homes since the early 1990s. That accounts for 1 percentage point of the annual growth of home-mortgage debt. Such purchases have accounted for much of the increase in the debt-to-income ratios, Mr. Greenspan said, but “one can scarcely argue that those previous renters are less well off since becoming homeowners.”

Rising U.S. interest rates, Mr. Greenspan said, aren’t likely to change the outlook much. “Most consumer and mortgage loans have fixed rates, suggesting that debt-service payments respond only gradually to interest-rate changes … ,” he said. “Even in a rising interest-rate environment, debt-service ratios at least for a while should rise only modestly.”

Mr. Greenspan also expressed doubt that the recent rise of U.S. house prices constitute a speculative “bubble” that could be destabilizing if it pops. “While local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely in the United States, given its size and diversity,” he said.

Under the circumstances, Mr. Greenspan said, a national crash in house prices is unlikely. “If house turnover and price increases both slow, and presumably mortgage-debt extensions on new homes do as well, increases in home-mortgage debt will slow,” he said. “Outright declines in mortgage debt seem most unlikely,” he said, because such debt has increased in every quarter since 1945.

Write to Joseph Rebello at joseph.rebello@dowjones.com1

URL for this article:
http://online.wsj.com/article/0,,SB109819690427749310,00.html