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Nomura R.Koo 2012-02-21

Nomura R.Koo 2012-02-21

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Published by: mm18881 on Feb 22, 2012
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Richard Koo
Real meaning of monetaryaccommodation in Japan andUS
February 21, 2012
Global stock prices received a boost over the last two weeks in the form of favorableeconomic data from the US and falling yields on Spanish and Italian debt.Japanese equities were late to join the party but finally responded to the BOJ’sannouncement of further monetary easing and a weaker yen.Meanwhile, the response to the problems in Greece continues to stumble, with someEuropean officials now hinting that the region might be better off with a Greek default.US house prices remain in a deep slump, and Fed chairman Ben Bernanke warned ina speech on 10 February that the housing market had fallen into a vicious cycle.
Why Fed extended ultra-low interest rates through end-2014
Mr. Bernanke’s speech (“Housing Markets in Transition,”http://www.federalreserve.gov/newsevents/speech/bernanke20110210a.htm) wasdelivered at a meeting of the National Association of Homebuilders and gives a goodindication of how the Fed views the US housing market.I found the speech extremely interesting because it casts light on the question of whythe FOMC pledged to keep interest rates at exceptionally low levels through the end of 2014.On the subject of housing market supply and demand, Mr. Bernanke noted there arecurrently 1.75mn empty homes in the US, compared with a more typical figure of 1.25mn units, and said the excess supply is weighing on the market.He also said an average of 2mn units a year had entered the foreclosure process ineach of the last few years and that this form of housing supply was expected tocontinue.On the demand front, the Fed chairman noted that household formation had declinedespecially for young adults. This was probably because the recession left younggraduates unable to find work and forced them to continue living with their parents.He also said the high unemployment rate and job market uncertainty left many newfamilies hesitant to buy a home.
Housing myth’s collapse strips away investment appeal
Other factors cited by the chairman as weighing on demand include the continueddifficulty of obtaining a home loan and the fact that housing has lost much of its appealas an investment.Analysis conducted by the Fed suggests that while US house prices have fallen about30% in nominal terms from the peak, the real decline is closer to 40%—not becausethe US is experiencing deflation but rather because other prices have risen modestly inthe meantime.
Richard Koo is chief economist at Nomura Research Institute. This is his personal view.
Richard Koo
To receive this publication, pleasecontact your local Nomurarepresentative.
See Appendix A-1 for importantdisclosures. Analysts employedby non US affiliates are notregistered or qualified asresearch analysts with FINRA inhe US.
Japanese version published onFebruary 20, 2012
Nomura | JPNRichard Koo February 21, 2012  
An effective 40% fall in house prices after 70 years of steady increases exploded the myth that houses were always a goodinvestment—much as Japan’s land myth collapsed in the 1990s—and prompted those who were buying in anticipation of speculative demand to leave the market.Until 2007 in the US (and until 1990 in Japan), home buyers were encouraged by the belief that prices would always go higher no matter how much they paid. As long as this myth persisted, houses were considered a safe asset as attractive as—if notmore attractive than—bank deposits.But the collapse of this view after 70 years and an effective decline in prices of almost 40% prompted homebuyers to becomemuch more cautious. Like their Japanese counterparts in the 1990s, they began using a very different yardstick to examinepotential purchases.Demand plummeted as a result, and US housing starts have averaged less than 500,000 units a year since 2009 after a 15-year period when they never once slipped below 1mn units.
More than half of homeowners’ equity has vanished
Mr. Bernanke also said the drop in house prices has caused more than half of homeowners’ equity to disappear, with lossesamounting to $7trn.He estimated that some 12mn homeowners—representing one in five mortgages—are now underwater as a result.The Fed chairman cited several studies estimating that a $100 drop in housing value depresses annual consumption by $3 to$5 and concluded that the fall in house prices thus far had reduced private consumption by $200bn to $375bn.
Reaction to excessive mortgage securitization
From a financial perspective, the outstanding value of home mortgages has fallen 13% from the 2007 peak in response to a risein defaults, a decline in new purchases, and banks’ unwillingness to lend. Regarding the final factor, Mr. Bernanke argued thecurrent credit crunch is attributable in some measure to past excesses in the securitization of home mortgages.The GSEs (government sponsored entities like Fannie Mae and Freddie Mac) demand insurance when purchasing homemortgages from financial institutions for securitization purposes, but the sharp increase in defaults over the last few years hasleft many of the providers of this insurance struggling to survive.The surviving insurers have become far more cautious as a result, and that has forced banks to become more cautious as well,since uninsured home mortgages cannot be sold to the GSEs.
GSEs and FHA only functioning cogs in US mortgage market
A second issue is that the dramatic increase in defaults has prompted the GSEs and other investors who purchased these loansto seek restitution from the originating banks.This is a reaction to the excessive availability of credit and securitization of home loans in the past, and the securitization marketis unlikely to revive until the extent of legal liability at the originating banks is clarified.New home mortgage securitizations by private entities remain extremely rare. The GSEs and the Federal HousingAdministration are essentially the only players still active in the securitization market.The issues of mortgage insurance availability and the legal responsibility of loan originators need to be resolved if this market isto regain its earlier vitality. Even if these questions are resolved, I do not think we will ever again see home loans being offeredwith the same kind of perfunctory credit checks witnessed during the housing boom.
End to US housing myth could have greater impact than in Japan
The issues facing the US housing market are numerous, ranging from the breakdown of the housing myth to the need to rebuilda securitization infrastructure. In a sense, I think the US may be worse off than Japan.The US economy, after all, is far more dependent on the housing market than Japan’s ever was, with a slump in the housingmarket having a correspondingly large impact on the broader economy. Housing was reportedly responsible for most of thegrowth in the US economy in the five years leading up to the market peak in 2007.The externalities in the US housing market are also far larger than those in Japan, where no one would expect a foreclosedhome to reduce the value of other properties in the neighborhood.The asset value of US housing, meanwhile, is influenced by the surrounding environment as well as the house itself. Neighborsoften complain if a resident lets the grass in his lawn grow a bit longer than usual. As many foreclosed homes are a mess bothinside and outside, the appearance of even one in a neighborhood can lower the value of nearby homes.
Extension of ultra-low rates reflects time needed to resolve problems
Mr. Bernanke said that 1mn foreclosed properties could be added to the housing supply in each of the next few years.Such properties are referred to in the industry as real estate owned, or REO. The Fed chairman said houses currently inforeclosure are more than four times as numerous as the entire existing inventory of REO.
Nomura | JPNRichard Koo February 21, 2012  
The Fed also estimates that only half the REO properties owned by the GSEs have been put on the market. That alone has ledto heavy downward pressure on prices, and conditions are likely to grow far worse if the entire REO inventory is put up for sale.These numbers suggest a great deal of time will be needed for the US housing market to turn around. I think that is the primaryreason behind the FOMC’s pledge to keep interest rates at exceptionally low levels at least through late 2014.
REO properties weighing on house prices
Mr. Bernanke said in his speech that the supply of REO properties would likely exert continued downward pressure on houseprices, and house prices are in fact falling.Sustained declines in house prices make adjustments that much more difficult and further postpone the eventual recovery byaggravating private-sector balance sheet problems.In Japan, it was not until asset prices finally bottomed in 2003–04 that people were able to adopt a forward-thinking mindsetonce again. As long as asset prices are falling, people are unable to determine how bad their own balance sheet problems areand therefore become increasingly cautious. A reliable bottom in asset prices enables them to calculate how many years it willtake to clean up their balance sheets.
Bernanke realizes balance sheet adjustments will take time
In a separate speech, the Fed chairman recently compared and contrasted Japan and the US, noting that Japan had beenforced to take a trial-and-error approach to its crisis because there was no precedent at the time, but that the US is able to applythe lessons learned by Japan. The Fed’s decision to take seriously the issue of private-sector balance sheet adjustments andextend exceptionally low rates until the end of 2014 is an excellent example.Ten years ago Mr. Bernanke singled out the BOJ for criticism, arguing Japan’s economy would improve immediately if only theBank had the courage to undertake quick, bold monetary accommodation. Since 2008 the Fed has faced the same problem asthe BOJ did and has responded with quick, bold easing, but thus far has very little to show for it.The end of 2014 will mark a full eight years from the peak of the US property bubble in 2007. In effect, the Fed hasacknowledged that any recovery will take time when the private sector faces balance sheet problems and that bold monetaryeasing alone will not be enough to resolve the problem.
Ordinary consumers may not be as pessimistic as financial sector 
Conditions in the US economy have improved substantially, as reflected in jobs growth and a falling unemployment rate.Purchases of automobiles and other durable goods requiring a certain degree of confidence on the part of consumers regardingthe future have also increased.I attribute the newfound strength in consumption to two main factors: (1) excessively pessimistic expectations among thefinancial sector analysts responsible for compiling market forecasts and (2) a release of pent-up demand that has been buildingsince the bubble collapsed four years ago.Regarding the first, the financial sector has become extremely cautious after experiencing first the Lehman-triggered financialcrisis and now the sovereign debt problems in the eurozone, which have the potential to develop into a crisis of similar magnitude to the Lehman shock if not properly addressed.But for ordinary Americans the problems in the eurozone across the ocean may seem largely immaterial. Many find it difficult tograsp the significance of the events unfolding in Europe— partly because of the distance and complexities involved—and thatmay be one reason why they were less pessimistic than financial sector analysts.
Ignorance is bliss” not a sustainable basis for recovery
This may be a variation on the old saw that “ignorance is bliss.” It may also be that people are finally starting to make thedurable goods purchases they have been putting off since the bubble burst four years ago.The recent stabilization of the economy may have also prompted some workers to resume taking out loans based on the belief that their jobs are safe for now. And US consumer credit is in fact increasing.All of this is welcome news; the question is whether it is sustainable. Recent jobs growth is a major positive in that it boostsincomes, but it continues to be offset by the aforementioned slide in house prices.As the Fed chairman noted in his recent speech, US economic recoveries have historically been supported by a rebound inhousing construction. With no such revival in sight, I suspect the US economy will continue flying on a single engine.The strong economic data may continue until the surge in pent-up demand winds down, but the slowdown in China and other overseas economies means any recovery is likely to be gradual at best.
Is acceptance of Greek default real or a bluff?
As yields on Italian and Spanish debt have fallen, some senior eurozone officials have had a change of heart and are starting tosay it would be better to let Greece default than to exert further effort in an attempt to prevent that outcome.

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